By Cardwell, Gail Davis
Mortgage Banking , Vol. 66, No. 10
The structure of the commercial real estate finance industry has changed dramatically over the past decade. A favorable interest-rate environment; increased capital and access to global capital markets; significant property appreciation; and a shift in the holders of commercial real estate debt to the public markets and to major financial institutions together have placed real estate alongside other investments as a mainstream product of choice. [??] The influx of public market funds into this sector has effected structural changes in our industry, as this investment product becomes more commoditized. Market players, in turn, have adapted their business models to take advantage of operational efficiencies, distribution networks, service quality, franchise value, product integration and earnings and growth potential.
Debt growth and net positive real estate appreciation
In 1990, commercial and multifamily debt outstanding totaled roughly $1 trillion, based on the Federal Reserve Board Flow of Funds data (see Figure 1). This number increased to $2.6 trillion by year-end 2005, reflecting the significant growth in the industry. Throughout this period, the holders of this debt shifted, with savings institutions and life insurance companies losing half their market share, while public market securities increased from a negligible share in 1990 to more than 25 percent of the total debt held by year-end 2005.
Dramatic increases in property values and record-low interest rates fueled this debt growth. Commercial appreciation topped 35 percent from 1996 to 2005, a particularly impressive jump, after rebounding from a 37 percent loss in value during the real estate crisis of the early 1990s.
Interest-rate declines supported the affordability of financings, with the benchmark U.S. Treasury 10-year securities yielding close to 9 percent in 1990, compared with averaging about 4.5 percent during the past three years. Low short-term rates also enhanced profits and growth, with the 30-day London interbank offered rate (LIBOR) yielding 8 percent in 1990, then dipping below 2 percent in 2003 and then rising to 4.5 percent more recently.
Continued boosts in both short- and long-term interest rates promise to impact our industry, as borrowers already have opted to take advantage of a flat yield curve and favorable long-term rates when faced with the prospect of rising interest rates. The record origination volumes over the past several years, coupled with projected increases in interest rates, will likely dampen future refinancing volumes, all other factors staying constant. These anticipated rate hikes could trigger a transfer in focus from credit risk to interest-rate risk--especially as commercial real estate becomes increasingly subject to global markets' interest rate fluctuations. This could lead to further structural modifications in the industry.
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Significant increase in public funds investment
Favorable real estate fundamentals have furthered public investment in commercial real estate. Pension funds, endowments, foreign investors and insurance companies have steered investment dollars into this asset class. Many market observers refer to the capital "overhang" flowing into real estate.
For example, in 2005 the top 50 public pension funds' investment in commercial real estate totaled $95 billion, or 5 percent of their assets--this includes an increased investment by those funds of $15 billion in 2005 alone. In addition, those pension funds have committed nearly $37 billion more to real estate, which has yet to be invested. This overhang of committed dollars will spike pension-fund investment in the sector by almost 40 percent.
Global markets, in turn, have gained access to real estate owners, contributing further to capital inflows and growth in public market funds flowing into commercial real estate. In 1971, there were 34 real estate investment trusts (REITs), with total market capitalization of approximately $1. …