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CRE Finance World, Winter 2013

CRE Finance Roundtable: Outlook for 2013 Contrast the secondary market trend to what has been happening Sam Chandan: in the gateway markets since the early stages of recovery. Prices There is a lot to like about multifamily. It is very attractive as an are up and cap rates have fallen in a way that speaks to continued investment and development opportunity right now, and of course risk aversion. In part those lower cap rates are supported by an that is in part a function of the complex dynamic that we have with increase in leverage and historically low borrowing costs for qualified single-family housing. We certainly have improving fundamentals borrowers. But there is more to it than that. There is a decoupling which are well reflected in property prices and investment flows. The of pricing movements from underlying fundamentals that is being challenge for us is not that we are making the same mistake on the driven by capital market conditions. lending side that we did during the previous cycle, underwriting to perspective cash flow in evaluating going-in risk metrics. Conditions So we come back to this discussion around interest rates and are a little bit different. We know that fundamentals are improving monetary policy and the Federal Reserve’s goals in ensuring that and there is an expectation that they will continue to improve. But the inflation-adjusted yield on the Treasury is essentially negative. there is also a subset of markets where the combination of a growing It is not just to keep borrowing costs low; it also ensures that construction pipeline and a rebalancing in single-family housing capital must go on a hunt for yield. That has played out significantly demand means somewhat more modest rent growth as we look in commercial real estate, principally in those gateway markets forward. The challenge is in how multifamily acquisitions are being where there is a lot of liquidity. In some cases the force of that financed. Our credit risk models are telling us that in many cases we capital, whether it be from the equity or the debt side of the market, are planting the seeds of a fairly significant increase in delinquency has been strong enough that it introduces distortions in asset and default rates in the way that we are structuring new loans, pricing and return performance. ignoring interest rate and balloon risks. And that is somewhat troubling. We know that there are significant The challenge is going to manifest — for example — in untenable differences in terms of the performance and attractiveness of assumptions about exit financing costs that are being made in different investment and lending opportunities across markets this environment of extraordinary low interest rates. Today’s newly and property types. That is always the case. In many cases those originated loans will mature and need to be refinanced in an envi- differences and perceptions of risk are exaggerated now. ronment where underlying risk-free rates have the potential to be significantly higher than what we see today. That implies upward It is not too different from what we’ve seen with other asset classes. pressure on cap rates and higher refinancing costs. We can look Because there are subsets of the commercial real estate market at deals that have come to market over the course of this year where low interest rates are being internalized very aggressively and see increasing leverage, lower debt yields, and an increase in — multifamily, more than office, retail or industrial because of the interest-only periods. Amortization has been declining consistently structural relationship that exists between monetary policy and the over the last year. cost of financing to the agency — there are distortions in pricing that ultimately allow us to conclude monetary policy is playing a We then have to take the next step and say; some of these properties significant role in pricing, even where fundamentals projections may are in markets where the cash flow growth will offset the increase still be rather modest. Lenders should not be myopic in evaluating in interest rates and the upward pressure we will observe on cap the risks that accompany these distortions. rates, such that we can refinance these loans. The strength in NOI growth will allow the loans to perform over the next ten years and Brian P. Lancaster: also at that point of refinancing. Sam, you mentioned the apartment market, and that the GSEs are providing subsidized financing, but that is also one of the Where we face a more significant challenge is that there are a large few markets where we have seen significant rent growth. There number of loans in these deals, where if you look at the location is also a lot of construction coming online. Two questions: are and the other characteristics of the properties, there is nothing in apartment valuations justified by the fundamentals and are you the historical analysis to suggest that cash flow will grow rapidly worried about overbuilding and supply? enough to offset the downside risks that will result from higher interest rates, even if spreads narrow further. A publication of Winter issue 2013 sponsored by CRE Finance World Winter 2013 9


CRE Finance World, Winter 2013
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