The Real Estate Industry Bets on Stability

A healthy real estate industry is crucial to a healthy economy. The vast majority of household wealth is tied up in residential property, while the commercial real estate sector plays a vital role in providing critical economic infrastructure. When the real estate market takes a hit, it echoes across the economy. The last financial crisis offered ample proof of that fact.

National Real Estate Investor, a leading commercial real estate trade publication, carries out periodic surveys of industry professionals in order to get a sense of overall sentiment, as well as to identify emerging trends.

NREI’s latest report presents an illuminating picture of the state of the industry. While still confident, the real estate industry remains conservative. Let’s discuss some of the key takeaways.

Expectations shift as Fed reverses course

In July, the Federal Reserve made the momentous decision to cut interest rates, the first time it has done so since 2008. Unsurprisingly, NREI’s survey showed the effects of this unexpected reversal:

“After a clear majority expected rate increases in previous surveys, this year only 20.5 percent expect rate increases in the year ahead, while 43.6 percent expect rates to remain flat and 35.9 percent expect them to fall. In terms of predicting the Fed’s course of action, responses were fairly evenly split. The most popular response was that the Fed will decrease rates once (32.0 percent), while 25.5 percent expect two decreases and 3.9 percent expect three or more decreases.”

This major policy shift was by far the most jarring event for commercial real estate companies and investors. Last year, a solid majority expected a continuation of rising rates. Rates had been rising ever so slowly, and this had barely registered in the industry thanks to the long and robust bull market in virtually every asset class, as well as solid underlying economic performance.

Most real estate investors and managers have been anticipating a dip for some time, but the Fed’s decision to preempt this with its so-called “mid-cycle adjustment” has caused some re-evaluation. With rates now expected to decline, the real estate industry appears to be somewhat more comfortable about stability in the relative near term.

Investment and lending discipline remains high

When the housing bubble burst in 2008, it caused catastrophic problems for capital markets. While the real estate market has made a robust recovery, investors and managers who lived through the Great Recession still feel the scars. Thus, while the interest rate cuts certainly surprised many industry professionals, most appear to remain committed to financial discipline:

“The common mantra throughout this cycle is that underwriting has remained disciplined. Yet respondents were split on whether commercial real estate lending is repeating patterns from the last cycle, with 27.9 percent who said ‘yes,’ 39.3 percent who said ‘no,’ and 32.8 percent who were not sure…A plurality of respondents (45.3 percent) said underwriting standards will remain the same in the next 12 months, which matched last year’s results. Another 42.4 percent said underwriting will tighten over the next 12 months (up slightly from the 39.4 percent who answered that way in 2018), and those who think underwriting will loosen fell to 12.3 percent from 15.6 percent last year.”

Overall, industry professionals believe lending standards will remain conservative. They may be heartened by the Fed’s proactive approach, but that has not caused significant deviation. Indeed, as the cycle ages, most pros expect a degree of tightening in underwriting standards, as underwriters prepare for an inevitable downturn.

Stable expectations on LTV and DSC, but changing feeling on risk premium

While NREI’s survey shows a continued commitment to financial discipline, there has been some deviation. On certain financial metrics of lender and debtor stability, investors expect a degree of stability:

“More than half of respondents anticipate that loan-to-value (LTV) and debt service coverage (DSC) ratios will remain the same in the coming year, at 54.3 percent and 58.5 percent respectively. A roughly equal amount of respondents believes LTV ratios could increase (20.7 percent) or decrease (25.0 percent). On DSC ratios, more respondents thought they were likely to increase (33.8 percent) than decrease (7.8 percent). Those numbers were largely in line with the responses in previous surveys."

This is in keeping with the overall industry sense of discipline that has been maintained throughout the business cycle. Investors and managers, however, now believe lenders will be less eager to expand risk premiums:

"When it comes to the risk premium (the spread between the 10-year Treasury and cap rates), just over half expect the premium to remain flat (50.1 percent), while another 35.9 percent expect it could increase. That’s a shift from last year, when a majority (51.7 percent) said it would increase vs. 33.1 percent who said it would remain flat.”

Verdict

Real estate investors, whether direct owners, REIT investors or private fund allocators, should review NREI’s latest findings with some care. Sentiment remains positive, and most pros expect a continuation of strong and stable capital flows to the industry. However, the underlying issue of economic slowdown cannot be dispelled.

It is wise to be conservative in this real estate market. Whether the industry’s particular conservatism will be enough to weather an eventual correction remains to be seen.

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