Wednesday, May 20, 2009

Cap Rates and Commercial Real Estate Default

Commercial real estate mortgages are different from residential mortgages in a number of dimensions. One of the most important is term: while residential mortgages are generally self-amortizing, commercial mortgages usually have "bullets" or balloon payments arising from terms that are shorter than amortization schedules. For instance, a commercial mortgage might have a ten year term with a 40 year amortization schedule.

Many of these commercial loans are currently due or will soon be due. Many of them are performing well, in the sense that buildings, even after rent reductions, are producing sufficient cash flow to cover debt service. But because expectation have changed, capitalization rates have risen. This creates a problem.

Real Estate may be valued similarly the way stocks are values using the Gordon Growth Model. Income gets capitalized into value via a capitalization rate, which has two basic terms: a required rate of return, or discount rate, and an expected rental growth rate. The formula for valuation is simply V = Income/(r-g), where V is value, r is the discount rate and g is the expected growth rate.

Five years ago, a high quality office building would have a cap rate of 5.5 percent. The ten year treasury rate at the time was around four percent, so the 5.5 cap rate might have reflected that four percent rate plus a three percent risk premium less a 1.5 percent expected growth rate in rents (4+3-1.5).

Now, the ten year treasury rate is around 3 percent (actually 3.24 at this writing), which would tend to push down cap rates. but risk premia have widened, and rents are expected to fall. Suppose the risk premium is now 5 and rents are expected to fall one percent per year (they don't change that much from one year to the next because long term leases are in place). Now we get a cap rate of 3+5+1, or 9 percent. This would imply property values falling by (1-5.5/9), or a little less than 40 percent. This may overstate what is happening--as best as I can tell, values have fallen by about 1/3.

Consider a loan originated 5 years ago at a 5.5 percent cap rate and a 70 percent LTV. The loan to value ratio would have been conservative, and yet if the loan had no amortization (certainly a possibility), the building owner would be upside down, with a loan due greater than the value of the real estate. These are the properties that are extremely difficult to refinance, and may produce the next credit crisis.

Of course, had the mortgages been self-amortizing without a bullet, many of the loans would not have turned into problems.

49 comments:

Salesman of the Year said...

IF you are going to run hypothetical numbers make them accurate. I realize that you are showing an example, but saying cap rates are going from 5.5 to 9 is absurd.

Great Article though.

Anonymous said...

I would respectfully disagree with Salesman of the Year. I would suggest that a 5.5% cap rate was absurd, just like the dot com bubble was absurd. With debt costs at 8%-10% for 70% LTV and GDP growth expected to be subdued for several years, a 9% cap rate may not be the bottom.

willie green said...

I think some of this could be adjusted or fixed with government loan guarantees to encourage banks to refinance with a lower assumed risk rate. It seems the only other option available would be the use of Chapter 11 of the Bankruptcy Code to force a modification of the loan into an amortizing loan based on value(if lower than balance) of the building rather then loan balance, but then to be paid at the market risk rate.

Bernie Madoff said...

re:"I would suggest that a 5.5% cap rate was absurd"

Absolutely! It's the last few years that were the aberration. Much higher rates are coming.

Anonymous said...

I must have had some bad breakfast, because I would also like to respectfully disagree with willie green. I think the government should stay away. Why force costs onto taxpayers. Further, I think the government is much less efficient and error prone than the private sector. There is plenty of money out there to clear the market. Let the bubble pop.

Anonymous said...

When in doubt, use a 10 cap.

AngriestOfAll said...

This is really amazing. The commenters here really have no idea how bad things are and are going to be. Did professional sports, american idol, and cnbc do this?

9 cap sounds high? Capitalize the income on an empty building. Let's say you can hang a large banner from a 50,000 square foot building and generate $1000 per month...

This is easy math: Miniscule "real" economy = massive unemployment. Massive unemployment = staggering vacancy rates. Empty buildings = empty cap rates.

[shaking head]

Anonymous said...

40 year self amortizing mortgages sounds like a sensible change to make. That and letting REITs keep a reasonable percentage of profits to expand, so they don't need to borrow so much.

San Diego Property Management said...

Salesman of the Year- you should stick to sales. Everything reverts to the mean- everything.

We *will* return to Cap Rates of 8-9.

I can just imagine when Cap rates were at 9 (80's), someone like yourself saying how absurd it would be that Cap rates could actually fall to 5.5.

For context, I write a blog on San Diego Property Management

Austin Kelly said...

homebuyers are engaged in life cycle savings and consumption. Most of these borrowers probably want a loan that will amortize, as it accomodates their saving profile (I wonder how much of the problem with single family IOs and especially Neg Ams stems from the kind of borrowers who self-selected into these programs). Most multifamily borrowers are partnerships, coroporations, and other such fictional persons that attempt to stay fully leveraged at all times, and don't have any life cycle motivation to save. Since a lot of multifamily refi activity is expressly for equity take out (yield maintainance, etc. precluding interest rate reduction motivations by and large) by making these loans amortize you'd just make them churn and refi more often,

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John Fox said...

Your comments are right on - especially the last paragraph! You hit the nail on the head several months ago. These mortgages that are coming due are upside down. Trying to refinance a 70% loan today on a property that is worth 1/3 less. You can't get a 70% loan and the value is down so you will be writing a check at closing.

Team AZ Advisory said...

Federal bank regulators are close to issuing guidelines aimed at encouraging lenders to work out distressed commercial real estate loans. But how will this happen if there's no liquidity in the market?

George M said...

9 cap sounds high? Capitalize the income on an empty building. Let's say you can hang a large banner from a 50,000 square foot building and generate $1000 per month...

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Do you have any latest predictions about the cap rates because I have joined this field newly? Thanks in Advance!
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Ericwipe287 said...

I think 7-8.5 will be better cap rate. What would you say?

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