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?

Can a mortgage be issued for virtual land? Apparently, it can in the metaverse

In a recent NAI article, we looked at the advent of the metaverse[SR1]  and what this new tech might mean for commercial real estate (CRE). Though we concluded that the answer to how the metaverse might impact the real world remains uncertain, since then, there have been some interesting virtual developments.

In particular, tech company TerraZero has started issuing “mortgages” for virtual real estate, and there’s very real money changing hands for entirely virtual properties.

A slice of (online) paradise?

To be clear, the “mortgages” in this case are funded entirely by TerraZero itself, rather than an external financial institution, but employ a system of down payment and instalments, much like the real thing. The first one was issued for a piece of land on a platform called Decentraland, where users can own, and sell, virtual assets. And as strange as this all sounds from a real estate perspective, there have recently been several big players setting up shop in the virtual world.

Perhaps the biggest, from a credibility point of view, is global financial leaders JPMorgan who recently launched a “virtual bank”, though at the moment it’s only being used for marketing purposes. In tandem with the purchase, JPMorgan issued a report, where they discuss their expectations for the metaverse’s development, saying:

“The success of building and scaling in the metaverse is dependent on having a robust and flexible financial ecosystem that will allow users to seamlessly connect between the physical and virtual worlds.”

They added that, in just the last six months of 2021, the average price for a virtual plot of land jumped from $6,000 to $12,000.

Hedging bets

Despite this apparent endorsement from one of the world’s leading financiers, there are still plenty of metaverse critics urging caution. One of the main points raised is that, unlike physical real estate, metaverse purchases can’t satisfy both property value fundamentals: namely scarcity and location.

Or as Louis Rosenberg, CEO of Unanimous AI and a veteran Augmented Reality (AR) developer, puts it:

“We don’t even know which platforms are [going to] be popular, let alone which locations… so it’s like somebody buying a piece of land anywhere in America and hoping that it becomes San Francisco or New York.”

For many companies though, hedging bets is taking the form of securing their own piece of the virtual pie. The Wall Street Journal reports that accounting firms PricewaterhouseCoopers and Prager Metis have also recently snapped up virtual sites, with the latter spending $35,000 on its purchase of a virtual HQ.

Is the metaverse here to stay?

Though it’s still early days, and impossible to say how the virtual property trend might play out, the recent developments in the space suggest it’s certainly worth keeping an eye on. At the very least, the metaverse poses an interesting proposition, and one a lot of people seem to be willing to speculate on.

SOCIAL: Do you think there’s a future for metaverse property? And if so, how do you see it unfolding?


Work smarter not harder: The impact of blockchain on CRE

So far in this blog series, we’ve looked at some of the most cutting-edge emerging technologies: The Internet of Things (IoT), robotics, and virtual reality. We’ve discussed the potential these developments have to revolutionize the way we do business and work in the real estate space. 

While each of those has its applications, none hold quite the same promise for changing the fundamental aspects of how we make, and document, commercial real estate (CRE) deals as blockchain. In this fourth entry in the emerging tech series, we have a look at the implications of this pivotal technology.

Blockchain basics

Nowadays, blockchain is a term everyone’s hearing with increasing regularity. To start, it’s worth having a brief recap of exactly what the tech is. At its simplest, a blockchain is a ledger – a record of information. Not all that different from the databases you’re already using to record details of properties, clients, or transactions. 

The feature that makes blockchain unique is the way that information is recorded. Each “block” can hold a certain amount of data. Once a block is full, a new block is started and the previous block forms part of an immutable chain – essentially a timeline extending outwards from the first block to the current one. 

Information on the blockchain is public and distributed across a network of computer systems – meaning that it’s very, very difficult for one person to hack or alter the information stored in the chain. 

Streamlined data

The opportunity blockchain presents for the CRE space, is the ability to streamline a lot of time-consuming tasks. Imagine having all of the paperwork for a given property digitized, accessible to everyone involved in the deal, and confirmed as accurate by multiple parties. 

Steve Weikal, MIT’s Head of Industry Relations at the Center for Real Estate, describes it like this:

“There are two areas where I think the blockchain is. There’s going to be the intersection with legal tech, so that’s land registry and recording and ownership, and all of that paperwork that exists in the system… the other is the intersection with fintech.”

Of course, an issue that comes up here is how this system can be used with potentially sensitive information – client details that shouldn’t be a matter of public record. For business networks, private blockchains can be set up to only allow access to specified parties. In this case, the identity of participants is verified in the network as well, unlike public blockchain where users can remain anonymous. Private blockchains function more like a traditional database in this sense, trading off some of the immutability of their data for privileged access. 

Sealing the smart deal

Maybe the most promising application of blockchain for CRE deals is being able to deploy “Smart Contracts” for things like tenancy agreements. Smart contracts hard code the details of an agreement on the blockchain, and are uniquely suited to real estate deals, because they can handle conditional clauses. 

As an example, startups like UK-based Midasium are already providing a prototype platform that replaces traditional landlord-tenant agreements. Using smart tenancy contracts, clauses of the agreement are automatically enforced when certain conditions are met. This can include paying rent, returning a security deposit, and directly deducting maintenance costs from the rental amount paid across to the landlord. 

It’s a system designed for transparency and rapid settlement, and the concept is gaining traction in other parts of the world. An added bonus of using smart contracts for tenancy is the possibility of building up a database of real-time data for rental prices and trends in the rental market.

A growing sector

Overall, enterprise reliance on blockchain is set for rapid acceleration. Forbes, quoting an International Data Corporation (IDC) report notes that:

“Investment in blockchain technology by businesses is forecast to reach almost $16 billion by 2023. By comparison, spending was said to be around $2.7 billion in 2019, and we will see this acceleration ramping up over the coming year.”

Blockchain adoption in CRE, however, is still in the early stages. The tech still needs to overcome a few growing pains – in terms of privacy concerns, operational complexity, and a lack of standardized processes – before we’ll necessarily see it forming the backbone of CRE transactions.

That said, it’s a space well worth keeping an eye on. There’s been growing interest, for example, in CRE tokenization –  splitting the value of a given asset into separately buyable blockchain-based tokens. What this means in practice is that instead of looking for one buyer for an expensive asset the value gets subdivided and opened to a much broader market. Which in turn may actually boost the value of the underlying asset.

There’s a lot of potential and little doubt that blockchain will make its way into CRE one way or another. But, like many things in the cryptocurrency and blockchain space, the real challenge will be separating the wheat from the chaff, the fact from the hype, and identifying functional applications of the tech rather than purely fanciful ones. 

Health check: the state of hospitality and hotel CRE

An economy reconfigured

It’s been a rollercoaster 18 months for everyone including market analysts who have had to provide insight and predictions on an unprecedented event, as the world bounded through recession, recovery, and reconfiguration. As it stands now, the US recovery has been swift, if uneven.

GlobeSt’s latest piece on this makes the argument for understanding this recession in different terms from so-called traditional ones, writing: “The COVID-19 recession was not caused by monetary factors, rather it has been a disruption akin to an unanticipated natural disaster which typically temporarily interrupts economic activity while leaving intact the underlying demand and supply of goods and services.”

Outlook

The above forms part of their outlook reporting for hotel sales, and as has been well-established hotels, tourism, and hospitality were dramatically affected during the peak of the pandemic travel-bans and “shelter at home” orders.

GlobeSt points to some encouraging signs, including the volume of startup businesses launching, low levels of household debt-service burdens (in relation to net income), rising house prices, increases in personal savings, and the Dow Jones Industrial Averaging gaining some 18% compared to Feb 2020 (a pre-pandemic peak for the index). Altogether, these are positive signs that the American consumer may well have additional discretionary spending in the coming months, and the tourism space could be on the receiving end.

Corporate travel is expected to increase in the second half of the year, on top of the increases already evidenced in daytrippers and weekend travel. As schools reopen, they are anticipating patterns to shift from leisure to work trips.

Early 2021 winners

The Wall Street Journal reported earlier this year that real estate investment trusts (REITs) and companies with holdings in retail and hotels “mounted a first-quarter comeback”.

“Real-estate investment trusts overall rose 9% during the three months, beating the S&P 500’s 6% gain,” according to data-analytics firm Green Street. Fueling the REIT rally was an 18% rise in the shares of lodging owners and a 32% gain by mall owners.

Creative strategies
Additionally, according to CNBC, distressed hotels were in demand from buyers looking for possible redevelopment and conversion projects, and other creative solutions to the low supply of affordable housing. “So-called Class C housing stock is now 96% occupied nationally and 99% occupied in the Midwest, according to RealPage, a property management software company,” CNBC writes.

And for hotels with no intentions of conversion – the vast majority – the pandemic also provided a kind of reset that allows for model innovation. “Similar to the airline’s ala carte approach, the hotel industry is attempting to move guests toward an opt-in choice for various services, such as daily room cleaning,” reports GlobeSt.

Counting the deals
This article provides a deep dive into specific deals and statistics from hotel sales and performance in 2021 so far and is a recommended read for those CRE professionals servicing the submarket.

It will also make for interesting reading from a capital markets perspective as it details funding activity: “As the U.S. hotel industry continues to emerge from the carnage induced by the global pandemic, an abundance of capital is beginning to fuel increasing activity with lodging sector mergers, acquisitions, and spinoffs,” they wrote.