The commercial mortgage-backed securities (CMBS) market is a major source of new financing, accounting for more than 50% of new lending in U.S. commercial real estate today. Accordingly, factors that affect the global fixed-income securities market now have an intense and direct effect on real estate lending.
Recently, two trends have emerged, each a direct consequence of the greater influence of global fixed-income markets on the domestic financing of real estate.
First, as a result of the preference of global fixed-income investors for floating-rate securities, lenders are originating a large proportion of their new loans as short-term floaters. Borrowers are attracted to short-term floaters because they generally carry a lower interest rate and may not require amortization.
The short-term floaters of 2000, however, differ markedly from the very profitable short-term floaters of the late 1990s. In the late-1990s, the overwhelming majority of short-term, floating-rate loans were used to acquire and improve transition properties (i.e., distressed properties), which were expected to increase in value significantly by the time the loan matured. The majority of short-term, floating-rate loans being made today, however, are secured by seasoned and stabilized properties, which won't likely experience an increase in value or outperform the overall market.
Both borrowers and lenders, therefore, are assuming substantially greater re-finance risk today in an increasing interest rate environment and setting the stage for market turmoil when the short-term loans mature.
Second, Federal Reserve Chairman Alan Greenspan's efforts to cool the U.S. economy by raising rates will have an additional negative impact on real estate. As rates rise, real estate owners - who are substantial borrowers - can be expected to be adversely affected. Simply put, the price of money is going up and that limits the price that can be paid by new leveraged buyers. Also, sooner or later rising rates will achieve Greenspan's objective of reducing demand in the broader economy, and the strong fundamentals of the underlying U.S. economy will weaken, resulting in reduced demand for commercial real estate, particularly office properties and, possibly, non-resort hotel properties, which are themselves directly dependent on the general level of business activity.
Other real estate concerns will also suffer as a result of changes in global fixed-income markets. REITs, for example, which have attempted to obtain new growth capital from unsecured debt capital markets, may now find those markets more difficult and expensive to access in order to fund their quests for growth through acquisition. Smaller REITs, in particular, which have already found the public equity capital markets unreceptive, may find them even more hostile.
Who are the winners, and where are the opportunities? Cheslock, Bakker & Associates believes that the greatest opportunities will accrue to private real estate investors who are patient and willing to exchange a lack of short-term liquidity for premium returns on their capital. These returns may be offered to investors in both the debt and equity markets, and the best returns will be harvested by those able to invest nimbly in both debt and equity as anomalies and inefficiencies in the $500 billion public real estate debt and equity markets emerge.