Like every part of the economy, real estate finance moves in cycles, from boom to bust and back again. Some evidence suggests that these cycles are moving faster than they used to, picking up speed and compressing what used to be decades-long trends into just a few years. This shortening is creating both opportunity and risk for investors.
Are cycles shortening?
Historically, real estate finance cycles have been measured in years and decades, following a well-documented sequence of boom, slump and recovery. The real estate boom of the early and mid-1980s was followed by the tax law change of 1986 and the slump in the early 1990s. What followed for the next five years was a lack of capital in the real estate sector, the S&L crisis and the RTC. In 1994 and 1995 capital began to flow, in part due to the start of CMBS, and the real estate markets pulled out of the slump. For the next 12 years we saw a strong real estate market punctuated only by the short lived Russian Rubble crisis of 1998 and the Dotcom bubble which burst in ’99 and 2000. We saw strong and steady growth from ’95 to ’07 in nearly all areas of real estate – both commercial and residential.
The most recent cycle points to a different pattern: a severe contraction, followed by a quicker-than-expected recovery.
The slump that began in ’07 and picked up steam in early ‘08 was the most severe since the Great Depression, and real estate finance contracted suddenly and drastically. The realization that real estate values, especially residential, can go down slapped the real estate market into reality. The recovery was expected to be long and difficult. However, the worries about the mass refinancing of 10-year commercial loans dating from the mid-2000s turned out to be somewhat overblown. Those who thought that the take backs, workouts and opportunistic buying opportunities would drag on have been disappointed. Unlike the more sluggish recovery of the broader economy, commercial real estate lending bounced back more rapidly than anticipated. While we continue to see maturing CMBS loans going to special servicing, we also see an abundance of capital available for refinancing commercial real estate as well as a significant amount of new construction money.
The Mortgage Bankers Association (MBA) reports that total outstanding commercial and multifamily mortgage debt rose rapidly in the mid-2000s to reach a high of about $2.5 trillion just as the slump began in early 2008. Total debt dropped for a few years, but by 2013 origination volumes had rebounded. The fact that a steeper slump had a recovery about as long as a moderate recession argues that cycles are different than they once were, since deep declines have historically been followed by long recoveries.
This recovery, however, has quickly become a strong market. While CMBS volume has not returned to the ’06 and ’07 levels, the ’13 volume and projected numbers for ’14 are a very healthy $80 to $100 billion. No one can argue that we have a shortage of capital for real estate finance – in fact it could be argued that we are well on our way to creating another bubble.
We saw the downturn of the late ‘80s take five years for recovery followed by 10 years of largely steady growth and a couple of years (’06 and ’07) of full out “irrational exuberance.” In contrast, the downturn that started in late ’07 for real estate only lasted for three or four years with opportunistic buying beginning to play out by the end of 2010.
Why would cycles shorten?
It is not entirely clear, but there seem to be temporary as well as more structural reasons. Lenders might have been burned by the late 2000s contraction in the economy and real estate, but are now living in a low-interest rate environment and a need to generate return on their capital. Whatever risk aversion lenders felt a few years ago, they need returns now, and commercial real estate loans offer much-needed yield. Are the low interest rates contributing to the rapid return to aggressive lending or simply an irrelevant factor brought on by quantitative easing?
But there seems to be a more fundamental change in real estate finance being driven by the global economy. The sheer amount of investment capital in the world is vastly larger than it used to be, shortening the downturn because capital has to find a home. The world, as Bain & Co. puts it, is dealing with an “environment of capital superabundance.” According to Bain research, by 2010, global capital had grown to roughly $600 trillion, tripling over the past two decades; by 2020, it’s estimated to be about $900 trillion.1) The movement of capital on a global basis has significantly contributed to the lightning-quick speed at which investors are looking for investment opportunities and deploying large amounts of capital.
What shortening lending cycles mean for real estate investors
If real estate lending cycles are in fact shorter, what does the compression mean for borrowers and investors? There are two sides to every coin; both recoveries and slumps come faster. Here are some implications to investors that will help navigate the compressed cycles:
- Rapid decision making. The old adage “he who hesitates is lost” could not be more true than now. With the rapid disposition of problem loans and assets in the most recent downturn, those buyers who felt that they had plenty of time to shop for properties found that the train had left the station. Furthermore, lenders that were in a strong position to negotiate loan terms in 2011 and 2012 suddenly found themselves in a borrower market by 2013. The last few years have seen a quick and substantial movement in the real estate market in many ways that have certainly created substantial value for those who moved decisively.
- Increased choice, decreased track record. One of the features of the recovery and especially the boom part of the cycle is a proliferation of lending products and the rapid change in their relevance. In a shorter cycle, it can be harder to keep up with the proliferation of new products. Many times new products as well as lenders do not yet have a demonstrable track record—and by the time they do, an investor may have missed the window in which the product is irrelevant or the product may not be the best execution from one moment to the next. This is true for both borrowers and for investors. In 2009 and 2010 a substantial amount of capital was raised for high yield lending/investing opportunities coming out of the downturn. Much of that capital could not be deployed as the mid-teen yields that were expected quickly evaporated as capital flowed back into real estate at much lower rates of return to the investors and lower interest rates to the borrowers.
- Recoveries are never too far away. It used to be that if you were stuck in a lending slump with an expiring loan, workouts were complicated because it would be a long time before the market returned. With compressed lending cycles, there may be more options for borrowers who need a bridge loan to get them through a refinance or access mezzanine debt and even equity.
- Will it be better tomorrow? With capital flowing into the real estate space the rates, terms and overall availability of capital can sometimes tempt borrowers to wait. The same can be said of sellers – can I get a lower cap rate if I just wait? One thing is certain: if you hesitated on the buy side, you were probably left on the sidelines.
Are we creating a bubble or will we simply slow the pace for a soft landing?
Most people would define a bubble as an unsustainable rate of growth and value that is ripe for a significant and potential decline. Oftentimes the bubble is created by an imbalance in investment opportunities – is real estate better than stocks or bonds or other investment alternatives. There is too much money chasing too few deals. In a market that is one way only – new money and players in the market but no one exiting the market – it is easy to get overheated and chase the deal. Will the bubble burst? If we continue on the same aggressive path we will soon see speculative lending and buying which will ultimately lead to another bubble bursting. Conversely, small market corrections bring a reminder of risk management to lenders, investors and buyers as they are “slapped” back to reality.
I would argue that shorter cycles are a good thing because they create small waves in the market as opposed to the tsunami we experienced in the last cycle. An extended boom has a propensity to end badly with a significant and painful adjustment as opposed to more frequent and manageable corrections.
As cycles become more compressed, there is an increasing need to stay current with the rapidly changing financing market. Information is moving more rapidly than ever, and with this information flow comes an unprecedented need to distill the data into a form that can allow for confident decision making. We continually need to answer the question, “What does this mean and what do I do with this information.” That is why it is critical that companies rely on partners whose focus is on the long-term view of the client’s success in the marketplace. As a trusted advisor, KeyBank Real Estate Capital offers industry expertise as a real-time guide to this rapidly changing landscape, with counsel grounded in what’s best for the borrower’s business over the long run.
For more questions, contact Clay M. Sublett, Senior Vice President – Southwest Regional Executive, KeyBank Real Estate Capital, at 913-317-4233 or firstname.lastname@example.org, or visit key.com/CMBS
1) “A World Awash in Money: Capital trends through 2020,” Bain & Co., 2012, available for download here: http://www.bain.com/publications/articles/a-world-awash-in-money.aspx.
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