High Leverage for Apartment Loans Troubles Moody’s

With prices so high for apartment properties, any loan based on today’s appraised values is going to look very large compared to historic prices. But multifamily CMBS loans are especially troublesome, according to Moody's Investors Service.

“The credit quality of U.S. conduit/fusion commercial mortgage-backed securities (CMBS) continues to deteriorate, with conduit loan leverage in the second quarter pushing past its 2007 peak,” reads a July report from Moody’s.

These loans may look relatively modest compared to the appraised value of the apartments properties now. But if prices were to fall, a number of these loans might be in serious trouble. Lending experts argue that problems may be mitigated by stronger loan underwriting standards overall. Also, property prices may have even more room to rise relative to the income from apartment properties, and don’t have to fall anytime soon, as interest rates creep upwards, according to some apartment experts.

“Lenders are holding to pretty good underwriting standards,” says Bill Hughes, senior vice president for Marcus & Millichap Capital Markets. For example, lenders still resist to the urge to offers loans with interest-only periods longer then a few years, unless the loan is relatively low leverage, covering less than 60 percent of the property’s appraised value.

Moody’s: Underwriting way past the peak

The average CMBS loan was equal to 117.8 percent the value of the property in the second quarter, as measured by the Moody’s loan-to-value (LTV) metric. That’s very high–largely because Moody’s LTV compares loans to historic property values, instead of the high values that properties are appraised for in today’s market. The average CMBS loan was equal to 66.4 percent on average of the underwritten value of its property over the same period, according to Moody’s.

“The appraisals on Q2 collateral fully reflect the run-up in commercial property prices to levels that top the pre-crisis peak, while our values use a through-the-cycle approach,” according to Moody’s.

Just to compare, in the third quarter of 2007 the average CMBS loan has an average Moody’s LTV of 117.5 percent on average of the underwritten value of its property over the same period. In response to rising leverage, Moody’s is getting tougher in its CMBS ratings, giving fewer bonds in every CMBS issue the coveted AAA rating because the rating agency expects losses.

“Loans sized to 70 percent of peak values likely will under-perform those sized to 70 percent of trough values, as can be seen by comparing loans from the 2007 peak with those from mid-cycle 2003,” says Tad Phillipp, Moody's director of commercial real estate research.

Sky-high prices

The issue of leverage affects the whole business of lending to apartment properties, not just the CMBS business, because it is driven by high prices for apartments.

Lenders are still avoiding some of the worst practices of the real estate boom, however. For example, lenders still require borrowers to show the expenses from a property on a trailing, 12-month basis, says Hughes. Also, borrowers typically can’t get away with forecasting rents that would justify a larger loan, even though the property has now history of earning those high rents.

“I’m not really seeing any of that,” says Hughes. That restraint makes measurements like a loan’s debt service coverage ratios much more meaningful today than it was during the last boom, when giant loans were made based on rosy projections of high rents and low expenses.

Even though apartment properties are selling at historically high prices, by at least one measure prices have room to rise even further. Apartment properties now sell at average cap rates of 5.5 percent. That’s 320 basis points higher than the yield on 10-year Treasury bonds. Just to compare, in 2006 at the height of the boom, cap rates were just 100 basis points higher, according to Institutional Property Advisors.

Cap rates are likely to get a little closer to the yield on 10-year Treasuries. “As investors seek opportunities in secondary and tertiary markets throughout 2015 and compress cap rates there, the spread nationwide to the 10-year will continue to narrow,” according to Institutional Property Advisors.

Interest rate outlook: Federal Reserve

The benchmark yield on 10-year Treasury bonds is also likely to stay relatively low for a long time. “Even the anticipated increase in the Federal Reserve’s benchmark later this year will likely have minimal short-term effect on long-term rates,” according to Institutional Property Advisors. That’s because the bond markets have expected the Fed to inch rates upwards for a very long time, and there is not much in the latest economic reports to pressure the Fed to act quickly. A strong dollar and low energy prices are helping keep inflation below the Fed’s target of 2 percent. “The Fed has the maneuvering room to adjust rates very slowly,” according to Institutional Property Advisors.

2015 Real Estate Forecast

Improving commercial property fundamentals, a steady stream of offshore capital and an accommodating Federal Reserve interest rate policy will sustain robust property investment in 2015 as buyers keep seeking yield and safe havens in the U.S.

But rising interest rates, the cooling of energy markets amid oil's price plummet, and other variables threaten to thwart those expectations. What's more, 2015 could be the year that reveals whether escalating property prices are sustainable, especially as underwriting becomes more aggressive.

Among other trends, buyers are building more ambitious rent-growth assumptions into their underwriting to make increasingly expensive deals pencil out, says Kenneth Riggs Jr., CEO of Houston-based Real Estate Research, a national commercial property valuation and consulting firm. That's a departure from the more recent conservative practice of pegging rent growth to inflation, he adds.

Up to this point, I think value and price have been in alignment," said Riggs, whose firm was acquired in February by global commercial real estate and loan advisory Situs. "But I think we're at an inflection point and may be getting ahead of our skis. Next year we may see price outpace value."

Momentum Continues
Through November, commercial property buyers and sellers had completed nearly $366 billion in U.S. deals in 2014, topping dollar volume for the full year of 2013 by almost $5 billion, according to Real Capital Analytics, which tracks sales of more than $2.5 million.

Capitalization rates have been trending down for most major property types over the last several quarters, indicating more aggressive pricing in anticipation of continued strong investment demand and low cost of capital. The rates measure a property's initial yield for the owners, and they fall as prices rise.

The average cap rate for office and industrial buildings in November marked a year-over-year decline of 50 basis points for each property type, to 6.6% and 7.1%, respectively, Real Capital says. Apartment properties fell 50 basis points to 5.8%.

Hessam Nadji, chief strategy officer for property brokerage Marcus & Millichap (NYSE:MMI), anticipates that vacancies in 2015 will keep tightening for most property types.

Retail properties could see the most pronounced improvement, Nadji says, with average vacancy rates dropping by 60 points next year to 6% nationally in light of growing small-business confidence. In November, the National Federation of Independent Business' small-business optimism index surged 2 points over October to 98.1, a slightly higher reading than the 40-year average. Apartments, however, may see vacancies rise nationally from a current average of around 4.5% amid increased supply, Nadji adds.

From an individual-markets viewpoint, the plunging price of sweet crude oil to less than $60 a barrel from around $100 six months ago could dent investment in cities tied to the energy sector, which along with technology markets have led the nation's commercial property recovery.

Much of the focus will be on Houston, where some 17.3 million square feet of office space was under construction in the third quarter, according to brokerage CBRE Group (NYSE:CBG). In a Houston report this month, CBRE noted that a "steep fall in oil prices" would have to last a couple quarters before energy companies would alter drilling and production projects, which are planned on a long-term horizon. But it said eliminated or scaled-back projects would ultimately reduce office demand in the market.

While Houston's average office rental rate climbed 4.4% to $26.81 per square foot in the third quarter from a year earlier, the average vacancy rate ticked up 20 basis points to 14.4% over the same period, Reis says. The fall in oil prices has caught the attention of Riggs, whose firm ranks the city as one of the top-performing property markets in the country.

"Houston's economy is more diversified than it used to be," he adds, "but falling oil prices will definitely slow the momentum."

Interest Rate Question

Rising interest rates could derail property investments on a broader scale. Yet observers who expected rate increases over the past few years now say that they wouldn't be surprised if interest rates begin and end 2015 without much change.

Still, investors are aware of higher-interest-rate risks, says Gerry Trainor, executive managing director of capital markets for Houston-based property brokerage Transwestern.

"But all in all, they're moving forward because it's anybody's guess as to what happens," said Trainor, who is based in the company's Washington, D.C., office. "I don't think anybody anticipates a big, sudden rise."

The yield on the 10-year Treasury note, a benchmark for conventional commercial real estate loans, would likely have to jump more than 80 basis points to around 3% or higher before investment activity would slow materially, adds Riggs. But the yield will stay lower longer than what most people expect, he argues.

"There's a tremendous weight on keeping Treasury yields down because of global uncertainty," he said.

Nadji notes that oil's recent price decline, combined with slowing economies in Asia and Europe, prompted overseas investors to buy U.S. Treasury notes in a flight to safety that pushed the 10-year yield down some 50 basis points over the last three months.

"In addition, any substantive rise in interest rates would be accompanied by strong economic and employment growth," he added, "both of which will boost demand of commercial real estate."

Similarly, a greater cost of capital won't deter foreign real estate investors who pay with cash, notes Avi Benamu, managing partner of New York-based real estate investment manager Winchester Equities. Like offshore Treasury buyers, individuals and families in the Middle East, Russia and other areas seeing strife are buying properties in the U.S. to protect their wealth, he says.

"Even if property prices seem a little bit unreasonable they'll just park their cash in the U.S. because they know it will be safe here," Benamu said. "The money is just flowing in."

Amid the trends, CBRE and Jones Lang LaSalle (NYSE:JLL) — the two largest companies by market cap in IBD's Real Estate-Development/Operations industry group — have risen by 33% and 48% in the stock market this year, respectively.

Real-Estate Funds Needn't Be Riled by Rising Rates

Investors have pulled money out of real-estate funds for two straight months, even though they remain among the year's best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.

Before joining the crowd, bear in mind that rising rates don't always mean losses for real-estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real-estate fund managers say they can still make money for investors, though they acknowledge that the performance won't be as good as this year and the recent past.

"One of the things you have to ask is why are rates rising," says John Wenker, co-portfolio manager of Nuveen's Real Estate Securities fund since 1999. "If rates are moving up moderately because the economy is starting to strengthen, that's fine for commercial real estate."

For real-estate funds, dividends are king. Most invest in real-estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.

Because they pay out so much of their income as dividends, REITs attracted income investors who grew tired of the low yields offered by bonds. That demand helped the average real-estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor's 500 index over the same time.

One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors to dump them and go back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.

Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real-estate fund into the red in the last three quarters of 2013. For the year, the average real-estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.

REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.

The economy hasn't been as strong as many had hoped, but it is improving. Many economists believe growth next year will be the strongest since 2005. The unemployment rate is also at its lowest level since 2008, and the job market is strong enough that the Federal Reserve earlier this week announced the end to its bond-buying program. The central bank could begin raising its target for short-term interest rates next year, and many economists expect a measured rise.

Investors have pulled money out of real-estate funds for two straight months, even though they remain among the year's best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.

Before joining the crowd, bear in mind that rising rates don't always mean losses for real-estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real-estate fund managers say they can still make money for investors, though they acknowledge that the performance won't be as good as this year and the recent past.

"One of the things you have to ask is why are rates rising," says John Wenker, co-portfolio manager of Nuveen's Real Estate Securities fund since 1999. "If rates are moving up moderately because the economy is starting to strengthen, that's fine for commercial real estate."

For real-estate funds, dividends are king. Most invest in real-estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.

Because they pay out so much of their income as dividends, REITs attracted income investors who grew tired of the low yields offered by bonds. That demand helped the average real-estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor's 500 index over the same time.

One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors to dump them and go back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.

Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real-estate fund into the red in the last three quarters of 2013. For the year, the average real-estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.

REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.

The economy hasn't been as strong as many had hoped, but it is improving. Many economists believe growth next year will be the strongest since 2005. The unemployment rate is also at its lowest level since 2008, and the job market is strong enough that the Federal Reserve earlier this week announced the end to its bond-buying program. The central bank could begin raising its target for short-term interest rates next year, and many economists expect a measured rise.

Troubled CMBS Debt to Get Permanent Homes

Summary:  CWCapital Asset Management LLC, a loan servicer, is eager to unload troubled mortgages from their book.  It would seem they fear on missing out on an easy lending environment (rising property values, low interest rates).

--(WSJ Blog)--

Firms overseeing troubled commercial real estate mortgages may suddenly be in a hurry to sell the debt after years of trying to find a better solution for investors.

The $2.57 billion sale of mortgage loans and commercial properties from CWCapital Asset Management LLC in coming months suggests the loan servicing firm may want to take advantage of rising prices and investor demand before they fade, perhaps at the hands of higher interest rates, said Harris Trifon, head of commercial and asset-backed bond research at Deutsche Bank.

The Moody’s/RCA national all-property composite index has increased 42.1% from the trough in December 2009 to July this year, a period largely accompanied by falling interest rates. Lower interest rates can make buildings more valuable because it takes less revenue to support debt.

“Values (of commercial properties) have increased throughout the year, especially for core central business district markets, Mr. Trifon said. Rising interest rates, such as the jump seen in May and June, are “not going to be conducive to higher property values,” meantime, he added.

In aggregate, the sale of mostly office properties is the largest of its kind and only the third that has exceeded $1 billion in the last few years, Mr. Trifon says.

The source of such sales has already been declining as CWCapital and other “special servicers” have made significant headway in resolving loans in properties overburdened with debt. In September, about $53 billion of loans sat with the servicers, down from the peak of nearly $90 billion in late 2010, according to Trepp, a CMBS data provider.

CWCapital decided to sell the portfolio based on its recent transactions, and to capitalize on improvements in debt funding as well as the real estate recovery, David Iannarone, CWCapital’s president, said in a statement.

Some of the buildings in the CWCapital portfolio may have been held in a distressed state for years as the servicer sought ways to reduce losses to bondholders. A sale too soon could mean a fire-sale price, but fees and other expenses to bondholders can rack up as a defaulted loan goes unresolved.

CWCapital won’t publicly identify the properties, but the list probably includes some of the most storied commercial real estate assets financed at the peak of the real estate boom, Mr. Trifon says. Among them could be Two California Plaza, a Los Angeles office tower dogged by low occupancy and part of one of the largest commercial mortgage-backed securities ever sold.

As the default specialist, CWCapital began servicing the building’s $470 million loan in December of 2010, and foreclosed on behalf of investors a year ago, according to servicing notes posted on Trepp’s website. A January appraisal put the building value at $343 million, about 54% of the estimate when the loan was packaged into CMBS in 2007.

In addition to losses dealt to riskier slices of the bond, senior investors may also take a hit, warned Mr. Trifon. That’s because principal is repaid to the senior bondholders at face value, below the current premium price that accounts for the bond’s higher interest rate.