If you own income real estate which has little burden of debt and is located in a market with a low surplus of space, today is a good time to consider using it as collateral to borrow more. In the general business cycle, the condition of many real estate and financial markets is favorable for further borrowing. This is true in spite of the fact that equity owners of properties heavily leveraged with debt were wiped out when property prices collapsed in the early-1990s. Admittedly, this advice is not suitable in all market areas or for all types of space. In some markets -- such as office space in downtown Los Angeles -- further leveraging would be not be wise.
The general business cycle that hit bottom in February 1991 is now well into its fourth year of improvement and growth. The cycle is nearing the point at which peak conditions exist. This means the level of economic activity is high but is still growing, so that demand for all types of space continues to rise.
Consequently, the three-phase real estate development cycle -- based upon my own definition of phases -- is now in the gradual absorption phase in most commercial real estate markets in the United States. The surplus of commercial space created in the last development boom phase in the late-1980s -- which severely depressed property markets in the subsequent overbuilt phase, from 1990 to 1993 -- is now gradually being absorbed by rising prosperity and little construction of new space. The development boom phase of the 1980s was unusually long and powerful, however, so the huge surplus it created led to more overbuilding than usual, as well as a greater collapse in property values and rent levels in the early-1990s. Moreover, it will take longer for the gradual absorption phase to soak up the remaining over-supply of vacant space. Consequently, it is unlikely that we will have a true development boom phase in this general business cycle before the next recession.
If this forecast is accurate, most commercial real estate markets will continue to experience strengthening supply/demand conditions until the next recession. The supply of space will not increase, however, and the demand will continue to rise; therefore, the supply/demand balance will become more and more favorable to owners and operators of existing properties.
There are many exceptions, of course. In some downtown office markets at the peak of the 1980s boom, large blocks of space were rented at high rates; currently, however, they are not in use because of subsequent downsizing. A number of the original tenants are subleasing space at rents which are just a small fraction of what they themselves are paying the owners. When the original leases on those properties roll over, the rents collected by the owners will fall sharply. For these owners, now is not the time to "leverage up" with higher ratios of debt-to-market value.
Conditions in which demand for space is rising but supply is both static and relatively tight are not favorable for developers. Compared to their full capacity, they will remain under-employed. These conditions are beneficial to the owners and operators of existing properties, however. Vacancies will decline, space markets will tighten even more and rents will start to rise from their depressed levels of the early-1990s. In fact, these conditions have become visible in most types of commercial properties across the United States.
A significant result of these forces will be upward pressure on prices of commercial properties. Prices fell to depressed levels in 1990 and remained there for several years. Property prices, however, are already rising again in many areas. This is apparent from the decline in going-in yields or capitalization rates for suburban office buildings, shopping centers and hotels. Investors are anticipating that rents must rise even more in order to reach the levels in to support the profitable construction of new space. Yet more space will be required when vacancies fall below 10% in office markets, which has already begun in some places. For example, large blocks of office space are now hard to find in downtown Washington, Northern Virginia and other metropolitan areas. If the only way users can meet their needs is through new space, they must pay rents high enough to make creating that space profitable. This will cause rents to rise well above the level at which they are now, and owners of most existing properties will profit when their leases roll over since they can charge much higher rents. If owners bought their properties based on the current rents, they stand to gain large increases in net income, which would raise the market values of their properties. Anticipating this sequence of events, many investors are willing to pay prices for properties that are above the level justified by current rents; this, in turn, reduces yields and capitalization rates.
If property values rise even further, debt placed on property at any given debt-to-value ratio will be at a lower debt-to-value ratio in the future. (This conclusion assumes that the buyer of the property has not already increased the amount he or she is willing to pay, in full anticipation of all likely future rent increases.
Equally important, interest rates on commercial mortgage loans are well below the earning power of most sound commercial properties. This is true even though going-in yields on those properties are falling. Both American and global capital markets are loaded with private funds seeking investment opportunities. Equity investors are still demanding internal rates of return in the high teens that most commercial real estate properties cannot produce at current price and rent levels.
Institutions seeking to place debt funds are in a different situation, however. American banks in particular are heavily over-capitalized in relation to their lending opportunities. This reflects the fact that the United States has too many banks and too much money and capital allocated to them. There are well over 10,000 American banks, compared to four major banks in the United Kingdom and less than a dozen in Canada; this accounts for the intense consolidation the banking industry is currently experiencing.
Pension funds are also packed with money that has no place to go. While the funds are focused on the present bull market in stocks and will remain cautious about putting large amounts of money into commercial real estate, they have such large amounts of money to invest, chances are that some will be directed to commercial mortgages or equity.
These funds have depressed the yields on fixed-rate instruments of all kinds, including government bonds, private bonds, private placements and mortgage loans. Although interest rates as of September 1995 are higher than they were in late-1993 -- the lowest point they have hit in many years -- the yield in the 10-year Treasury securities as of July was still well under 6.5%, which is much lower than in the 1980s, 1992 and late-1994. The entire interest rate structure has also declined. In fact, spreads over Treasuries are narrower than usual in markets for all types of debt instruments. Consequently, investment officers in insurance companies, banks and pension funds are having difficult), placing funds allocated to debt investments at rates that they believe justify the risks they are taking.
These conditions are pushing more investment officers toward opting for mortgage loans on commercial properties, since loans of this kind are getting higher nominal rates than many investments in bond markets. The result has been a remarkable change in the attitudes of many investment officers toward lending money on commercial real estate. In fact, underwriting standards for such loans have eroded significantly from the stringent levels in the early-1990s. Lenders have recently been permitting increasing debt-to-value ratios, falling coverage ratios, declining rates and other improvements in terms beneficial to borrowers. Fortunately, this shift in underwriting has caused more mispricing of loans -- not getting interest rates high enough to be commensurate with the risks involved -- than either mis-selecting properties -- choosing properties unsuitable for investment -- or overloading properties with debt. The latter two errors were key factors in the overbuilding debacle of the '80s.
Up until now, these changes in financial markets have not included heavy investments in the creation of new space on a speculative basis, as in the late-1980s. Most lenders are still focused on actual current cashflow returns, not on pro formas involving big increases in future net income. While some new construction is beginning to appear, it is primarily on a build-to-suit or other heavily preleased basis. As long as the financial community refrains from underwriting speculative space, the supply/demand situation in commercial space markets will continue improving until the next recession, which is not expected until late-1996, 1997 or even later. The longer the recession is held off, the more construction of new commercial space will be launched before then. Even so, until the end of the next recession, it is not likely that we will experience a boom in the development of new commercial space.
In today's market, it is possible to borrow mortgage funds at interest rates below the rates at which the properties are earning profits on the capital invested in them. This positive spread means that every dollar borrowed increases the yield on the remaining equity funds. From the property owner's viewpoint, the act of borrowing frees capital that can be used for upgrading existing properties or purchasing new ones. In short, it can be a good time to borrow money against normal mortgage lending channels in commercial real estate -- but only if the property meets the two criteria.
Word of Caution
It is not, however, a good time to leverage properties so heavily with debt that the owner would be vulnerable to losing all equity due to downward movement in rents or property prices. This occurred in the late-'80s with devastating results for most developers and property owners. Therefore, debt-to-value ratios should be kept moderate, with significant equity remaining. Major financial institutions are now making mortgage loans on sound properties with 75% debt-to-value ratios and reasonable accompanying terms, with values based upon current rents. This level seems sound-from the viewpoint of both lender and borrower -- especially if property values continue rising until the next recession.
When the recession does strike -- and another overbuilt period begins -- it will not be as devastating as the last. First of all, the surplus of space will be much less than in 1990, as there will not have been an excessive period of overbuilding beforehand. Secondly, rents are not likely to fall as dramatically from their pro-forma levels, thereby grossly undercutting property values. In addition, pro-forma rents will not have risen to unrealistic levels; thus, they will not have as far to fall before balancing supply and demand.
Property owners, however, must be prepared for some downward movement in prices in the next general recession and should not leverage their properties so heavily with debt that their equities would be depleted. The purpose in borrowing now is to take some equity out of existing properties and leave them capable to continue paying off their debt, even under adverse general economic conditions. The free equity capital that results can then be used to purchase more properties, or, simply to place the owners in a more advantageous position for the future. If your property meets the two criteria, disregard Shakespeare's advice: "Neither a borrower nor a lender be." If you do, be sure to exercise more prudence than property owners in the late-1980s.
Anthony H. Downs is senior fellow at the Brookings Institution, Washington, D.C. The views expressed here are those of the author and not necessarily those of officers, trustees or other staff members of the Brookings Institution.