Danger Signs Ahead

The 2006 outlook contains both good news about the U.S. economy and disquieting danger signs in property markets. Economic growth will probably slow this year as the Federal Reserve continues to try to keep inflation in check. But low unemployment and high usage of industrial capacity imply Gross Domestic Product will still rise more than 3%. Hence, in property markets vacancies will decline and rents will move decidedly upward.

On the other hand, danger signals include declining credit quality, high property prices and low current yields, heavy speculation, likely increases in interest rates, and a potential for overbuilding. This column will examine these conditions.

Because of the immense flood of capital into real estate, competition among buyers and lenders has driven property prices upward and caused plunging credit standards. Debt has become mispriced because rates are still very low. Both lenders and buyers are receiving unusually low rewards for the risks they are assuming.

Even the risk premiums for vacant buildings have fallen. Some condo converters buying 8- to 10-year-old Florida apartments have recently accepted 3.5% cap rates. Many experts believe real estate is now more expensive than stocks or bonds in relation to underlying earning power. Hence, during 2006 bargaining power may shift away from property sellers toward more of a standoff with investors.

Many foreign investors and U.S. public pension funds are still relatively unfamiliar with real estate, an asset class they are now embracing. They often pay high prices because they can securitize their investments and sell the resulting paper to others. Loans at 90% of value have become “terms du jour.” Many lenders do not ask, “Is this a good or bad loan?” Instead, they ask, “Can I sell it?” There is huge leveraging of commercial mortgage-backed securities (CMBS) because the initial lenders typically sell off most parts of their original deals to others. There is a lot of interest-only money with no covenants, and hence little protection in case of defaults.

Yet, over 80% of the recent rise in most commercial property values has been due to cap-rate compression rather than improvements in property performance. Many deals are now close to negative leveraging — borrowing funds at rates above the earning power of the properties. Today, real estate spreads are below those for most other investments.

Wake-up call coming

These lending conditions create the potential for a large number of defaults triggered by the next recession — though that is unlikely in 2006 — or from some unpredictable global shock. The relative ease with which lenders are making loans and securitizing them could cause problems two years down the road. This is especially likely in the housing market where many low-income households have been cajoled into becoming homeowners. But much CMBS paper is being sold abroad to investors who will have no recourse or workout capabilities in case of defaults.

Meanwhile, banks increasingly are moving into construction and conversion lending. Even bank loans are looking more and more like CMBS structures. Bank loans to developers were previously split among different sub-lenders who all had the same terms. But now even first mortgages are split into tranches with differing terms. Who gets control in case of default?

Furthermore, competition is so keen that lenders must respond to proposed loan packages without time for due diligence; often there are no covenants and no resort in case of difficulty. With all these layers, there is no legal way for lenders to gain control in times of trouble. This whole situation portends serious trouble in the event of a recession and ensuing defaults.

Climate ripe for oversupply

Another potential problem is overbuilding. If loans made at 75% to 90% of property cost remain available in a climate of sky-high property prices and low yields, there is a danger of increased new development to gain higher yields. This is especially tempting because market fundamentals are good for most types of real estate, except single-family and condominium housing.

True, reproduction costs have gone up with high construction costs, and property deals are more transparent than they used to be. Consequently, not much overbuilding has taken place yet — except in lifestyle shopping centers and condominiums. But for many buyers and developers, relative value is no longer the key factor in making a deal. The key is the availability of debt, which is now greater than ever. Hence, the longer that debt remains available and underpriced, the greater the danger that overbuilding will rise sharply.

A rise in interest rates above their still-low levels — plus all the difficulties described — means that real estate capital availability is likely to moderate by the end of 2006. True, really big credit problems will not appear until the next recession, unless there is an unexpected global shock. But nothing lasts forever, and the intensifying danger signs in property markets should not be ignored.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].

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