Flowers & Roots

Alec J. Pacella

I’m always pleased to see comments from loyal readers. Most of the time, these are complimentary. But as a wise Yoda once told me, “Compliments grow flowers, but criticisms grow roots.” And while one of the comments I received in response to last month’s column wasn’t a criticism, it was insightful.

The gist was a historically limited viewpoint from the lender’s perspective. The comment wasn’t wrong; prior to the concept of 365/360 loan amortization covered last month, it had been a few years since anything related to the lender’s perspective was considered. And make no mistake – lenders are a dominant part of the commercial real estate landscape. Last year, nearly $4 trillion of capital invested in commercial real estate came from lenders, as compared to $2.7 trillion of equity. Given the significant role that lenders play, this month will be a bit of a ‘two-fer’ and follow up on some basic metrics that a lender uses to determine the appropriate level of participation in an investment.

One of the most common (and easy to understand) metrics used by a lender is the loan-to-value (or LTV) ratio. This approach considers the underlying value of the real estate as compared to a ratio established by the lender. For example, the lender determines a property to have a value of $1 million and has established a 75% LTV ratio.

In this instance, the lender would be willing to provide a maximum loan of $750,000 ($1,000,000 x .75). Another metric related to LTV but less common is the leveraged ratio. It measures the amount of equity as compared to the total investment. In the example above, the leveraged ratio would be 4:1, which means that every dollar of equity equates to four dollars of total value ($1,000,000 divided by $250,000). LTV and leveraged ratio are both focused on the underlying value of the real estate, but a lender will also look at the income characteristics of the asset. A primary measure with this focus is known as the debt service coverage ratio (or DSCR), which helps to ensure the property has sufficient cash flow to make the loan payments. LTV and leveraged ratio are simple and only require one step. DSCR is a bit more involved and requires two steps. The first step is to determine the maximum annual debt service given the property’s income, as represented by net operating income (NOI) and the DCSR established by the lender.

This ensures there is not just enough but more than enough income to service the debt. Assume a property has a NOI of $80,000 and the lender establishes a DCSR of 1.25. In this instance, the maximum annual debt service would be $64,000 ($80,000 divided by 1.25). This ensures a measure of safety for the lender, as the NOI could fall by up to

Another metric that has risen in popularity over the last decade is known as debt yield, which represents the percent of NOI as compared to the original loan amount. This is a helpful measure of risk for a lender as it illustrates the yield that a lender would realize if they were to come into a direct ownership position due to a default by the borrower. It is also a valuable metric as it helps to ensure the loan amount is not inflated by low cap rates, low interest rates or a long amortization period. Calculating this is straight-for- ward: dividing NOI by the loan amount. Again, using our example and assuming a $750,000 loan, the debt yield would be $80,000 divided by $750,000 = 9.375%.

The last metric I would like to discuss is also one that has been around the longest  the venerable loan constant. It measures the annual debt service, including principal and interest, as compared to the original loan amount. Using our example and again assuming a $750,000 loan, the loan constant would be $61,910 divided by $750,000 = 8.255%. At the risk of sounding like the kid that had to walk to school and back uphill and in two feet of snow, a loan constant was used to calculate loan payments in the days before financial calculators. The cutting-edge real estate tool back then was a little book with a red cover entitled “The Ellwood Tables.” It was filled with pages upon pages of tables with eight-digit numbers.

At the risk of sounding like the kid that had to walk to school and backup hill and in two feet of snow, a loan constant was used to calculate loan payments in the days before financial calculators. The cutting- edge real estate tool back then was a little book with a red cover entitled “The Ellwood Tables.”

To use it, you would match up the columns for the lender’s nominal interest rate and loan amortization period. Once the corresponding eight-digit number was found, you multiplied it by the initial loan amount and, shazam, the annual debt service would be known. In the example above, matching up the column for a 20-year loan amortization with the row for 5.5% interest would result in a factor of .08254667.

Upon reviewing a sampling of past articles, the topics associated with mortgages and the debt market are indeed far and few between. And if it wasn’t for some- one taking the time to point this out, this month’s article would likely have been centered around internal rate of return, net present value or cap rates.

Keep those comments coming, gang! AP

Published in Properties Magazine July 2022

Report says CRE leaders expect post covid resurgence

In May, law firm DLA Piper released the 2022 edition of their Annual State of the Market Survey report, highlighting that “optimism about the future of commercial real estate (CRE)” remains strong despite the headwinds the industry faces.

The survey on which the report is built was conducted in February and March of 2022, by collating and analyzing input from CRE leaders and professionals in the US – specifically their take on matters including “pandemic recovery, economic outlook, attractiveness of investment markets and overall expectations over the next 12 months”. This input is further contextualized with additional research, presented the report.

Highlights

Overall, the report [PDF] shows “increased bullishness”, with “more respondents in 2022 [having] a higher level of confidence for the real estate industry’s next 12 months”.

Findings from the report also include that 73 percent of respondents are “expecting a bullish market”. This is consistent with 2021 expectations. “However,” they added, “this year, respondents reported feeling a higher level of confidence in a bull market over the next 12 months; 33 percent described their bullishness as an 8 or higher in 2022, compared to just 16 percent in 2021.”

Top contributing reasons include the apparent availability of capital in the market, with over half of the respondents citing this as the main source of their confidence.

Viewed per sector, Commercial Property Executive says in their analysis of the report, “Industrial (66 percent) and multifamily (57 percent) remain the property types that investors believe offer the best risk-adjusted returns over the next 12 months.”

Shaping CRE

Inflation and interest rate changes were ranked most likely to have an impact specifically in the CRE market in the coming year, but ecommerce, migration of workers out of city centers, and the “redesign/reimagining use of office and other commercial spaces” were also common responses.

Concerns remain

Top concerns included interest rate increases (cited by 26 percent of respondents), inflation (18 percent), as well as the Russian invasion of Ukraine.

US gains and advice

Finally, respondents to the survey said they felt the US would be seen as a safe and stable option, attracting non-US investment. “During times of uncertainty – like the pandemic or the conflict in Ukraine — investors often flock to safe havens,” the report reads, adding “a well-defined legal system, transparency and proven economic resiliency” are among the US’s assets.  

In the face of global uncertainty though, the report authors caution that CRE professionals and firms must “remain agile and prioritize adaption, with an eye towards staying ahead of the curve”.

SOCIAL: Do you see the US CRE market as a safe haven in times of global uncertainty? How do you expect inflation to make itself known in your CRE specialty?

REITs sag under general market pressure in April, May 2022

The Q2 2022 has been a scary ride for markets and investors around the world. Increased geopolitical tensions, widespread inflation, and rising interest rates in many territories have been a cause for concern, and the capital markets bore the brunt of that low sentiment.

A recent look at the numbers shows that real estate investment trusts (REITs) didn’t escape the sell-off.

Crunching the numbers

The FTSE Nareit All Equity REITs index shows a decline of 3.66 percent in April. This is, as Wealth Management succinctly argues, “a major reversal from 2021, when REITs posted a 40 percent rise in total returns”.

Benchmarking against peers

Despite this, REIT total returns are trending stronger than many other indices in 2022, including some “darlings of the market” like S&P 500 (contracted 12.92 percent) and the Dow Jones Industrial Average (declined by 8.73 percent).

A history of performance

Bezinga data says: “The FTSE Nareit All Equity REITs index has outperformed the S&P 500 in total returns during 13 out of the last 20 years with an average total annual return of 13.1% versus 11.1% for the S&P 500 over the same time period”.

REITs use case

As an investment vehicle type, REITs are considered one of the most accessible ways for individuals to buy into commercial real estate (CRE), which has long been the terrain of institutional investors.

Although regulation changes have opened up this category in recent years, REITs still enjoy popularity with retail investors for the above reasons, and the relatively high dividend yields.

Takeaway

Although we do not offer this as financial advice and individual investment products must be reviewed on their own fundamentals, REITs are still largely considered an inflation hedge when rents are rising – making them one fascinating asset type to watch in 2022.

Industrial CRE’s “strong fundamentals” mean resilience

A recent report – released in late May 2022 – shows the industrial commercial real estate (CRE) boom is far from over, even when the “headwinds” are accounted for.

The May 2022 Matrix Industrial Report, from Yardi Matrix, says that although the “economy hit a rough patch in the first quarter due to inflationary pressures and rising energy prices, […] demand for industrial space continues to be robust”.

The continued presence of market fundamentals like increased consumer spending and job growth are adding to the sense of resilience seen from the sector, which has made huge strides since the dawn of Covid-19 kicked online shopping and fulfilment into particularly high gear.  

Drag factors

CRE in general and the industrial CRE sector in particular do face a range of economic pressures as we look to the second half of the year. Slower economic growth in the first quarter, supply chain issues, and “persistent inflationary pressures” are not insignificant depressive factors, but the drivers of demand are not going anywhere either.

Boost factors

The boost factors, on the other hand, include “healthy consumer spending”, and “the need to bring the nation’s stock up to snuff to support modern logistics”.

Additionally, occupancy across most US metros remains high and “rents are growing well above historical levels around the country,” according to the report. Rental averages across the US have increased by 440 basis points year-on-year.

Industrial building supply chain

The report calls the new supply chain for industrial building “extraordinarily robust”, but, as Commercial Property Executive reporting on the report highlights, “[a]lthough the under-construction pipeline is ballooning, experts see the industrial market as severely undersupplied”.

This assessment, from Prologis, draws from several different data sources including the Purchasing Managers Index, retail sales data, and job growth statistics, to posit that the US has “16 months of available industrial inventory”.

Reportedly, over 640 million square feet of industrial space was under construction nationwide at the end of April. Including planned projects takes the pipeline to 650 million square feet.

Global trend

Far from being a US-only trend, demand for industrial is high among most developed economies – or almost anywhere with a strong consumer base demanding more and quicker online shopping and delivery.

As this Financial Times article shows, that’s the case even where Amazon space acquisition is slowing: “There has been record demand for UK warehouses in the past two years,” they write, “with take-up north of 50 [million] square feet compared with a pre-pandemic average of 32 [million square feet]”.

Social: Are you operating in a well-supplied industrial CRE market, or are people scrambling to find space? Tell us where in the world you are, and what the “pulse of industrial” is in your region?

US foreclosures: records and rebalancing

Foreclosures in the US were up in the first quarter of 2022 – setting what the data provider calls a “post pandemic high”. The data provider in this case is Attom, who specialize in real estate and property data – including tax, mortgage, deed, risk and other information for “over 155 million properties” country-wide.

It must be noted however that this level of foreclosure activity is still considerably better than the highs seen in 2020, before government intervention (more below).

A tale of two months

Attom’s Q1 2022 U.S. Foreclosure Market Report – released in April 2022 – shows a total of 78 271 properties filed for foreclosure in the first quarter of 2022. This is, they write, “up 39% from the previous quarter and up 132% from a year ago”.

Additionally, in March 2022 alone, the data indicates over 33 000 US property foreclosure filings – an increase of 29% from the prior month, and 181% compared to March 2021.

A mere month later, however, in the month-to-month reporting from the same provider (April 2022, released in mid-May), showed “a total of 30,674 properties with foreclosure filings — default notices, scheduled auctions or bank repossessions”. This was down 8% from March, but up 160% from April 2021.

Questioning the headline

As covered before on this blog, it is important to assess data and market reports like this one as pieces of a larger picture – viewed in context of time and other indexes. It is also worth noting that there is typically a delay between economic “crunch”, consumers feeling the pressure, and market movements showing the effects of said pressure.

The above caveats notwithstanding, the trend line this report highlights is concerning for investors who watch the residential market, and commercial brokers whose specialty/sectors are affected by residential, such as multi-family.

Specifically, the data point that March 2022 was “the 11th consecutive month with a year-over-year increase in U.S. foreclosure activity”, is not a positive direction for this metric.

Post-moratorium balancingWriting about the Q1 2022 “record”, a spokesperson for Attom explained that this foreclosure activity is “gradually return[ing] to normal levels since the expiration of the government’s moratorium” and the CFPB’s enhanced mortgage servicing guidelines”.

What economic and commercial property data do you keep a close eye on?