Jim MacCrate, MAI, CRE, ASA, has worn many hats in his career. He taught a number of the appraisal classes I have taken through the Appraisal Institute. and I think he is one of the few people who actually understands the “J-Factor.” His wife Judy is an SRA and is an accomplished appraiser in her own right, having managed an appraisal panel for a large lending institution throughout its various mergers for a number of years. I can only imagine the riveting conversations at dinnertime. This week, Jim uses negative leverage to make his point. …Jonathan Miller
Reviewers and mortgage underwriters beware. I ran across the following chart and wondered if mortgage costs are higher than the cash returns on real estate, why would anyone buy? And why would anyone lend either?
Based on this chart, at the end of last year, the average capitalization rate dropped below cost debt. This phenomenon is known as negative leverage in terms of current cash flow. Negative leverage decreases return to equity and occurs when the cost of debt is higher than the unleveraged return. The yield on a real estate investment is the capitalization rate plus growth. If this situation continues, what happens if there is no growth? The return is negative.
Financial risk, in addition to market risk, is magnified when leverage (debt) is used to acquire property. When more debt is incurred, the return to the equity position decreases at an increasing rate. This escalation also becomes alarming when equity investors are attracted to the returns that real estate has produced over the last five years and utilize mezzanine financing to acquire assets. Rising interest rates may also have an adverse impact on commercial real estate loan performance as the debt service on variable rate loans increases. Investing and lending become risky business if this trend continues.
From a lender’s perspective to protect against default, the maximum loan-to-value ratios and the debt coverage ratios should be altered or additional collateral required. (But will loan officers, corporate executives, and others who are paid based on income received by making loans act responsibly to change these ratios?) Most commercial loans are relatively short term and require refinancing in five, seven or ten years.
From the investors’ perspective, they hope that their income will increase over time, which becomes uncertain if the economy slows, companies cut back space requirements, and corporate and/or personal incomes lag. Where does the growth come from to increase the income return from holding real estate properties or portfolios? Leverage is positive when investors can earn more on the property than it costs to finance the acquisition. Investors always gamble that price appreciation will bail them out. Although this gamble paid off in the past, people forget about the 1970s and 1980s cycles. Is today any different?
It is critical to remember that local economic conditions are the most important determinants of the potential cash flow that can be derived from investing in real estate. If the economic fundamentals weaken in a metropolitan area such as New York, real estate will be affected. Real estate cycles vary by market and by property type and are influenced by the cost and availability of debt.
Appraisers, lenders, and investors must remember that high interest rates reduce the demand for real estate and liquidity. Prices must fall when this occurs until equilibrium is achieved. Since this phenomenon took about seven or eight years to recover in the 1970s and again from 1989 to 1995, we should be prepared for the next real estate market cycle. And the FDIC as always is protecting our insured deposits, while the SEC and other regulators are protecting the ultimate investor, the general public who buys Wall Street products. As long as deals have sufficient equity and the debt coverage ratio is adequate, real estate may still produce satisfactory long-term returns.
So what happens if interest rates increase, but the cash flow to the property does not? Sub-prime problems ripple through the commercial real estate markets. Some say that will never happen. But remember, they said that in the 1970s and the late 1980s too!
To quote my friend and mentor, Bill Kinnard, PhD., who would remind us that “real-estate has a ten year cycle with a five year memory.” The natural segue to Kinnard’s statement is that real estate investors may be currently in the buying high stage of the cycle, only to find themselves, most probably, selling low at the end of the cycle, which brings up the natural conflict that we have as appraisers and counselors. As appraisers, we merely report what is being experienced in the marketplace and estimate value based on empirical data (whether that data is good, bad or indifferent).
As counselors, however, we have an obligation to inculcate or impress upon our clients the inherent risk to the reversionary value of investments acquired at the apex of market value. As many have advised, the only problem with a long term discounted cash flow analysis is that one is absolutely certain to miss the correction in the marketplace if it is not correct. However, when investors sequaciously follow the market, opportunities for others are bound to materialize. Markets have a history of providing excellent learning experiences for the uninformed.