NORMY. quarterly data, Y UPDATE. considered in. market, observations. safety, while. risk-free rates. property markets since 2010.

Transcription

1 NORMY Y UPDATE SECOND QUARTER Q 2014 By Hugh F. Kelly, PhD, CRE Clinical Professorr of Real Estate, NYU/Schack Real Estate Institute NPV Advisors Economic Consultant September 2014 NORMY NORMY is an acronym for f the "NPV Observed Risk in Market Yields" analytical tool, developed for NPV Advisors by Hugh F. Kelly, PhD, CRE. This analysis a examines market risk premiums over time, at the propertyy level, and for the debt and the equity positions in the capital stack. Extending back to 1995 andd using quarterly data, time-series are developed and graphed. The means and medians of the time series are identified, and the distribution of the observations is calculated. Risk premiums falling within the bounds of the 35th and 65th percentiles of the data are considered in the normal range of risk-adjusted returns. Observations extending higher than thee 65th percentile of risk premium are considered to provide superior safety, while observations below the 35th percentile are considered to show underpricing of market risk. Analysiss thus far is indicating that the NORMY scale descended below the 35th percentile prior p to the onset of "the bubble" in commercial property asset pricing in the first decade of the 21st century - and might provide a useful early warning of problems to come. Currently, thanks to low risk-free rates in the U.S. Treasury market, observations aree well above the 65th percentile for most investment positions. This would help explain the return of liquidity to the commercial property markets since Atlanta Chicago Los Angeles New York Newport Beach Salt Lake City Seattle

2 Behavioral studies teach us that relative change in the recent past carries more weight than long-term perspective in framing decisions. It s human nature. Memory is a filter for experience, and not a very reliable one. Memory is predominantly shaped by two particular features of our experience. The first is that the recent past is over weighted in importance compared to events occurring a year or more ago. The second is that peaks, rather than averages, are what the mind remembers best. The Nobel Prize-winning behavioral economist, Daniel Kahneman, has shown that this psychological tendency is a powerful influence on our reading of economic conditions, but is not necessarily a good guide to sound business decisions. In his Thinking, Fast and Slow, Kahneman writes, Confusing experience with the memory of it is a compelling cognitive illusion. The remembering self is sometimes wrong, but it is the one that keeps score and governs what we learn from living, and it is the one that makes decisions. Our intuitions and inclinations are shaped, in a deep way, by this trait the fast thinking of the book s title. One difficulty that arises is that broad framing for instance, taking into account the longer-run context leads to better outcomes than narrow framing. A second is that intuitions, and the decisions that flow from them, are based on sentiments rather than data. Analytical thinking what Kahneman calls slow thinking requires the examination and systematic exploration of data. That s harder than following intuition, but ultimately more productive. The NORMY analysis of risk premiums at the summer of 2014 drives home the relevance of Kahneman s distinction in a profound way. Throughout the real estate industry, discussions of the underpricing of risk and even the potential for a bubble in real estate asset pricing are being driven by variables quite apparent in the fifteen graphs showing the patterns of risk pricing since For the last 24 to 30 months, risk premiums have been generally declining. And the peak pricing of risk occurred not long: Taken together, the market has the intuition that we have rapidly moved from risk off to risk on conditions. That intuition is shaping much industry commentary and investment expectations. HUGH F. KELLY, PHD, CRE Hugh is a Clinical Professor of Real Estate in New York University's Master s Degree Program in Real Estate Investment and Development. He heads his own consulting practice, Hugh F. Kelly Real Estate Economics, which serves national and international real estate investment and services firms, governmental organizations, law firms, and not-for-profit agencies in the analysis, interpretation and application of economic variables for real estate decision making. Prior to establishing this consultancy, he was chief economist for Landauer Associates, where he worked for 22 years until early He has published more than 200 articles, been a contributing author on several books, and is a featured speaker at national real estate conferences. Sentiment, or market psychology, should not be discounted. After all, it is clear that markets are prone to episodes of euphoria and panic. The simple assumption of market rationality has long since been called into question by texts as varied as John Kenneth Galbraith s A Short History of Financial Euphoria and Nassem Taleb s The Black Swan, not to mention Justin Fox s exhaustive review in The Myth of the Rational Market. But sentiment is not all. Feelings aren t facts. And so NORMY s more analytical and longer run perspective on risk pricing serves as a healthy (and, we think, necessary) corrective to popular intuitions. Our midyear findings help in understanding the sorting-out process currently underway in the commercial real estate market. As it turns out, even under the pressure of enormous capital volumes, investors are not blithely ignoring risk. In most instances, they are demanding and receiving appropriate payment for the risks they are willing to take. CAP RATES The risk premium for cap rates, across all property types, has dropped 151 basis points from its Third Quarter 2012 peak, and now stands at 4.43 percent. This puts it at the green line the 65th percentile or the top of the normal range of cap rate premiums tracked since So, yes, there has been significant cap rate compression. But, no, this doesn t mean that risk is being inadequately priced.

3 This proximately to the green line is consistent across all four major property types, all which are near the top of the normal range or even slight above it. This is hardly a risk on story except by comparison to those two fast thinking criteria. Remember that the peaks earlier this decade were the highest level of risk premium available since the mid-1990s, and hardly represent a viable standard of judgment over the long haul. It is probable that capital pricing in commercial property has gotten ahead of property market fundamentals in this real estate recovery. But the trend seems to be that the gap is closing, as projected supply/demand fundaments play catch-up. The rebalancing and realignment of user markets and investor markets seems to be at work in the recent cap rate compression, as buyers once again incorporate improving occupancy and NOI growth into their projections. A review of supply/demand forecasts, published by recognized analysts such as Reis, Inc. and CBRE-EA, for the major property types suggest that over the near term (2015 to 2017) the occupancies for apartments, offices, and industrials will be stronger than their long-term averages, and that retail will be getting close to its average by A long-term quantitatively based perspective on cap rates, then, challenges the sentiment that prices are frothy and risk is being underestimated in cap rates. This is important data in evaluating not only the pricing of real estate assets but transaction volumes as well. At 2014 levels of risk premium, it should not be considered surprising or even anomalous that all segments of the investment community should be seeking to grow their real estate footprint. There is a big distinction to be made between current compensation for risk and the underpricing of risk in the Niagara of Capital years of 2004 to The NORMY graphics show that distinction in vivid detail. DEBT Our discussion of cap rate premiums notwithstanding, there is real evidence that the mortgage markets have gone risk on, especially in the most popular investment categories, multifamily and office. In previous quarterly discussions, we have noted that debt risk premiums have dropped back into the normal range, and considered it an open question as to whether lenders would return to the discipline that characterized spreads from 1995 to 2003, or would bow under the pressure to deploy capital and drop pricing to dangerously low levels of risk premium. That is still an open question, but we now see that for the all-property-type compilation, mortgage risk premiums have stayed between the Green and Red lines for four consecutive quarters. That hasn t been seen since The property types do differ. Multifamily and office are marginally below their respective Red Line values, while Industrial is in its normal range, and Retail remains above its Green Line. The ACLI lenders may be responding to relative levels of financial demands. Offices and apartments have led the transaction volume total reported by Real Capital Analytics, and ACLI mortgage issuances have been weighted toward these sectors as well. Thus the risk premiums on the debt side could very well represent current supply/demand balancing for mortgage capital. We have also noted in previous reports that interest rate premiums are not the only tool in debt risk management. If spreads are low, so are loan-to-value ratios for life company lenders at about 6 as of the Second Quarter, as they have been since the brunt of the financial crisis hit. Debt service coverage ratios are also conservative at That tempers the view that mortgages are entirely risk on, a reason why we are keeping an open mind about whether lending is heading to dangerous territory or not. LEVERAGED EQUITY The willingness of all capital sources institutional investors, private equity funds, public and private REITs, and international players to commit significant volumes to U.S. commercial real estate has been one of the headline factors that have prompted fears of another asset bubble such as we saw in the middle of the last decade (the naughty aughts? ). Has the equity sector become risk seeking rather than risk averse? And does this portend future disappointment and capital flight? Remember that the risk level priced into cap rates has to be distributed across the capital stack.

4 If the risk premium in debt has descended below the Green line, the same cannot be said for levered equity capital whose spreads are staying well above the 65th percentile mark for all property types, except retail. The ACLI data tell us that 78.3 percent of the loan volume recorded in the first half of 2014 has been in fixed-rate instruments, with borrowers locking in today s rates for mortgages than have an average life of between nine and ten years. So the equity is sidestepping interest rate risk, and the performance of levered equity should not be adversely impacted (at least directly) in the inevitable Fed tightening. Couple this with the substantial equity cushion implied by 60 percent LTVs (lower than the standard 75 percent borrowing rate employed in the NORMY analysis), and it appears that downside risk is being well-managed and that there is very little probability that commercial property will see the pressure on levered equity that prompted fire sale pricing and rising asset distress in the financial crisis era.

5 Risk Premium in Cap Rate 7%

6 Risk Premium in Cap Rate Multifamily

7 Risk Premium in Cap Rate Office 7%

8 Risk Premium in Cap Rate Industrial 8% 7%

9 Risk Premium in Cap Rate Retail 7%

10 Risk Premium in Mortgage Rate 7%

11 Risk Premium in Mortgage Rate Multifamily 7%

12 Risk Premium in Mortgage Rate Office 7%

13 Risk Premium in Mortgage Rate Industrial 7%

14 Risk Premium in Mortgage Rate Retail 8% 7%

15 Risk Premium in Levered Equity Rate 1 1 8% -

16 Risk Premium in Levered Equity Rate Multifamily 1 1 8% - - -

17 Risk Premium in Levered Equity Rate Office % -

18 Risk Premium in Levered Equity Rate Industrial 18% %

19 Risk Premium in Levered Equity Rate Retail % - - -