Since the Great Recession of 2008/2009, the steady growth in the commercial real estate capital and lending markets has led many real estate professionals and commentators to look for signs that this expansionary cycle would be ending. Historically, most real estate recoveries tend to last for approximately seven years. As we enter the eighth year following the Great Recession, this recovery is different. It has been one of steady but moderate growth. Based upon the tremendous upheaval caused by the Great Recession, lenders and investors have remained conservative and moderated their behavior – although, in the case of lenders, some of this was required due to government regulation. In addition, interest rates have rarely, if ever, remained at such historically low rates for so long. Despite predictions that the Federal Reserve would more aggressively raise the discount rate in 2017, this has not proven to be the case.
Job growth remained steady in 2017, although slightly less than that in 2016. Real gross domestic product increased slightly from 2016, and inflation remained low. Despite all of these positive economic indicators, wage increases for Middle America remained largely flat. The wage inequality gap continues to remain significant leading to less than robust customer demand for entry-level new housing and goods and services. The recently passed Republican tax bill should significantly stimulate the economy in the short term; however, it remains to be seen if the large budget deficit it creates will eventually lead to economic troubles. It also remains to be seen if the Republican tax bill will close the income inequality gap.
Most recoveries that end with a “thud” are those that started with a “boom.” Since this recovery never experienced the “boom,” but rather a very slow and conservative recovery, most economists do not now foresee a “thud.” As noted in 2017 Emerging Trends in Real Estate (published by the Urban Land Institute and the accounting and consulting firm pwc) (“Emerging Trends”), [s]uch a defensive posture has translated into discipline on both the equity and the debt side…[the] trends in lower leverage … are taken as the key lesson learned from the previous hard landing. As one money manager put it, ‘People don’t lose money on the real estate, they lose it on leverage.’”
In our capital markets forecast from last year, we discussed the uncertainty of the “Trump Factor.” We defined the “Trump Factor” as being the many contradictions of a president whose pro-business policies inspired confidence in the business community, but whose unpredictability, nationalism and hawkish rhetoric regarding other countries often times caused great concern among investors. Notwithstanding the “Trump Factor,” the commercial real estate industry seemed to be largely unaffected in 2017. In addition, the President’s pro-business policies appear to have stimulated the stock market and consumer confidence.
2017 was a year in which journalists and commentators grossly overestimated the impact of e-commerce on retail. Although e-commerce is very definitely causing the transformation of “brick and mortar” retail, shopping centers are here to stay. People are “social animals” that enjoy the interaction with others at shopping centers. This has not changed since the inception of public markets hundreds of years ago. However, some major trends are developing in retail. For the most part, departments stores will not survive in regional malls that are not located in “A” markets. However, they will continue to thrive in the right locations so long as they continue to adapt to meet current market demands. Shopping center developers are continuing to reposition their tenant-mixes with retailers that provide products and services that are largely immune from internet sales. Supermarkets, drug stores, theaters, fitness facilities, restaurants and medical and entertainment uses continue to thrive. In addition, discount apparel retailers (e.g., Ross and Marshalls) and high-end luxury retailers (e.g., Tiffany and Coach) are also doing well in the right shopping centers. “Experiential” and “omni-channel” seem to be the buzz words heard over and over when discussing successful shopping centers and retail. Retail developers that provide customers with an “experience” that cannot be replicated on-line will be successful, as will retailers with excellent products and customer service that provide consumers with the ability to access their products across omni-channels (both on-line and in-store). The irony is that Amazon now owns Whole Foods and is briskly opening “brick and mortar” bookstores nationally to augment its on-line presence.
According to Emerging Trends, “[e]ven with these changes taking place, the retail industry is still considered healthy overall, with abundant capital available to owners and investors at historically low costs. And while retail overcapacity is widely acknowledged to be a problem for the industry, financial markets have largely priced this risk into individual asset valuations and investors are still widely attracted to well–conceived, well-positioned retail real estate assets.”
Investment sales of retail assets may have slowed somewhat in 2017, but sales were still significant and at cap rates that remained historically low. However, capital, both debt and equity, continue to be deployed conservatively. In the long run, this is a healthy sign for commercial real estate and will lead to a more prolonged recovery without significant risk of a major recession.
We believe 2018 will be another solid year for investment sales of retail projects. We expect that capital will continue to remain readily available, but at a slightly higher cost than the historic lows of the last few years. However, new shopping center construction, other than in infill locations, will continue to be largely dormant in 2017 due to moderate new entry-level home construction. Retail development likely will continue to be driven mostly by the re-positioning of poorly-performing regional malls, the renovation of existing retail centers, new in-fill development (often paired with a multi-family or medical use component), and some new ground-up construction in robust economic pockets such as Silicon Valley.
International capital continues to flow into commercial real estate assets in the U.S. Illustrative of this, is the vast amount of capital from Asia flowing into the development of office, hospitality, multi-family and retail in Downtown Los Angeles. During most periods of the economic recovery, the majority of global capital has looked primarily at retail investment opportunities in primary markets. As a result, the competition for retail assets in primary markets has been fierce. However, international capital in 2017 began to be deployed in the acquisition of retail assets in secondary markets, along with significant investment in the acquisition of regional malls. In 2018, we believe that offshore investors will continue to exhibit significant interest in retail projects in secondary markets and in regional malls in primary markets or in markets where they can be re-developed.
Debt has had a terrific run since the Great Recession. As indicated in Emerging Trends, “[d]ata from the Federal Reserve (in its June 2017 report) show year-over-year growth in mortgage debt outstanding at 3.7 percent. Tepid change in one-to-four unit family loans (2.4 percent) was far outstripped by commercial nonresidential assets (4.8 percent) and by a major surge in multifamily loans (9.7 percent). Banks posted a significant 8.6 percent increase in commercial property loan assets. Life companies, meanwhile, showed an even more rapid increase (9.2 percent) in their portfolios of commercial real estate loans.”
Lending is always a balance between safety and yield. As a result of lessons learned following the Great Recession, most experts predict that the security of capital will dominate over a desire for higher yield for the foreseeable future. When loan-to-value (LTV) ratios approached 60 percent following the Great Recession, the expectation was that LTV ratios would slowly increase to the typical 70 to 75 percent as the market strengthened. However, this has not occurred. Most economists believe this to be a positive sign that should result in a longer economic recovery, with most lenders not repeating many of the behaviors that led to the Great Recession.
With lower LTV ratios, many borrowers are seeking to take advantage of higher leverage, leading to greater opportunities in the middle of the capital stack, with most borrowers leaning toward mezzanine lending rather than preferred equity. Mezzanine debt is collateralized and therefore cheaper. Mezzanine lenders can obtain yield returns in the high single digits. Both senior and junior lenders are underwriting on cash flow and debt-service coverage. However, lenders are reluctant to fund speculative development, given the impact of failed land and construction loans on institutional balance sheets following the Great Recession.
It is our expectation that commercial bank lending for 2018 will be consistent with their lending practices in 2017. Bank pricing is favorable when compared with debt funds, and represents a broader market for borrowers than they find with life insurance companies. In addition, borrowers much prefer relationship banking when compared with CMBS.
As observed in Emerging Trends, “[f]undamentally, there is no reason to think that commercial banks will be a diminished source of debt capital going forward. Mortgage lending is a core function for these financial intermediaries. Profits are high and steady in the banking sector, roughly $110 billion as of early 2017. Cost of funds is exceptionally low – in the Fed Funds rate, and in the infinitesimally small rate paid on deposits. So the spread on mortgage lending is excellent. And the outlook for regulation is ‘less, not more’ as pressure to ease Dodd-Frank restrictions now prevails in Washington. Borrowers always want the loan spigot open wider, but, objectively, commercial bank lending is unlikely to be disappointing in 2018.” However, most banks view the commercial real estate market with a certain degree of skepticism. Bankers have become extremely risk averse and are leery about uncertain property prices, capitalization rates, and vacancy rates.
With regulatory constraints impacting large banks, regional and community banks have been able to find numerous lending opportunities. These local institutions are more familiar with secondary and tertiary markets. They have long-term relationships with local developers and have intimate knowledge of the small businesses that make up much of the tenant base in these smaller metro areas. Surprisingly, risk from real estate in many cases is actually greater with regional and community banks than with money center banks.
CMBS has failed to return to anything close to what it was prior to the Great Recession, when volume reached approximately $228 billion. Although CMBS surpassed the $100 billion mark in 2015, it dropped about 25 percent in 2016, and volume in 2017 was comparable to 2016.
CMBS is currently a niche product in the debt markets. Thankfully, CMBS delinquencies are nowhere near what was predicted following the Great Recession. According to published reports from the Mortgage Bankers Association, CMBS delinquencies are running at about 5 percent, while other lender categories are less than 1 percent. The calamity that many feared as the “wall of maturities” of CMBS underwritten a decade ago hitting the market has not materialized.
As stated in Emerging Trends, “CMBS is available for those with less than sterling credit. Such deals tend to be in tertiary markets, but also for the largest deals in prime markets, either for single-asset CMBS or for portfolios. The B-piece buyers are money managers, with BBB tranche going to bond funds based in Europe.”
Mortgage lending by life insurers should continue on the steady path it has been on since aggressively reentering the market in 2011. Life companies now hold approximately $472 billion in mortgage assets. According to the American Council of Life Insurers (ACLI), its members generated $64.9 billion in commitments in 2015 and $66.7 billion in 2016. New commitments in 2017 minimally surpassed those in 2016.
Life insurance company fixed-rate commercial mortgages held at about 4 percent in 2017, providing life companies with an approximately 200-basis-point spread. The average loan-to-value ratio for life insurance company loans in 2017 was 60 percent, and we expect the same to be true in 2018. As balance sheet lenders, life companies typically diversify their holdings across property types and geography. In attempting to minimize risk, life company lending will continue to be at fixed-rates rather than at floating-rates, with maturities approximating ten years. In a few circumstances, life companies are able to provide construction financing so long as the assets are located in prime markets, are of high quality, are underwritten very conservatively, and have prearranged permanent “take-out” loans.
The availability of debt and equity capital for retail development and acquisitions is deep and diverse, and should be expected to remain healthy through the foreseeable future. Although most capital providers anticipate a slowing of the economy over the next decade, they have learned valuable lessons from the period leading up to the Great Recession. Low leverage, moderate assumptions, and careful risk-pricing should be enduring features shaping retail real estate capital markets for the foreseeable future. This should bode well for retail real estate since it will extend the slow and steady availability of capital over the coming year without contributing to conditions that could lead to another economic recession.