A More Precarious Investment Climate

The near collapse of two residential subprime lenders rescued by loans from owner Bear Stearns, plus bankruptcies of other subprime lenders, has apparently caused several big debt issues to be cancelled or reduced in size because of investors' negative reactions. Even the mighty Blackstone Group's stock price fell below its IPO level. Is this a sea change in the availability of low-yield debt that has fueled the immense run-up in commercial property prices since 2000?

In early July 2007, the 10-year Treasury yield registered 5.07%, still below its level one year earlier, but about 50 basis points higher than a few months earlier. If investors are becoming more reluctant to purchase low-rate debt issues, that may alter the major basis for the huge increase in property prices during the past few years.

REIT share prices take a tumble

Another big change in real estate markets has been the significant decline in REIT share prices since they peaked Feb. 7, 2007. On that date, the NAREIT Equity Index reached 10,980.62, or 340% above its level on Dec. 31, 1998. The broader equity indexes didn't fare as well over that same period. As of Feb. 7, the Dow Jones Industrial Average was up some 38% over its value on Dec. 31, 1998, the S&P 500 was up 17.9%, and the Nasdaq composite was up 13.6%.

But from Feb. 7 through June 28 of this year, the NAREIT Equity Index fell 16.4%, while the other three stock indexes all rose from 3.8% to 6%. The long period in which REIT shares greatly outperformed the stock market has at least temporarily ended, another sign of a possible dramatic change in property market conditions.

It is too early to determine whether these signs will turn into long-run trends. A pause in real property financing conditions has occurred — and it may become more than a pause. The driving force in real estate finance for the past six years has been an immense flow of capital into the property markets.

That inflow drove interest rates and other borrowing terms downward and property prices upward. The inflow started before 2000, but received a major stimulus from the 2000 stock crash, which drove capital from stocks into real estate.

The subsequent inflow of capital led to a huge fall in the cost of borrowing money to buy properties. That was augmented by widespread securitization of all types of debt instruments, which reduced both their actual and their perceived risks.

The combination of a huge capital supply and securitization slashed the cost of borrowing and reduced its covenant limitations, thereby encouraging purchasers of real estate to borrow heavily. This in turn gave rise to the expansion of private equity firms, who used cheap debt to buy out firms listed on the stock market, including some REITs.

Private equity firms pounced on the opportunity to outbid the more conservative REITs by combining high amounts of leverage with cheap debt, often public debt in the form of commercial mortgage-backed securities. This strategy transformed real estate properties from their traditional category of long-term, heavily management-oriented investments to the short-term, sell-and-run category.

Possible scenarios ahead

If the combination of cheap debt, rising property prices and low property yields that dominated commercial property markets from 2000 through 2006 were to continue, many investors and developers would shift from buying properties at low yields to developing new properties at what they hope would be higher yields.

This could start a development boom that, if continued for 18 months to two years, would undermine the prosperity of all properties, new and old. And it would soon end the huge capital flows into property markets that have dominated real estate since 2000.

But if borrowing costs start significantly rising, which has not yet occurred on a large scale, that could cut off prospects for a new development boom. That would in turn insulate the prosperity of existing commercial properties as long as the U.S. economy remains strong.

So far in 2007, economic prosperity has been hurt by a slump in new housing construction and retail sales. Homeowners can no longer finance their spending by borrowing against rising home equities. But alas, what will happen to the economy in 2008 and 2009 is too difficult to predict reliably at the moment.

In the short run, rising borrowing costs appear to be almost a certainty. Such a development could have a dramatic impact on transaction activity and market conditions in U.S. commercial property markets.

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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