A satirical commercial real estate proposal in the tradition of Jonathan Swift.
Originally published February 2022.
Fellow citizens of the real estate investing world, may I submit for your consideration that the time has arrived to discard and dispatch the long held, well trusted, underwriting standards that have governed commercial real estate investment for so many decades. Time to untether the market from the arcane standards that place a heavy emphasis on the so-called fundamentals of investing: cost per square, market rent and the like. Time to consider that a new master has come to govern the landscape, who slipped in under the cover of darkness and usurped the ruler upon the throne and stole his thorny crown.
“They shifted from being income generators, seeking to build their ‘nest egg’ for retirement, and became pensioners in need of monthly income”
That new master is the child of a world awash in equity searching for yield and a lending market quite content to supply ample quantities of moderately leveraged debt to achieve those ends. One of the unforeseen consequences of the Covid-19 pandemic (and there are many) was the surge in early retirement in developed Western nations. Rather than soldier on under difficult conditions, many Baby Boomers decided to call it quits and move into their golden years. As they did so, they shifted from being income generators, seeking to build their ‘nest egg’ for retirement, and became pensioners in need of monthly income to sustain the decades ahead. Upon surveying the landscape of depressed yields in the corporate and government bond markets, new retirees and their financial advisors scoured the landscape for yield-based investments. Whether through REIT stocks, broker-dealers or other sources, the most compelling sector for yield quickly became real estate.
“With the bond markets providing incredibly cheap capital to potential corporate borrowers, lenders have had to consider where to deploy the potential loans on their balance sheets”
Meanwhile, the lending market has faced a similar quandary from a separate perspective. With the bond markets providing incredibly cheap capital to potential corporate borrowers, lenders have had to consider where to deploy the potential loans on their balance sheets. And voila, real estate has provided a wonderful potential outlet to generate higher interest rates, while maintaining a semblance of restraint in the leverage standards on new issuance. The Great Recession still very much on the minds of senior bank executives has meant there has been restraint not so much in loan per square metrics but, rather, loan to value ratios. In the run up to the Great Recession (2003-2007) banks were commonly making 80-85% LTV loans available and in some cases higher. Such loans were incredibly vulnerable to pull-backs in prevailing market valuations and a wipeout of borrower equity caused many to fail after the collapse of Bear Sterns and Lehman Brothers and the ensuing financial fallout. Today, prevailing leverage is in the 60-70% range, which provides a far higher degree of security for the loans held by banks even if property prices should pull back.
The end result is investors are able to secure moderately leveraged loans and prevailing interest rates in the 3.50-4% range, with loan constants (the total percentage of the annual debt service to the initial loan amount) in the range of 5.3-5.7%. There is no shortage of high caliber assets that can be acquired in the US CRE market today, at yields in excess (sometimes well in excess) of these loan constants, and thus allowing real estate owners to achieve strong leveraged returns on the magnitude of 6.5% and up.
“Investors stand to receive long-term cash flow”
It’s tempting to argue that the acquisition and financing of CRE assets without a diligent and rigid focus on fundamentals will lead to a future day of reckoning. The argument is that assets purchased without laser-like reliance on the residual values will lead to a wave of loan defaults and foreclosures at some point in the future. Such a view fails to appreciate the conservative prevailing leverage in today’s marketplace and the long-term nature of loans. With 10-year loan terms by far the most common option for stabilised assets, investors stand to receive long-term cash flow, and inflationary pressures are likely to further insulate the underlying values and loan security over the investment horizon.
In the current environment, a rigid and constraining focus on traditional standards of real estate investing have taken a back seat to a leveraged investment market, in which compelling debt can be secured and robust yields can be generated. It would, of course, be unfair to suggest that analysis of residual values have been abandoned altogether, for they have not, yet investors who refuse to acknowledge the ‘new master’ and instead focus on only traditional standards, are likely to find themselves locked out of being competitive with the broader investment market.
