Despite Global Jitters And Significant Fluctuations In The Stock Market, 2016 Is Expected To Be Another Positive Year For Retail Capital Markets
Despite recent concerns about China’s economy, the glut of oil, the severe fluctuations in the stock market and the long-awaited one-quarter point increase in the overnight federal funds borrowing rate, most of the fundamentals of the U.S. economy remain strong, and in 2016 capital should be readily available to retail developers and investors at rates that should remain low.
The statement by the Federal Reserve at the time of its interest rate increase provides great insight into the U.S. economy. The Federal Reserve’s statement read, in part: “The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen. Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced. The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”
For retail in 2016, the outlook is quite good (but somewhat cautious due to recent global economic events) as unemployment comes down and consumers start spending more aggressively from their savings in gas. There are some structural issues in retail, mainly the challenge from e-commerce and the lack of new suburban housing to fuel new shopping center construction. However, this generally leads to greater demand for existing retail space at higher rents, as well as in-fill development and the redevelopment of regional malls in secondary and tertiary markets. The outlook is reasonably good for bricks-and-mortar retail if it can continue to make itself relevant to consumers. Lifestyle and wellness retailers such as restaurants, theaters, grocery stores, health clubs, vitamin shops and beauty suppliers should all prosper since they remain largely unaffected by e-commerce. In addition, the “barbell” effect continues; both discount retailers (such as Ross and Marshalls) and high-end retailers (such as Tiffany) should continue to prosper.
With respect to capital in 2016, borrowers should continue to encounter a market where capital is both cheap and plentiful, and even modest interest rate hikes are not expected to negatively impact the current robust lending climate. In the third quarter of 2015 commercial and multifamily mortgage loan originations were 12 percent higher than during the same period last year, according to the Mortgage Bankers Association’s (MBA) Quarterly Survey of Commercial/Multifamily Mortgage Bankers Originations. In addition, the MBA is predicting a 6 percent increase in commercial/multifamily mortgage originations in 2016 with new originations of $485 billion. That activity would raise the total commercial/multifamily mortgage debt outstanding by an additional 1.8 percent by year-end 2016 to $2.8 trillion, the organization forecasts.
As stated in 2016 Emerging Trends in Real Estate (published by the Urban Land Institute and the accounting and consulting firm pwc) (“Emerging Trends”): “[a] year ago, 35 percent of the respondents anticipated an undersupply of … capital. Now, 35 percent say they expect an oversupply of money for refinancing. The 2016 refinancing expectation resembles what the acquisition financing projections were a year ago. If oversupply for acquisition debt was the consensus last year, respondents think that 2016’s environment will be ‘even more so.’ But, for development, debt capital is forecast to remain disciplined. With the exception of the government-sponsored enterprises (GSEs), debt capital availability is expected to grow at a moderate pace from all sources. That could signal that this recovery is hitting its mature phase. The majority of survey respondents are not suggesting further easing in debt underwriting standards, and the number expecting less rigorous loan requirements dropped by about ten percentage points compared with the prior year. As noted last year, lenders’ spreads have been compressed almost to the point where the following critical question assumes paramount importance: ‘Are we being paid for the risk we are taking?’ If spreads are thin, risk must be managed in other elements of the deal—most particularly, in the loan-to-value ratio where the borrower’s ‘skin in the game’ has had to increase. Intense competition exists among the lenders for the ‘A-quality’ deals in the market, and it is here that we may see some underwriting flexibility to secure core properties for the balance sheet. The expectation that a regime of rising interest rates is upon us and will shape mortgage and construction loan pricing in the 2016–2021 period is virtually universal. In the short run, recent past experience about Fed caution leads 30 to 40 percent to anticipate general interest rate stability for 2016 itself.”
Bank lending remained strong in 2015. Despite new governmental requirements, we believe that bank lending should continue to be robust in 2016. The new government requirements will require bank lenders to maintain higher capital reserves for acquisition, development, and construction lending. However, this is a positive development since disciplined lending by banks that have strong capital foundations are essential for solid real estate market performance, as well as for the well-being of the financial system.
Banks are not pricing new deals to perfection. They are remaining disciplined and providing for a cushion against risk. Banks generally are providing loans with loan-to-values (LTVs) of 75 percent with partial recourse, but 65 percent or lower with no recourse. However, spreads have been reduced, which is a clear sign of competition for real estate lending among the banks. In addition, many smaller banks are now lending after having resolved most of their problem loans from the financial crisis and recession. “Extend-and-pretend” actually worked pretty well for banks. It allowed banks to address problems over time as the markets recovered, rather than using a “mark-to-market” approach. Banks are also providing longer loans much like the life insurance companies.
The CMBS market was a bit volatile in the second half of 2015 with spreads widening. However, the current forecast for 2015 CMBS loans in the U.S. is that they will top 2014’s $94 billion, with loans approximating $100 billion. Wider spreads on CMBS loans are leading to higher rates for borrowers of 50 to 75 basis points. Most borrowers are willing to pay the higher rates in exchange for securing more dollars, and conduits are still aggressively lending on stabilized property types with leverage of around 75 percent. The broader financing market is also continuing to watch the wall of CMBS loan maturities that will hit the market in 2016 and 2017.
Many experts forecast $125 billion to $135 billion in new CMBS loans in 2016. The CMBS market is very efficient for secondary and tertiary markets, a very valuable capital source as investment activity accelerates beyond the high-priced gateway markets in the coming years.
A major concern is whether the CMBS market will remain disciplined with its underwriting standards. That should be the case, since for CMBS loans to be marketable as a securities issuance, the great bulk of CMBS needs to be rated as “investment grade.”
No source of debt capital is exploiting the surge of demand for commercial real estate funding more adroitly than the life insurance companies. Even as they expand their volume, there has been a strategic focus on asset selection for the long term. Federal Reserve data show that life insurance companies have $305.7 billion in commercial mortgages outstanding, a 12.7 percent market share that has remained basically stable over 2015.
The strategy of life insurance companies is to secure assets that will perform well across cycles. The enviable default/delinquency record of the insurers during the global financial crisis demonstrates the wisdom of such attention to relative value.
For life insurance company loans, twenty- to thirty-year amortization is fairly standard, with interest-only loans considered if the LTV is below 65 percent. Even when participating in structured lending ventures—co-lending or allowing subordinated debt—the life insurance companies retain decision-making rights, and require institutional-grade property and sponsorship.
Life companies are willing to sacrifice market share to preserve loan quality. There are enough qualified potential borrowers to satisfy underwriting standards while funding the insurers’ allocations for commercial real estate. Keeping future defaults to a minimum level is the chief objective of life companies.
In 2015, institutions and investors providing equity remained disciplined while dealing with a very competitive environment where capital is pervasive and ready to be “put to work.” In the current real estate climate, it is not difficult to raise money; rather, it is hard to find good deals, and significant competition exists when good deals are found.
Institutional investors have discovered that core properties in gateway markets are so richly priced, they have broadened their horizons and are now considering many property types such as value-add and opportunistic development, as well as investments in secondary and tertiary markets.
Offshore investors were very active investing in real estate in the U.S. in 2015. Capital has flowed into the U.S. from Germany, Italy, Japan, China, and Canada, among others. With global uncertainty, foreign investors see U.S. real estate as a safe haven. Notwithstanding the geographic spread of offshore investment, most foreign investment dollars have found their way to New York, Los Angeles, and other coastal markets, since international investors know and covet U.S. cities with air and sea ports. In the twelve-month period ending in June of 2015, net cross-border real estate investment amounted to a robust $31.2 billion. Given the continued uncertainties in Europe and the increasing volatility in Asia, we expect to continue to see foreign capital flowing into U.S. real estate markets in 2016.
Watchful waiting continues to be the dominant perspective on crowdfunding. This is a rather new method of raising capital that is still in its infancy. Although crowdfunding shows strong growth when measured on a percentage basis, its market share is minimal when compared to other capital sources. In the near future, crowdfunding is unlikely to grow to the point where it represents a meaningful competitor to more traditional funding sources.
Another source of capital for many developers in 2015 has been the EB-5 program, which grants visas that can lead to permanent residency in the U.S. for those making eligible investments here. Those investments must create at least ten jobs for U.S. workers, and amounts are set at a $1 million minimum, or $500,000 for rural or high-unemployment market areas. Although many developers have taken advantage of EB-5 loans, the availability of cheap capital from many other sources has kept the more cumbersome EB-5 funding as a “niche” program.
Despite global events and the vicissitudes of the U.S. stock market, over the short term, we continue to believe that the U.S. economy will outperform other developed markets, thereby providing the necessary backdrop for significant capital to find its way to retail real estate investors and borrowers in 2016.