Over the last 10-15 years commercial real estate has moved from a predominately local/private to an international/market enterprise due almost exclusively to the maturing capital markets for real estate backed paper, specifically CMBS. Likewise residential real estate also changed from a local to an international business because of RMBS. The subprime meltdown has caused significant, but not irreparable, harm to the industry. The result of this crisis will be a decline in real estate values, not just residential, but commercial. It seems to me this issue goes back to the fundamentals that we learn in economics of supply and demand. Inherent in the supply and demand model is the assumption of liquidity, an agreeable currency to facilitate the trade. That currency in real estate is bonds. Investors in CMBS have left the house which has disrupted trade between buyers and sellers of CRE (just as it has hammered buyers and sellers of residential real estate). Cheap, easy credit made the world go-a-round, it drove up values, which drove up returns, which brought more buyers to the dance, which in turn drove up values. Now the credit is gone, the music has stopped, and many have gone home. The potential recession aside the underlying supply and demand fundamentals for CRE have not changed significantly over the last two years the difference this time around is that liquidity drives the market and with $200 billion of the table in 2008 (the ballpark reduction in CMBS issuances from 2007) it impacts all participants.
What I see from my vantage point are developers for whom the world has changed, users (e.g. drug stores) who continue to price deals like they did in 2006, traditional lenders who have taken a couple of big steps backward, and a non-functioning CMBS arena. Where is this going? I suspect that the CMBS market will return, those with a vested interest say it has to, but probably in a different format and running on lower horsepower. Deleveraging continues, developers will get used to this though the pain is significant now. Gap players will become more important, mezz, hard money, bridge, private equity sources will all have a place at the table where prior to the crash 75% to 85% senior positions were common, sometimes even higher if there was a value play (and lenders bought into pro forma numbers). It will take more creativity and work to build the capital stack for even the typical deal. Developers will probably start to use more early stage funding as commercial banks will be less willing to go too far out on the risk curve. With more players in the capital stack the cost of capital will increase which will force up costs for new projects and create an inflationary environment in CRE over the longer term. For the short term, higher capital costs mean that investors will have to pay less to generate the returns the same returns.
Consider a Walgreens purchased in 2006 for a 6.00% cap with $375,000 NOI, the purchase price would have been $6,250,000. The ROE (EBTDA/Equity) on this asset with an 80% LTV at a 5.79% interest rate is 6.84%. Today the same asset would be valued at $5,393,355 with a 70% LTV and a 7.00% interest rate to generate the same 6.84% ROE.
This is to say, that for the same asset between 2006 and 2008 the value has declined $856,645, a 95 BPS increase in the cap rate. Why, higher interest rates and lower leverage require a lower asset value to generate the SAME return on equity. Are market participants willing to take a lower ROE than they were in 2006? Probably not as the risk in the market has increased significantly, arguably they would demand a higher ROE which would push prices down further. Buckle your seatbelt, it will be a bumpy ride…
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