Jones Lang LaSalle
Why Aren't You Deeper Into Debt?
Jon Southard, SVP, Director of Debt Management and Valuation
February 24, 2006 Volume 7, Number 7
jsouthard@tortowheatonresearch.com
I've always found it interesting that while institutional real estate investors will generally build up an apparatus to forecast the financial future of properties they're interested in owning, they less frequently apply the same forward thinking to putting loans on those properties. Well, if the current TWR forecasts prove accurate, it's time they start getting involved in debt investing.
Clients who have been paying attention to our TWR conference calls know that, for many markets, we project that the improving economy will lift the net operating incomes of buildings, but that these increases will be offset by the long-term effects of higher interest rates on building values. The net result is the possibility of returns coming solely from income as values stay flat or decline. Taking this scenario to an investment strategy, it's not hard to see why investing in debt rather than equity might become attractive.
Who would stand to gain the most from our forecast coming true? With these countervailing forces netting relatively flat values for upcoming years, those with conservative mortgages will be best positioned. This is because equity is in the first loss position and would feel the full-effect of a small decline in value. A commercial mortgage, on the other hand, is insulated since only those declines large enough to bring the value of the building down to the value of the loan (usually 75% to 80% of the initial building value) will prevent a loan from receiving the entire amount of its interest payments. This assumes the loan is held to maturity.
Take, as an example, a loan in the somewhat-average Chicago office market. Rents for the market are expected to grow 3.5% annually--better than inflation and resulting in our estimation of a 1.5% annual rise in NOI. Cumulatively, this raises income by 7.5% after five years. However, TWR expects cap rates to increase in this market from 6.7% to 7.5%. The effect of this increase on value is to subtract about 12 percentage points from appreciation. Put together, TWR expects the typical office building to be valued at 95.5% of today's value five years from now.
The effect of this forecast playing out is dramatic for an equity investor. The loss of value is subtracted from returns leaving only income returns. Subtracting not just the value decline, but also expenses not included in the cap rate, TWR's expected annual total return for equity holders is just 3.2%.
We'll contrast this with a conservative loan on the same property, one with a starting loan-to-value of 80%. The decline in value is mild enough that there is no reason for a borrower to want to default on the loan. As a result, assuming the loan is held for its entire life, the mortgage holder can expect to reliably receive an annual interest payment of around 5.5%, according to CBRE Capital Markets. Risk adjusted, TWR expects returns of 5.2%.
This pattern of better returns for debt than equity is repeated in many of our base case scenarios for typical buildings. If rate increases truly do neutralize an up-tick in the real estate fundamentals, equity players have more to lose than do investors in commercial mortgages--either through holding mortgages privately, or investing in the Commercial Mortgage Backed Securities market.
All Commercial Mortgage Backed Securities Are Not the Same
Another reason for equity investors to think more about debt in the coming years that there will be more, and better, information available. Moody's CMM, for example, powered by TWR, will be providing its analysis to users of the Trepp system to better analyze and compare CMBS deals. The chart above compares deals issued sometime in 2004 against one another and finds that some deals have a substantially higher expected loss (given as a percentage of the value of their underlying loans) than other deals. In much the same way TWR's rent forecasts benefit equity investors, debt investors will soon have this resource to better inform their decision making. We hope to make clear that, while the commercial mortgages have different financial characteristics, they remain tied to real estate market outlooks just as tightly as equity investment.
Go to www.tortowheatonresearch.com to register for a free subscription to About Real Estate.
Why Aren't You Deeper Into Debt?
Jon Southard, SVP, Director of Debt Management and Valuation
February 24, 2006 Volume 7, Number 7
jsouthard@tortowheatonresearch.com
I've always found it interesting that while institutional real estate investors will generally build up an apparatus to forecast the financial future of properties they're interested in owning, they less frequently apply the same forward thinking to putting loans on those properties. Well, if the current TWR forecasts prove accurate, it's time they start getting involved in debt investing.
Clients who have been paying attention to our TWR conference calls know that, for many markets, we project that the improving economy will lift the net operating incomes of buildings, but that these increases will be offset by the long-term effects of higher interest rates on building values. The net result is the possibility of returns coming solely from income as values stay flat or decline. Taking this scenario to an investment strategy, it's not hard to see why investing in debt rather than equity might become attractive.
Who would stand to gain the most from our forecast coming true? With these countervailing forces netting relatively flat values for upcoming years, those with conservative mortgages will be best positioned. This is because equity is in the first loss position and would feel the full-effect of a small decline in value. A commercial mortgage, on the other hand, is insulated since only those declines large enough to bring the value of the building down to the value of the loan (usually 75% to 80% of the initial building value) will prevent a loan from receiving the entire amount of its interest payments. This assumes the loan is held to maturity.
Take, as an example, a loan in the somewhat-average Chicago office market. Rents for the market are expected to grow 3.5% annually--better than inflation and resulting in our estimation of a 1.5% annual rise in NOI. Cumulatively, this raises income by 7.5% after five years. However, TWR expects cap rates to increase in this market from 6.7% to 7.5%. The effect of this increase on value is to subtract about 12 percentage points from appreciation. Put together, TWR expects the typical office building to be valued at 95.5% of today's value five years from now.
The effect of this forecast playing out is dramatic for an equity investor. The loss of value is subtracted from returns leaving only income returns. Subtracting not just the value decline, but also expenses not included in the cap rate, TWR's expected annual total return for equity holders is just 3.2%.
We'll contrast this with a conservative loan on the same property, one with a starting loan-to-value of 80%. The decline in value is mild enough that there is no reason for a borrower to want to default on the loan. As a result, assuming the loan is held for its entire life, the mortgage holder can expect to reliably receive an annual interest payment of around 5.5%, according to CBRE Capital Markets. Risk adjusted, TWR expects returns of 5.2%.
This pattern of better returns for debt than equity is repeated in many of our base case scenarios for typical buildings. If rate increases truly do neutralize an up-tick in the real estate fundamentals, equity players have more to lose than do investors in commercial mortgages--either through holding mortgages privately, or investing in the Commercial Mortgage Backed Securities market.
All Commercial Mortgage Backed Securities Are Not the Same
Another reason for equity investors to think more about debt in the coming years that there will be more, and better, information available. Moody's CMM, for example, powered by TWR, will be providing its analysis to users of the Trepp system to better analyze and compare CMBS deals. The chart above compares deals issued sometime in 2004 against one another and finds that some deals have a substantially higher expected loss (given as a percentage of the value of their underlying loans) than other deals. In much the same way TWR's rent forecasts benefit equity investors, debt investors will soon have this resource to better inform their decision making. We hope to make clear that, while the commercial mortgages have different financial characteristics, they remain tied to real estate market outlooks just as tightly as equity investment.
Go to www.tortowheatonresearch.com to register for a free subscription to About Real Estate.
posted by Jones Lang LaSalle NJ News Blog at 9:56 AM
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