October Rate Watch
DARBY: Hello, this Darby Worley, your host for the Capital Synergies Talk Show for Commercial Real Estate Investors, and today we have with us Mr. A. Sean Aguilar, CCIM and Vice President of Steelhead Capital, along with our guest, Mr. Dan Fasulo, Director of Market Research for Real Capital Analytics.
Sean and Dan are here to talk with about commercial mortgage rates, and to give us some insight as to the affects that recent rate changes have had on the psychology of investors in today’s market.
Good Morning, Sean and Dan, welcome to the show.
SEAN: Good morning.
DAN: Good morning.
DARBY: Thanks guy for coming on. So in commercial real estate investing, we generally have three types of buyers, institutional, private investment and exchange. And each of these groups has been affected in some way by the recent turmoil in our capital markets, and more specifically with the recent interest rate adjustments.
So Sean, can you speak to the point…how have recent financial events impacted each type of commercial real estate buyers?
SEAN: Sure, I think the impact is on different levels, and more specifically the greatest impacts on the investment client, or the market in which we are currently experiencing interest rate volatility in the tightening of debt markets. Therefore from the banks, you know, we’re seeing tighter credit standards, higher borrowing costs, if you will, and I think this is affecting every borrower at all levels except maybe the institutional buyer as they typically have the ability to pay all cash, and when they do use debt, it is usually at a very low leverage.
As for the private investment companies and the exchange buyers, they tend to take a shorter term view, if you will, and they tend to use high leverage. And they’ve clearly seen a major impact to their business these days in reference to loan proceeds, yields, and returns. And…I have to say that the impact is probably greatest upon them right now.
DARBY: Okay. Dan, talk a little about the psychology of sellers and buyers out there. How is it impacting deal flow today? And how are interest rates also impacting that psychology?
DAN: Well, you know, there’s no question that the credit crunch that occurred in August had a significant act…impact on deal activity throughout the country. Now like Sean said, we’ve certainly seen the greatest impact being felt by, you know, your highly levered private investors. You know, the groups that were using 90 percent leverage. But I think, you know, what’s great about the market right now is that the diversity of capital groups that are out there looking for commercial real estate in the U.S. And you almost have to bifurcate the different markets across the U.S.
Now the primary markets where, you know, there…there’s been capital groups that have been ready to kind of fill the void when we lost these highly levered private investors, have sustained themselves relatively well considering the environment. And you know, it’s the institutions that really have stepped up their buying recently.
But more of your markets that are dominated by private investors, we…we certainly expect to get hit the hardest over the next couple of months.
DARBY: Sean, what’s the relationship between interest rates and cap rates in relation to this psychology?
SEAN: Well, I think as we know, you know, the interest rate it’s a…it’s comprised of a spread plus an index. You know for instance, long-term fixed rate are tied to a 10-year treasury which, you know, today is prob…you know, hovering around, you know, 470 and the spreads, you know, they’ve moved up to about 220 basis points more or less over, you know, from the past when I think on the same type of asset you’d be quoting 100 basis points.
So you know, clearly the interest rates have changed, you know, through this credit crunch, more specifically the spreads. And as for the psychology though, I think its fair to say that, you know, if you’re a trade buyer you’re not seeing the upward adjustment in cap rates yet that you like to see, which you know, because obviously, you know, translates to lower value, lower price. And you know, so they’re not seeing the sellers lower their price to reflect the increasing cost of borrowing. And this is becoming a big concern for them because, you know, for…in reference to positive leverage, it’s really not being obtained, or it’s being limited because of the difference between the cap rates, and the interest rate. And, you know, it’s impacting motivation of…of buyers doing deals, and again, this…like what Dan was saying, I think if we took the exchange buyer and the trade buyer, I think you see a big impact on them right now. You know, from the difference in interest rates and cap rates.
DARBY: Dan, since the spreads have widened, and therefore interest rates are reflecting these adjustments, where do you see cap rates going over the next 6 or 12 months?
DAN: Well, you know, there’s no question, you know, if you just do some simple math. You have to believe that cap rates are going to move upward. However that being said, I have to go back to the bifurcation of markets, and you know, sellers are certainly holding…holding their prices relatively firm in the primary markets. However, you know, we track new offerings to the marketplace, and in secondary and tertiary markets we’ve definitely seen some rising cap rates on the offering side.
Now it’s going to be interesting to see how that really plays out over the next couple of months. And whether, you know, the buyers are really matched up perfectly with the sellers.
DARBY: I mean, can you even venture a guess as…and in terms of the actual number or…
DAN: Well, you know, there’s certainly some evidence already that cap rates have…have risen about 30 basis points in secondary and tertiary markets.
DARBY: Okay.
DAN: We have little evidence to show any type of significant increase in the primary markets just yet. I think what many investors were worried about was whether or not this credit event was going to move over to the general economy and push us into some sort of recession. But now that those fears have kind of dissipated a little bit, I think that we’re going to see buyers and sellers start to get together once again on pricing by the end of the fourth quarter, and I think we’ll see deal activity return pretty strongly.
DARBY: Okay. Sean, ultimately if we see sellers taking a more analytical approach to cap rates, isn’t this what’s going to lead to more activity in the commercial real estate market?
SEAN: Yes, I mean, you know again, kind of leveraging off what our counterpart Dan is saying here. You know, for the institutional borrower and the buyer if you will, you know, their activity probably really hasn’t changed that much; and again, they tend to chase, you know, operate in these primary markets chasing Class A assets, and again, since they have the ability to pay all cash, or use very low leverage, or no debt at all, there probably won’t be much moving in the price right now over time. And I guess that over time we’ll see because the market will tell us.
But you know, we haven’t really seen much moving in that either and we haven’t really seen the activity change much on that. Maybe the interest into the properties because of the private investment companies maybe had to back off because they tend to use more high leverage financing to acquire those deals. But you know, there are…there’re still out there buying, and actually buying deals now and taking a second look at deals because they’re getting, you know, things at a…at a maybe a slightly higher cap rate, and so they’re re-looking at deals, and getting active.
But I think in reference to, you know, looking at exit cap rates, and you know, more deal activity it’s really going to be interesting for again, in the exchange market, what happens there because, you know, the sellers in the exchange markets, at least on the single tenant side for an example, or specifically more the merchant builders, the developers, I think they’re going to have to start rethinking their cap rates, and to see, “Hey where do they need to be on the exit side,” because the exchange buyers now actually have a…a viable alternative that they’re looking at in reference to capital gains.
You know, there’s con…some concern out there that the…there maybe a change of parties in Washington in reference to the White House. And capital gains, you know, are currently at a very low tax rate. There’s a concern that that may be increasing with the change of parties in Washington, and so, you know, trade buyers are sitting there saying, “Well if I can’t get the yield I’m looking for, maybe I should pay the tax, and take my cash and sit on the sidelines and see where the market goes.”
So in reference to deal activity I think, you know, if we see the merchant builders start moving their cap rates we’ll see some…you know, we’ll see some good activity. I think if they’re holding out, I think when it comes to the trade bar because of the time restrictions they’re under, we may see less deals done there as they take cap gains and sit on the sidelines.
DARBY: Okay. So you sounded…you guys have both mentioned a couple of concerns of investors. Dan, aside from the concern over the general economy and the capital gains, are there other concerns of investors as they look at transactions over the coming months that you’d like to speak out…speak to?
DAN: Yes, you know, there’s no question that the CMBS marketplace has been a key source of debt financing for commercial real estate over the past several years. You know, some have said it…it made up approximately 30 percent of the overall debt market. And I think whether or not that reappears, or the conduit window, I think that will kind of determine where we’re going to go in the near term.
There’s no question that many of the mega deals that have been financed over the last couple of years have used public financing and the conduit window. So I…I think depending on what form that reappears in upcoming months, I think that will really have a significant impact on whether these mega deals in the marketplace return.
DARBY: Sean, do you have any closing comments or questions for Dan?
SEAN: Well, in reference to a closing comment, I just think a…we’re probably going to see a lot of private companies, if you will, and investment houses. You know, they are definitely re-looking at their yields, and I think you’ll see an adjustment in expectations in returns for their clients. So we’ll start seeing that filtering through the market.
But in reference to something Dan said, and I’d like to ask Dan because he referenced the CMBS market, Dan, can you give us some color in our eye, and some…some color on the current CMBS market in reference to securitizations, because that’s usually how they recycle their money if you will, to be able to lend more out. Can you kind of give us a State of the Union on what’s…what’s currently happening in that area, and how it’s impacting deals?
DAN: Well, there’s no question that securitizations have stalled, and I think that many of the financial firms that are holding some of these notes are going to need to clear out their inventories before we really get started again. And there’s no question that the lack of public financing for deals is…is having an affect on pricing. And you know, I think that, you know, for these mega deals pricing is going to have to come down because buyers are going to need to use some traditional forms of financing to get them done.
A good example of that was certainly the Archstone deal that just closed last week, and it…it took a completely different form at the end than what it originally was going to look like in the beginning when they went under contract.
Well, overall though, I think we’re really bullish on commercial real estate in general. It still looks relatively attractive versus, you know, the other asset classes out there, and you know, for the most part, especially in primary markets, you know, supply is very much constrained, and fundamentals are strong. And I think we’re gong to need more than this…this credit hiccup to really stop us from continuing to see a healthy commercial real estate market.
SEAN: Dan if I may just ask ...
DAN: Yes.
SEAN: As a follow up, when you reference pricing for the…and specifically the Archstone deal, it took a different form, I’m assuming you’re saying in reference to interest rate and terms, the interest rate probably increased if you will, and then that actually…in reference to terms and stuff, on Archstone, did it therefore require them to lower the price of the overall deal?
DAN: Well, from my knowledge they did not lower the price of the overall deal. What I was referring to as far as structure is…is bringing in some government sources of financing through Freddie Mac and Fannie May.
SEAN: Okay.
DAN: Which allowed the deal to get done at the existing, or the terms they originally agreed on. That’s just…the fact that it got done in this type of environment is a very bullish sign for the marketplace, I believe.
DARBY: Thanks to Sean and Dan. This has been a very helpful discussion on commercial mortgage rates, and the impact that rate changes are having on the psychology of investors.
Dan, I know we don’t need to tell this, but it has been a real honor to have you share this information from Real Capital Analytics, and we certainly hope to have the good fortune of your joining us again on the show in the future.
DAN: My pleasure.
DARBY: All right, very good. Again, if you’re an investor, or in addition to financing looking for guidance in the acquisition or disposition of commercial real estate, be sure to checkout the new advisory services offered by Steelhead Capital. Just visit Steelheadivenstments.com, and request your no obligation portfolio review today.
This has been Darby Worley your host for Capital Synergies. Thank you again, Sean and Dan, and we’ll see you next time on the show.
DAN: Bye, Darby.
SEAN: Bye, Darby.
DARBY: Bye, guys.
Sean and Dan are here to talk with about commercial mortgage rates, and to give us some insight as to the affects that recent rate changes have had on the psychology of investors in today’s market.
Good Morning, Sean and Dan, welcome to the show.
SEAN: Good morning.
DAN: Good morning.
DARBY: Thanks guy for coming on. So in commercial real estate investing, we generally have three types of buyers, institutional, private investment and exchange. And each of these groups has been affected in some way by the recent turmoil in our capital markets, and more specifically with the recent interest rate adjustments.
So Sean, can you speak to the point…how have recent financial events impacted each type of commercial real estate buyers?
SEAN: Sure, I think the impact is on different levels, and more specifically the greatest impacts on the investment client, or the market in which we are currently experiencing interest rate volatility in the tightening of debt markets. Therefore from the banks, you know, we’re seeing tighter credit standards, higher borrowing costs, if you will, and I think this is affecting every borrower at all levels except maybe the institutional buyer as they typically have the ability to pay all cash, and when they do use debt, it is usually at a very low leverage.
As for the private investment companies and the exchange buyers, they tend to take a shorter term view, if you will, and they tend to use high leverage. And they’ve clearly seen a major impact to their business these days in reference to loan proceeds, yields, and returns. And…I have to say that the impact is probably greatest upon them right now.
DARBY: Okay. Dan, talk a little about the psychology of sellers and buyers out there. How is it impacting deal flow today? And how are interest rates also impacting that psychology?
DAN: Well, you know, there’s no question that the credit crunch that occurred in August had a significant act…impact on deal activity throughout the country. Now like Sean said, we’ve certainly seen the greatest impact being felt by, you know, your highly levered private investors. You know, the groups that were using 90 percent leverage. But I think, you know, what’s great about the market right now is that the diversity of capital groups that are out there looking for commercial real estate in the U.S. And you almost have to bifurcate the different markets across the U.S.
Now the primary markets where, you know, there…there’s been capital groups that have been ready to kind of fill the void when we lost these highly levered private investors, have sustained themselves relatively well considering the environment. And you know, it’s the institutions that really have stepped up their buying recently.
But more of your markets that are dominated by private investors, we…we certainly expect to get hit the hardest over the next couple of months.
DARBY: Sean, what’s the relationship between interest rates and cap rates in relation to this psychology?
SEAN: Well, I think as we know, you know, the interest rate it’s a…it’s comprised of a spread plus an index. You know for instance, long-term fixed rate are tied to a 10-year treasury which, you know, today is prob…you know, hovering around, you know, 470 and the spreads, you know, they’ve moved up to about 220 basis points more or less over, you know, from the past when I think on the same type of asset you’d be quoting 100 basis points.
So you know, clearly the interest rates have changed, you know, through this credit crunch, more specifically the spreads. And as for the psychology though, I think its fair to say that, you know, if you’re a trade buyer you’re not seeing the upward adjustment in cap rates yet that you like to see, which you know, because obviously, you know, translates to lower value, lower price. And you know, so they’re not seeing the sellers lower their price to reflect the increasing cost of borrowing. And this is becoming a big concern for them because, you know, for…in reference to positive leverage, it’s really not being obtained, or it’s being limited because of the difference between the cap rates, and the interest rate. And, you know, it’s impacting motivation of…of buyers doing deals, and again, this…like what Dan was saying, I think if we took the exchange buyer and the trade buyer, I think you see a big impact on them right now. You know, from the difference in interest rates and cap rates.
DARBY: Dan, since the spreads have widened, and therefore interest rates are reflecting these adjustments, where do you see cap rates going over the next 6 or 12 months?
DAN: Well, you know, there’s no question, you know, if you just do some simple math. You have to believe that cap rates are going to move upward. However that being said, I have to go back to the bifurcation of markets, and you know, sellers are certainly holding…holding their prices relatively firm in the primary markets. However, you know, we track new offerings to the marketplace, and in secondary and tertiary markets we’ve definitely seen some rising cap rates on the offering side.
Now it’s going to be interesting to see how that really plays out over the next couple of months. And whether, you know, the buyers are really matched up perfectly with the sellers.
DARBY: I mean, can you even venture a guess as…and in terms of the actual number or…
DAN: Well, you know, there’s certainly some evidence already that cap rates have…have risen about 30 basis points in secondary and tertiary markets.
DARBY: Okay.
DAN: We have little evidence to show any type of significant increase in the primary markets just yet. I think what many investors were worried about was whether or not this credit event was going to move over to the general economy and push us into some sort of recession. But now that those fears have kind of dissipated a little bit, I think that we’re going to see buyers and sellers start to get together once again on pricing by the end of the fourth quarter, and I think we’ll see deal activity return pretty strongly.
DARBY: Okay. Sean, ultimately if we see sellers taking a more analytical approach to cap rates, isn’t this what’s going to lead to more activity in the commercial real estate market?
SEAN: Yes, I mean, you know again, kind of leveraging off what our counterpart Dan is saying here. You know, for the institutional borrower and the buyer if you will, you know, their activity probably really hasn’t changed that much; and again, they tend to chase, you know, operate in these primary markets chasing Class A assets, and again, since they have the ability to pay all cash, or use very low leverage, or no debt at all, there probably won’t be much moving in the price right now over time. And I guess that over time we’ll see because the market will tell us.
But you know, we haven’t really seen much moving in that either and we haven’t really seen the activity change much on that. Maybe the interest into the properties because of the private investment companies maybe had to back off because they tend to use more high leverage financing to acquire those deals. But you know, there are…there’re still out there buying, and actually buying deals now and taking a second look at deals because they’re getting, you know, things at a…at a maybe a slightly higher cap rate, and so they’re re-looking at deals, and getting active.
But I think in reference to, you know, looking at exit cap rates, and you know, more deal activity it’s really going to be interesting for again, in the exchange market, what happens there because, you know, the sellers in the exchange markets, at least on the single tenant side for an example, or specifically more the merchant builders, the developers, I think they’re going to have to start rethinking their cap rates, and to see, “Hey where do they need to be on the exit side,” because the exchange buyers now actually have a…a viable alternative that they’re looking at in reference to capital gains.
You know, there’s con…some concern out there that the…there maybe a change of parties in Washington in reference to the White House. And capital gains, you know, are currently at a very low tax rate. There’s a concern that that may be increasing with the change of parties in Washington, and so, you know, trade buyers are sitting there saying, “Well if I can’t get the yield I’m looking for, maybe I should pay the tax, and take my cash and sit on the sidelines and see where the market goes.”
So in reference to deal activity I think, you know, if we see the merchant builders start moving their cap rates we’ll see some…you know, we’ll see some good activity. I think if they’re holding out, I think when it comes to the trade bar because of the time restrictions they’re under, we may see less deals done there as they take cap gains and sit on the sidelines.
DARBY: Okay. So you sounded…you guys have both mentioned a couple of concerns of investors. Dan, aside from the concern over the general economy and the capital gains, are there other concerns of investors as they look at transactions over the coming months that you’d like to speak out…speak to?
DAN: Yes, you know, there’s no question that the CMBS marketplace has been a key source of debt financing for commercial real estate over the past several years. You know, some have said it…it made up approximately 30 percent of the overall debt market. And I think whether or not that reappears, or the conduit window, I think that will kind of determine where we’re going to go in the near term.
There’s no question that many of the mega deals that have been financed over the last couple of years have used public financing and the conduit window. So I…I think depending on what form that reappears in upcoming months, I think that will really have a significant impact on whether these mega deals in the marketplace return.
DARBY: Sean, do you have any closing comments or questions for Dan?
SEAN: Well, in reference to a closing comment, I just think a…we’re probably going to see a lot of private companies, if you will, and investment houses. You know, they are definitely re-looking at their yields, and I think you’ll see an adjustment in expectations in returns for their clients. So we’ll start seeing that filtering through the market.
But in reference to something Dan said, and I’d like to ask Dan because he referenced the CMBS market, Dan, can you give us some color in our eye, and some…some color on the current CMBS market in reference to securitizations, because that’s usually how they recycle their money if you will, to be able to lend more out. Can you kind of give us a State of the Union on what’s…what’s currently happening in that area, and how it’s impacting deals?
DAN: Well, there’s no question that securitizations have stalled, and I think that many of the financial firms that are holding some of these notes are going to need to clear out their inventories before we really get started again. And there’s no question that the lack of public financing for deals is…is having an affect on pricing. And you know, I think that, you know, for these mega deals pricing is going to have to come down because buyers are going to need to use some traditional forms of financing to get them done.
A good example of that was certainly the Archstone deal that just closed last week, and it…it took a completely different form at the end than what it originally was going to look like in the beginning when they went under contract.
Well, overall though, I think we’re really bullish on commercial real estate in general. It still looks relatively attractive versus, you know, the other asset classes out there, and you know, for the most part, especially in primary markets, you know, supply is very much constrained, and fundamentals are strong. And I think we’re gong to need more than this…this credit hiccup to really stop us from continuing to see a healthy commercial real estate market.
SEAN: Dan if I may just ask ...
DAN: Yes.
SEAN: As a follow up, when you reference pricing for the…and specifically the Archstone deal, it took a different form, I’m assuming you’re saying in reference to interest rate and terms, the interest rate probably increased if you will, and then that actually…in reference to terms and stuff, on Archstone, did it therefore require them to lower the price of the overall deal?
DAN: Well, from my knowledge they did not lower the price of the overall deal. What I was referring to as far as structure is…is bringing in some government sources of financing through Freddie Mac and Fannie May.
SEAN: Okay.
DAN: Which allowed the deal to get done at the existing, or the terms they originally agreed on. That’s just…the fact that it got done in this type of environment is a very bullish sign for the marketplace, I believe.
DARBY: Thanks to Sean and Dan. This has been a very helpful discussion on commercial mortgage rates, and the impact that rate changes are having on the psychology of investors.
Dan, I know we don’t need to tell this, but it has been a real honor to have you share this information from Real Capital Analytics, and we certainly hope to have the good fortune of your joining us again on the show in the future.
DAN: My pleasure.
DARBY: All right, very good. Again, if you’re an investor, or in addition to financing looking for guidance in the acquisition or disposition of commercial real estate, be sure to checkout the new advisory services offered by Steelhead Capital. Just visit Steelheadivenstments.com, and request your no obligation portfolio review today.
This has been Darby Worley your host for Capital Synergies. Thank you again, Sean and Dan, and we’ll see you next time on the show.
DAN: Bye, Darby.
SEAN: Bye, Darby.
DARBY: Bye, guys.
