People in this industry like to talk about how many real estate cycles they've seen and how many booms and recessions they've operated through. Such talk is usually meant to allay any concerns when conversations inevitably get to the question of whether today's cap rates represent a “new paradigm” or not and whether commercial real estate can continue its gonzo run for much longer.
But it seems to me that no matter how many cycles you've gone through, there are some aspects of how the real estate industry operates today that are divergent from the past and which will leave a permanent mark whenever this cycle reaches its end.
This may be true of every boom cycle. It was almost 20 years ago that the easy money coming out of newly deregulated savings and loans produced an orgy of overbuilding and the collapse of commercial real estate in the late 1980s. Out of the aches came major changes in how real estate companies were structured and how lenders functioned. It took years to work through that oversupply of space and to get bad debt off the books.
Since then we've had both the REIT revolution, which began in earnest in 1995 and has perhaps done more to reshape the retail real estate business than any property sector. More so than in office or industrial, publicly-held REITs dominate retail. The majority of the largest players are public REITs and they own all but a handful of the top 100 regional malls.
Similarly, the emergence of the CMBS market has put the lending business under a more watchful eye. Originators looking to sell their loans have second and third pairs of eyes checking their work. B-piece buyers, assuming the brunt of the risk, won't buy issuances that are too risky. In the late 1980s the CMBS market was in its infancy. Now it controls more than half a trillion dollars of loans. In 10 years, CMBS will account for a full 75 percent of commercial mortgages, according to some estimates.
While REITs and CMBS have had a stabilizing effect on retail real estate, they have not eliminated tell-tale fin-de-cycle excesses. Even as the economy begins to slow, the construction pipeline is fatter than it has been in a decade. And, as we detail in our cover story, starting on p. 20, borrowers are scrambling to get the last of the easy money before the Federal Reserve takes the punchbowl away. Lenders are crabbing about it, but they are eagerly doling out long-term interest only loans, underwriting loans with 100 percent (and higher) loan-to-value ratios and, in general, doing whatever it takes to put money to work for eager investors. We are “starting to see things that got the industry in trouble,” one veteran told our reporter.
As the cycle continues to wind down and the road gets bumpy, it will be interesting to see what changes this cycle breeds. The Mills Corp. situation alone illustrates that even within the safe haven of REITs problems can by hidden for years through improper accounting. So far there's no reason to believe that there are more Mills-like blowups waiting in the wings. But accounting practices are always an area that can be improved. And if delinquencies or defaults become a real problem for CMBS, B-piece buyers will have to adjust their underwriting.
I don't think anyone can know for sure how it will play out. But it will sure be fun to watch.
Retail Traffic Magazine