A Perfect Storm on the Horizon?

We find ourselves in a time of unquestionable doubt and mystery regarding that which the financial and economic futures may have in store for us.  As a result, the hesitancy to make a move is very palpable throughout the market, particularly for those in the commercial real estate market.  Has the market bottomed out?  Is the stimulus working?  What would the market be like without the enormous intervention of the federal government?  Often the answers to these vital questions depend too much on the political stance of the expert we’re looking to, and no matter what they say, there are usually convincing arguments supporting the opposite view.

With the unprecedented availability of  “free money”, we know that the spectre of rampant inflation is a very real possibility.  Sure, inflation is good for commercial real estate, but it is horrible for the economy as a whole.  In an age of rock bottom interest rates, higher yields can be and are being obtained rather easily as commercial property sale prices stay high.  There’s a problem resulting from this, however, and there are several aspects to it.

Of mode lately, in commercial real estate lending especially, is the practice of many banks of restraining from foreclosing on problem loans, preferring to restructure them so that the borrowers can continue to pay on them in the hopes that they may get out of trouble and eventually pay off the loan.  The bank is extending the loan while “pretending” there is no problem, hence the sobriquet “extend and pretend”.  Under normal circumstances, these property owners would be forced to sell and there would be many more properties on the market.  Now, however, most of the sellers are not being forced into their sales and are holding to their premium asking prices, keeping the market buoyed in an artificial sea of scarcity.

Adding to this phenomenon are the continued low interest rates, making money for purchase of properties more available than it would be otherwise.  The result then is more cheap money looking for fewer high-priced properties, exacerbating the problem even more.  With an abnormally high cash-on-cash return possible, many investment companies are not willing to pass up the apparent opportunity.

The dark cloud looming behind this scenario is that such low interest rates as have prevailed in the past few years are going to have to end sometime, probably well within the next five years.   Since today most loans are written with five year terms with an option to renew in another five years, you can bet that the new terms are not going to be as sweet as the first.  If we just look at a return of interest rates to a near normal 7%, we’re going to see those wonderful 10% or so cash-on-cash returns now possible diminish to somewhere around 6.8%, which equates to a 32% drop!  It’s going to be hard to make up the difference by bumping up rents, and selling the property even at its original purchase price might be rather difficult since the new buyer is going to be looking for an even better return.  This could mean that even more properties are going to get the “extend and pretend” treatment if the government and banks don’t overhaul the rules.

If this is an accurate reading of the current and future situations, we could be looking at a rather catastrophic turn of events somewhere around 2015 or 2016, when the Fed finally allows interest rates to seek their natural level and more mortgages come due.  It would be prudent indeed to review one’s long term view and exit strategies!

US Capital Markets Update

Robert White, President of Real Capital Analytics, shares his forecasts for both national and specific market segments along with a review of Q3 2012 in this valuable and exclusive investment forum.

In an optimistic overview,                   
Mr. White explores the good
signs he sees right now, noting
that capital is beginning to spread
out, there is obvious growth in the
apartment sector (up 23%), and multi-family land sales are also turning around and warming up around the country.

Learn more about why RCA is
feeling cautiously optimistic about the year to come: http://vimeo.com/51303445

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