Warner: “Major markets continue to see a decrease, where secondary and tertiary are seeing an uptick in transactions.” Warner: “Major markets continue to see a decrease, where secondary and tertiary are seeing an uptick in transactions.”

 

LOS ANGELES—We’ve scaled halfway up the wall of anticipated maturities from pre-recession loans, but there may not be a wall there at all, Matthews Real Estate Investment Services’ SVP and national director of shopping centers El Warner tells GlobeSt.com. We spoke exclusively with Warner about the incongruence between pricing and transaction volume in commercial properties and where he sees it heading.

GlobeSt.com: How are prices and transaction volume interacting with each other during the current cycle, and where will this lead?

Warner: In Q3 we witnessed the fourth consecutive drop in transactions as they were down 10% YOY. However, cap rates for office and retail have flattened in the last year, while apartments, hospitality, and industrial sectors have continued to decrease. We’re seeing a stronger pace of transactions and significant loan maturity in the secondary and tertiary markets, while major markets are down 21%.

So here’s what’s happening: Given this decrease in transactions year-over-year, it’s not having as large of an impact as it could. The decrease is actually more of a bifurcation of the different markets. Certain markets are not strong enough for people to get out from under their debt, so they’re exiting those markets.

What we’re noticing is that sellers are taking asset risk, but not market risk. Cap rates in core markets are 100-150 bps lower than in secondary and tertiary markets. This gap will likely continue to increase as over $100B of debt matures in 2017 while more investors sell in secondary markets than refinance, creating additional supply. Conversely, strong market fundamentals will create the opportunity for investors in primary markets to refinance their properties, creating more supply constraints in primary submarkets.

GlobeSt.com: How does debt come into play here—what are the dynamics?

Warner: In 2015, there was $54.5 billion due; in, 2016, it was $87.1 billion, and in 2017, it will be $105.8 billion. That’s a total of $250 billion. In 2018, that amount will be $12.8 billion, a significant decrease from previous years. Office and retail make up half of that debt. So, what happened to it? A total of 17% of borrowers refinanced early, indicating that their perception of rising interest rates created the incentive to pay off debt early, regardless of penalties. Delinquencies ranged from 5.45% down to 4.15% and back up to 4.6% in June 2016. Retail delinquencies are at 92% now, and if rates increased 200 bps, the secondary markets would suffer and delinquency rates could drop down to 80% based on DSCR restraints.  While delinquencies would be affected by an increase in interest rates, values may not be as elastic to movement in interest as delinquencies have been.

The way debt plays into the overall market is that when interest rates increase, we see a potential increase in the delinquency rate. In the past 18 months, interest rates have varied but cap rates have steadily declined.  Interest-rate increases will affect delinquencies, but they may not significantly increase cap rates.  It appears, based on decreased velocity, that many sizable loans in major markets have been refinanced while in secondary and tertiary markets selling versus refinancing is more evenly weighted.

We’re about halfway through that wall of maturity cycle, and with the next $120 billion or so, when you see where those are happening, it’s directly correlated with debt in the secondary market. In 2006/2007, individuals bought properties, and the majority of the ones who kept these assets went through emotional distress. Fortunately for us, the low interest rate environment coupled with strong market and property fundamentals has tremendously helped investors solve their debt calls. In 2015, we didn’t know if we would make it through that wall of maturities, and now we’re halfway up it and we’re not sure there is a wall.

GlobeSt.com: Do you see continued slowing in the investment market?

Warner: We see continued slowing in core markets, but—as interest rates rise—we’ll see an increase in secondary markets and for certain retail and office products. The offset will probably still be a slight decrease, but not as significant as it was in all of 2016. With 2017 loans coming due, this will normalize from the previous year.

The question is, once the $250 billion has been completely recast, what happens to transaction velocity at that point? It comes down to basic economics: supply and demand. Once all the loans are recast, there will be less product on the market. You may continue to see decreased cap rates or flattening in some property types and an increase in others. Even though the majority of debt comes due in 2017, I don’t see cap rates significantly increasing, unless interest rates significant increase.  While there will be some upward movement in interest rates, it will not be sizable enough to increase cap rates but may flatten them out.  However, the gap in cap rates between primary and tertiary markets will continue to increase. More assets will come due in the secondary markets, people will not be able to come out from under their debt, and will be forced to sell.

GlobeSt.com: Can you tell us about the debt program established at Matthews?

Our firm has formed a Debt Asset Resolution Team (DART) to deal with the expected wave of loan maturities. Between 2006 and 2007, there was a tremendous number of loans that were issued, and now those loans are maturing. We’re halfway through the unwinding of this debt that was issued pre-recession. So we built a program to help investors out with the decisions they have near term with “What do we do when debt comes due?”

We wanted to create a program for our clients that provided empowering advisory and financial services to procure and safeguard their investments for current and future generations. Alleviating the concerns and difficulties our clients face with near term debt maturities, shifting the power dynamic to favor sellers and borrowers rather than buyers or lenders.

When we created this program, we thought a lot more investors would want to sell than refi, but we’re noticing a lot more investors are refinancing than selling.  This is not ideal in many situations but investors are either too emotionally connected to their assets or fearful of how to exchange into better long-term investments with flexible debt.

GlobeSt.com: What else should our readers know about debt in the current real estate market?

Warner: Liquidity is king; it’s all about liquidity. One of the rules I live by in my own personal investments, and what I tell clients is, you always want to be in a position where you can choose when you sell your property. Don’t hold on to assets due to emotional connections or a lack of knowledge of the markets. You don’t want to be in a situation where you’re stuck in debt and forced to sell. Some investors were forced to sell in the downturn and lost a lot of money. Now, the real estate market is stronger in some markets and product types than it was in ’06 and ’07, but a lot of investors want to continue to put long-term debt on their assets due to emotional connection. We advise our clients not to tie themselves to debt long term because they may not have the market in their favor when they do decide to sell. Make sure you get into debt that gives you the ability to prepay without significant penalties. Banks and credit unions give them more flexibility than CMBS, and while the LTVs may not be as strong as CMBS, when the market pulls back they won’t be stuck in same situation as before.

Join Matthews at booth 141 during this year’s ICSC New York National Deal Making event.