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Thursday, August 24, 2017

Is Commercial Lending Heading for A Fall?

By Kelly Haughton
June 13, 2017

Topics:
Kelly Haughton
Commercial Real Estate
Bubbles


Kelly Haughton, CEO of Global Index Group, Gig Harbor, Wash., is creator of the Russell 2000 Index and a member of the Index Hall of Fame. He can be contacted at: kelly.haughton@globalindexgroup.com.

HousingStarts

Commercial real estate lending continues to be strong, although not quite as strong as it has been throughout the past few years. Given the softness in certain sectors, like retail, and signs that there's over-building of high-end properties in major urban markets, should lenders and investors be worried? And if they are, what can they do to protect themselves in the event that there's a new bubble?

In the beginning of May, the Mortgage Bankers Association reported commercial originations by mortgage bankers climbed 9 percent in the first quarter on a year-over-year basis. "Multifamily properties remain the key force behind the overall origination trends," the report said. The question is, for how long?

Recently, the Wall Street Journal looked at a number of different metrics and came to a chilling conclusion. "The rising demand for luxury apartments has spurred an epic building boom that now threatens the health of this sector of the U.S. housing market," the Journal said. "While overbuilding so far seems limited to the priciest properties, analysts are watching this segment closely for any signs of spillover."

Some data points behind this conclusion: massive inventory that's about to come on market, higher vacancy rates and a softening on high-end rental growth.

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Some trends playing out in the multifamily sector are also present in the broader commercial real estate market. Earlier this month, S&P Global Ratings noted commercial real estate lending overall had reached a new milestone: it passed the peak set in 2008 and now accounts for more than $1.63 trillion worth of loans on bank balance sheets. This is up from $1.53 trillion just before the last real estate crisis. Not surprisingly, S&P is worried and warning that downgrades are likely.

What can be done now?

While it is still too early to say whether a bubble is developing in CRE (or for that matter, in residential real estate too) even if there is, what can lenders and investors do about? Nobel Prize Laureate Robert Shiller believes that until there are effective short-selling options, real estate will always be susceptible to bubbles.

"Short selling helps prevent bubbles from forming, but such negative bets cannot easily occur in the housing market," Shiller said. "You can't routinely borrow a house and sell it, promising to buy back the same house later to repay the loan." He added, "Markets without the possibility of making these negative bets will be inefficient. That's because if it is not possible to short, the smart money can do no more than avoid holding an overpriced asset."

While the market has tools to hedge interest rate risk and prepayment risk, there hasn't been a tool to efficiently hedge equity risk in real estate. Hedging options are relatively limited in commercial and multifamily: Basically your options are shorting publicly traded REITS and ETFs or using the CMBX in the case of CMBS.

Why aren't there more precise hedging options? Over the past decade there have been several attempts to develop more efficient tools, in both the CRE and the residential space. Two prominent but ill-fated initiatives involved exchange trade funds and futures, respectively. The unique nature of the real estate markets proved challenging in both instances. For example, the static nature of the asset class--properties don't trade with the same frequency and liquidity as stocks or bond--made this asset class a bad fit for frequently traded instruments, such as ETFs.

The CRE futures market was just getting its footing in 2007 when the mortgage crisis hit and made investors skittish about counter-party risk in the post-Lehman Brothers days.

Recently, our firm and CBRE Capital developed a new class of securities for institutional investors that attempts to address this challenge for the overall private commercial real estate market. The securities, called Down/Up Equity Trust Securities, or duETS, are tied to the future performance of the NCREIF Property Index's Market Value Index. They allow investors to more efficiently adjust their exposure to the broader market. Interestingly, we have already seen a fair amount of interest in multifamily and retail versions of these securities, an indication of the concern that is growing in the sectors.

It is too early to tell whether investors will gravitate to this new hedging option. But one thing is for sure: sooner or later commercial real estate will peak and equity risk will return. The question is, will our industry be ready?

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor does it connote an endorsement of a specific company, product or service. MBA Insights welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at msorohan@mba.org; or Michael Tucker, editorial manager, at mtucker@mba.org.)

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