Lending Advice
by Mark Levine
For those of you who have read this column in the past, you may have noticed that I generally come from a positive point of view because I have always found at least some reasons to be optimistic about our industry. Of course, that positive frame of mind hasn’t been too difficult to maintain over the past several years. No matter what part of the business you are in, market conditions for most of this decade have been nothing short of excellent. Housing prices have skyrocketed, commercial cap rates have consistently declined, debt and equity have been inexpensive and readily available, and the market has matured perhaps more than any other industry in recent years. Some might say that this has been a golden age for nearly all facets of real estate.
So, is the party over in 2007? Will the slumping housing market bring down the economy? Will rising interest rates lift cap rates on an upward ride? Will all of these factors cause lenders and investors to stop handing out bags of cash? And most importantly, should you be running for the hills instead of reading this column right now?
In short, the answer is no. I believe that nearly everyone in our industry recognizes and understands that we are experiencing a significant hiccup in the housing market. In fact, nearly anyone who watches television, reads the local newspaper or listens to a radio is aware of the housing slump. In a sign of how mainstream real-estate investing has become, these recent developments are now front-page headlines among most news sources. But beyond the mainstream media, there are some additional indicators that are important to watch if you have an interest in the overall health of our industry.
One troubling sign, which is just beginning to rear its ugly head, is the sudden rise of residential mortgage delinquencies. This has not yet become a general interest story for mass media and, frankly, it probably will not. Fortunately, we have learned from our past mistakes when banks and other financial institutions (think: savings and loan crisis) were nearly or completely wiped out due to overexposure to real-estate and interest-rate risk. Now the capital markets are highly developed and sophisticated; they spread the risk among many investors who are theoretically well diversified. This should protect the financial markets and the overall economy from another crisis situation.
However, just because you are not reading about delinquencies in the Sunday Chronicle, that does not mean that everything is perfect. Let’s look, for instance, at the subprime mortgage industry. Somewhat quietly near the latter half of 2006, the major rating agencies began announcing that they were downgrading several classes of mortgage-backed securities backed by subprime loans. They noted that delinquencies have increased during the latter half of 2006 and that the rate of defaults will likely accelerate throughout 2007.
But, why should you care what the rating agencies think? The reason is that there are billions and billions of dollars that move everyday according to what they report. When the rating agencies speak, investors listen. To be more straightforward, if the rating agencies downgrade a bond, you pay more to borrow money.
Without getting into too many details, investors who buy mortgage-backed securities require a certain rate of return that is commensurate with the risk level of the bond. For someone to invest in an “AAA” bond, they might only ask for a 5% rate of return, but someone buying a “BBB” bond might require a 6% return. If the rating agencies suddenly start to show a trend of downgrading bonds, and investors therefore believe that their “AAA” bond is going to become a “BBB” bond at some point, they will, of course, require a higher return. Because the markets are so efficient these days, this higher rate quickly gets passed to the lending institution and—you guessed it—then gets passed directly to the borrower.
It is important to note that the downgrades lately have been focused on subprime loans and not necessarily traditional first mortgages. Subprime loan pools are heavily comprised of mortgages that carry over 100% loan-to-value ratios and loans that require no borrower income verification. As always, hindsight makes it somewhat puzzling to even think about why someone originated these loans in the first place. But let’s not forget that at this time last year, prices were still appreciating faster than lenders could write checks and nearly everyone thought that the good times would continue to roll.
Unfortunately, troubles in the financial markets tend to happen in waves, and more often than not, defaults on aggressive loans are precursors to trouble in the more traditional mortgage markets. After all, mainstream residential mortgages have recently required only a 5% down payment, which is not far from the aforementioned subprime loans with no equity required. I expect that we will be talking about much more widespread delinquencies and downgrades at this time next year.
In my opinion, the troubles that will almost certainly magnify themselves in 2007 will be centered on the residential real-estate industry. Although the criteria to borrow money in the multifamily and commercial markets have certainly loosened significantly, the markets have maintained some level of discipline. Lenders and investors have fortunately not relinquished their rights to perform extensive due diligence on mortgaged properties. Although this can lead to onerous and sometimes expensive processes for a borrower seeking to obtain a mortgage in the capital markets, it has hopefully been beneficial for the overall good of the industry.
Despite these precautions, there will probably still be a small price to pay. The most obvious is a likely increase in the rates that lenders will need to charge in order to offset the perceived increase in risk. Your property and your loan might not change in terms of credit characteristics, but as you know, a few bad apples will make investors slightly more suspicious about the rest of the bushel. When General Motors has financial troubles, Ford investors also pay a price. The same goes for the big picture of credit investors and, more specifically, those who invest directly in mortgage-backed securities.
Another repercussion might be a constrained supply of mortgage funds available to borrowers. Because most of the lenders and investors in the residential mortgage market are also heavily involved with the commercial and multifamily markets, any creditors who are significantly hurt might pull back from the mortgage markets altogether. As mentioned earlier, there is great diversity among investors and lenders now, so you should not expect a drastic or even significant lack of funds. However, it could still be noticeable. In the end, you will still be able to tap many resources for financing your properties; but you might no longer have the power to obtain some of the more aggressive terms that have characterized commercial mortgage lending over the past few years.
Remember, though, there are some potential benefits to multifamily and commercial owners when the residential mortgage industry has its hiccups. First, and perhaps most obvious, is the migration of homeowners back to multifamily living.
As Americans realize that leveraging themselves beyond their means in order to obtain their dream McMansion is imprudent, they remember that renting is again a smart alternative. Furthermore, there are many institutional investors who are fully committed to real estate, either because it is required by their organizational structure (REITs and industry-specific investment funds) or because they fully believe in the long-term nature of the asset class. If these investors begin to perceive significantly higher risk characteristics in residential real estate relative to commercial real estate, the majority of that money will flow to the commercial and multifamily side.
A more indirect result of the residential mortgage industry’s problems is that interest rates could actually be held down. We already discussed why rates could increase due to the credit issues in the market, but it is important to note that there might be an opposing force to fight this rise. This force is known as the Federal Reserve Open Market Committee, and it is formidable. If the Fed continues to view the residential housing market and the overall credit market as two of the most important barometers of the national economy, certainly a downturn in both arenas will not go unnoticed. Whether there is a downturn in investor sentiment due to mortgage delinquencies, or an actual slowdown in spending and prices due to lower consumer confidence, the Fed will have a very difficult time even considering rate hikes in 2007.
So, in sum, the news is not a resounding good or bad for the apartment and commercial real-estate industry. The point is really to just keep an eye on what happens in the residential mortgage arena and be aware of the various implications. There are certainly credit issues out there and they are quietly beginning to snowball into some relatively serious problems. High leverage mortgages and other aggressive lending tactics have been masked by extremely favorable price appreciation in the recent past, but now the winds are clearly beginning to change. For better or for worse, all aspects and all types of real estate are along for the ride.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2007 by the SF Apartment Magazine. All rights reserved.