Deflation risk in income-property investments and permanent loan portfolios: a 2008 update.

Note: These are the views of the author, and not necessarily the views of Bank of the West.

THIS ARTICLE UPDATES A PREVIOUS ARTICLE I WROTE for the Summer 2003 issue of Real Estate Issues (REI) under the same title.

Since then, I've observed that the amount of leverage and collateral value of income properties have inflated largely because of high liquidity stimulated by 40-year low interest rates and the proliferation of commercial mortgage-backed securities (CMBS). As a consequence, high-loan production among CMBS conduit lenders created a "hustle and flow" loan production process. The rapid growth in the CMBS market was, in part, the result of aggressive underwriting practices that led to a 186 percent increase in loans outstanding over a five-year period. The income-property industry leverage from 2002-2007 was not entirely due to CMBS: 94 percent is attributed to leverage growth in commercial banks. (4) These banks also participated in this high-debt growth period, and will most likely be faced with the consequences of collateral value deflation in their loan portfolios. It is my contention that the combination of a high demand for investment real estate and favorable lending market conditions for investors created a significant credit bubble. As a result, a higher risk for deflation of income-property collateral values now exists for income-property investors and owners of income-property collateralized debt, including commercial banks.

In addition to observing and lending in income-property capital markets since 2003, I have pursued studies on adaptive complex systems at the Santa Fe Institute (SFI). The Institute's objective is to find simplicity in adaptive complex systems. Given the complexity and volume of economic data, I believe it has become more difficult for most market participants to determine where the capital and investment markets are heading. Studying complex market systems helps in understanding how markets behave, and in determining when the risk of a market correction is increasing, for the purpose of implementing effective hedging strategies.

PURPOSE

I write this article from the perspective of a career banker who works with income property. I have a vested interest in my bank and my borrowers to identify capital market issues and make recommendations to help both align for prosperous long-term growth. I hope this article will help lenders and borrowers avoid being exposed to a potentially negative capital market environment. I believe that if you understand the risk, you can hedge it. Experience also tells me that lender and investor exposure to problem loans and subsequent foreclosures can be mitigated by prudent loan underwriting. In addition, I have observed income-property real estate capital markets at both the systemic and process levels, and have made recommendations for process changes. Further research is needed to study ways of curbing "hustle and flow" loan production or capital distribution systems from naturally occurring in complex adaptive markets. But, I believe that implementing these recommendations will help stabilize real estate-collateralized capital markets in the future. The recommendations are attached as addendums for further review.

CHAOTIC REAL ESTATE MARKETS

As indicated in my 2003 REI article, the income-property real estate markets are adaptive complex markets, and susceptible to collapse. They are difficult to predict because they are non-linear, or subject to uncertain or chaotic outcomes. The only difference between chaotic stock markets and income-property markets is time scale. The difference in time scale is significant, with long cycle times for income-property real estate, and daily cycle times for the highly liquid stock market. As an example, I estimate that on average, it takes six minutes to decide to sell a stock and sell it on the stock market during an active trading session. By comparison, the sale of an income property will take an average of six months from the time a decision is made to sell and when cash is received at closing (in a good market). I estimate a six-month time frame since many income properties must be positioned to sell, and may also be subject to closing delays because of market inefficiencies, etc. Based on this six-month time scale, real estate investment cycles can range from 7-12 years. In California, the bottom of the last investment real estate cycle occurred from 1993-1996. I estimate that, nationwide, we are at the end of an 11-year investment real estate cycle collateral-value growth period. In the current income-property cycle, I expect to see U.S. income-property markets-both regional and national-deflate largely at the same time. I believe, based on my research, market observations and lending experience, that the U.S. income-property market is at significant risk of entering into a 2- to-3-year deflation period before collateral-value growth is again realized on an aggregate basis.

OVERSTIMULATION BY THE FEDERAL RESERVE

During the last income property economic cycle I experienced in California, the downward trend began in 1990, and bottomed out from 1993-1996. In 1996, most product types were beginning to experience positive cash flows and collateral value growth. This trend continued through 2001, until the events of September 11, which devastated the economy. Central Business District office vacancy rates in San Francisco rose from two percent in October 2002 to 19 percent (1) in 18 months. Silicon Valley vacancy rates experienced a similar negative trend. But, a rise in loan default rates did not occur because of the Federal Reserve's rate cut downward to one percent, which stimulated investment in all real estate. During this time, most income-property investors with loan difficulties were able to sell their holdings without causing lenders to incur losses. I believe this low interest rate environment, in combination with the innovative structured loan products that began to appear in 2002 from CMBS conduit lenders, helped to overstimulate investment demand.

CAPITAL MARKETS ADAPTING

When interest rates began to rise in 2005, conduit lenders and market participants responded by creating more innovative, financially engineered lending products and more effective trading desks to sell their mortgage-backed securities. Collateralized Debt Obligations (CDOs) that bought subordinate debt or B-pieces, proliferated. For example, CDO issuances increased from $7.8 billion in 2004 to $21.33 billion in 2005, a 173 percent increase. (4) In addition, CDO issuances increased another 71 percent from 2006 to $36.6 billion. (4) Prior to 2004, B-piece buyers more effectively controlled market risk by holding originators accountable for aggressive loan underwriting by kicking out high risk loans in CMBS pool offerings. In 2005, loss derivatives were developed for CDOs, making securities more attractive for investors to purchase. (3) With CDO proliferation, many conduit lenders became complacent since they could sell down the unacceptable B-piece first-loss risk traunches to a CDO. These CDOs were structured to hedge default and repayment risk using complicated financial computer-modeling techniques based on loan default probabilities. Computer-generated risk-modeling to assess loan default and repayment risk was relied upon by the credit rating agencies. The buyers of CDOs relied upon the credit rating agencies' assessment of risk, using their own credit ratings systems. It is my contention--to be supported by further institutional research--that capitalization rate compression was, in part, stimulated by the high income-property investor demand, armed with low-cost, covenant-light and aggressively underwritten debt provided by CMBS conduits. Unfortunately, most bankers competed for loans in this highly competitive marketplace and won their fair share of originations, thereby increasing deflation risk in commercial bank income-property loan portfolios.

As the CMBS markets adapted to changes in the debt market by increasing loan product offerings, production flow volumes further accelerated debt growth and subsequent deflation risk. Of the existing $723 billion CMBS loans outstanding, 47 percent are fully amortizing, with 53 percent as interest-only loans as of June 30, 2007. (4) Of the interest-only loans, 25.6 percent have a partial interest-only period, and 27.4 percent are interest-only for the full term of the loan. With interest-only under writing, conversion to a conforming fully amortizing loan after an initial interest-only period may increase default risk depending on the performance of the property. In my assessment, given the aggressive composition of CMBS loan portfolios, there is increased risk of default because of their resemblance to subprime mortgagebacked securities (MBS) portfolios, if not in credit quality, then certainly in aggressive loan structuring. This is a concern since of the $723 billion in CMBS loans outstanding as of June 30, 2007, 95.1 percent were rated as investment-grade (BBB or better). With the recent downgrades on many types of MBS, it appears that the credit rating agencies also were out of alignment in assessing the risk of commercial real estate and multi family collateralized loans.