The International Monetary Fund (IMF) has been sounding warning bells about the high levels of global debt. But U.S. commercial real estate has been defying that trend, which could make the sector even more attractive as a “safe haven” for global capital.
The financial crisis exposed the risks of high-leverage commercial real estate debt strategies. Many owners worked to restructure debt and lower leverage across portfolios as property values plummeted. REITs in particular ratcheted back on leverage as ratings agencies adopted a tougher stance on debt levels. Nearly a decade after the financial crisis—and a prolonged period of exceptionally interest rates—commercial real estate companies continue to operate in a lower leverage environment.
A recent CBRE report noted that loan-to-value (LTV) ratios on permanent, fixed-rate financing are now averaging nearly 60 percent, more than 15 basis points below the 2007 average of 75.3 percent. The report also cited NCREIF data that shows a similar trend with debt-to-market value at 41 percent compared to an average of 48 percent in 2007.
The more conservative climate is a stark contrast compared to high global corporate and government debt levels. The IMF has noted its concern for high debt levels and the risk that might pose in the event of a downturn. According to the IMF, global debt hit a new record high of $164 trillion in 2016, which is the equivalent of 225 percent of global GDP—12 percent higher than the previous high set in 2009. Of that $164 trillion, 63 percent is non-financial private sector debt and 37 percent is public sector debt.
LTVs remain conservative
In a market where debt remains cheap and plentiful, the continued conservative streak in the commercial real estate sector may be a sign of lessons learned in the last downturn. Banks have also been more conservative on lending due to tighter regulatory scrutiny, especially as it relates to construction loans.
“The most important factor is the amount of equity that has been available in the marketplace. There simply hasn’t been the need to gear up quite as much as in previous cycles,” says Richard Barkham, global chief economist for CBRE. Low bond rates have helped to funnel more institutional capital into real estate. “There is ample equity out there and our view is that that will continue,” he adds.
Debt levels are lower as compared to the last cycle, but leverage is also different across property types, adds Jeff Erxleben, executive vice president and regional managing director at financial services provider NorthMarq Capital. “Retail is one where deleveraging continues to occur because the availability of debt capital that is interested in going into retail is more limited,” he says. At the other end of the spectrum, leverage is beginning to move higher in the industrial sector and some areas within multifamily. Borrowers are finding non-bank lenders that are willing to be creative and provide more capital, Erxleben notes.
Specific to multifamily construction loans, for example, leverage is still fairly low compared to historical levels. Most construction loans are typically being done at 60 to 65 percent leverage. “When you see specific lenders stepping out to do perhaps 75 or 80 percent and charging a premium to do that, and doing it non-recourse, that’s where I’m starting to see leverage creep up a little bit,” says Erxleben. There are also a lot of bridge lenders out there and they have continued to push the envelope in terms of lower debt coverage ratios, which often results in higher leverage, he adds.
Equity levels support solid foundation
There could be some modest moves in leverage levels ahead, but nothing on the horizon suggests that leverage will make a big move either up or down. The impact of rising interest rates on debt strategies will likely vary depending on individual borrowers. Some groups will opt to lever up with other forms of debt, such as mezzanine financing or preferred equity, as equity requirements rise from senior lenders due to higher interest rates. Other borrowers will be more prone to drop LTVs, especially if cap rates don’t go up, says Erxleben.
The lower leverage climate bodes well for a commercial real estate industry that many believe is in the later stages of its expansion cycle. More conservative debt levels should keep commercial real estate on a more solid footing to weather a downturn when it does occur.
Owners that over-leverage can be prone to distressed sales in a downturn, which negatively impacts real estate values across the broader market. “Our point is that we probably won’t see that in the next downturn,” says Barkham. Downturns are always volatile, but real estate might be a safe haven, because investors won’t have to make the fire sales that they did in previous cycles, he says.