This Very Curious Real Estate Cycle

In theory, the current U.S. real estate cycle should be good for at least another five years, according to Glenn Mueller, a university professor and the real estate investment strategist at the Denver-based Dividend Capital Group. Mueller is no empty talking head on the evening news. He is noted ' and has been awarded the Richard Ratcliff Award by the American Real Estate Society ' for his ground-breaking research in real estate market cycles.

His top-line prognosis: Assuming the U.S. economy continues its slow but steady improvement, the next recession will be between 2018 and 2020. Per the usual trajectory, the real estate cycle will follow the economy and crash as well. The exception, he says, is if developers overbuild ' and they aren't, except in apartments. There, Mueller says the industry is oversupplying the market by about 10% a year. Otherwise, “the economy is still growing and there is still strong demand for commercial assets. This cycle is still in a good place.”

Two CRE Cycles Not Moving in Tandem

Dig a little deeper with Mueller, however, and the “but this cycle is different” advocates out there can find plenty of material with which to work. For starters, there are, in fact, two real estate cycles to watch, he explains: the physical or brick-and-mortar cycle that represents supply and demand, and the financial cycle. In normal times, these usually move in tandem, although not always.

But now they seem to be diverging at an unusually fast clip. The financial cycle is getting a bit wonky due to the volatility in the global equity and bond markets. This volatility appears to be here to stay, more or less, interspersed by the occasional quiet period. Another problem with the current financial cycle is that upcoming capital market regulations are unusually opaque in terms of their effect, making it harder than ever to predict liquidity. We'll get back to this in a moment.

The Mini-Black Swan That Is Technology

And while the physical cycle is stable for the moment, it could be affected by tech developments that, again, could upend the supply/demand trajectory. Some of the expected changes go beyond mere cycle disruption and could be considered a mini-Black Swan event, given how widespread the ramifications are.

This is partly in reference to WeWork and co-working in general, as well as Airbnb. These trends have made clear in a short period of time exactly how easy it is for technology to knock demand and/or supply off of its expected course.

Rumor has it, according to Bloomberg, that WeWork is discussing a possible partnership with the Australian Lendlease Group to lease offices and living spaces. The first project would be in London, with developments ultimately spreading throughout Europe, North America and the Asia-Pacific. One rough metric Mueller uses to describe the impact co-working, collaborative design and technologies have had on office space is that it now takes two workers to absorb the same space that one used to.

Airbnb, for its part, is having a similar effect on the hotel sector, much as hotel companies like to deny it. CBRE Hotels reported recently that Airbnb users spent $2.4 billion domestically between October 2014 and September 2015. Of that, 55% was spent in New York City, Los Angeles, San Francisco, Miami and Boston, representing a significant portion of the lodging revenues in these markets.

Airbnb will impact hotels in two ways, relates R. Mark Woodworth, senior managing director of CBRE Hotels. Existing hotels will keep their average daily rates competitive with Airbnb's relevant offerings in the market. Increasingly, this also includes business hotels, as more luxury homeowners are listing their properties on the site. It could also stymie hotel construction and supply growth, he adds.

The tech sector has more to throw at commercial real estate, now that the latest in cognitive computing and artificial intelligence is being applied to the space. Even Mueller hesitates a bit when he's asked if technology could still derail the current real estate cycle from its prescribed trajectory. “Any technology that changes the dynamics of demand can impact the cycle,” he answers after thinking for a bit. “That is the definition of disruptive technology.”

Another definition of disruptive tech is a development that established industry players didn't see coming. And with CRE being such a ' let's face it ' hidebound sector when it comes to high tech, it's less likely to spot this disruption in time to prepare for the change.

A big-picture view about the upcoming changes is provided by Deloitte, which has been using machine learning capabilities developed by a start-up called Kira Systems in its tax, consulting and audit divisions. Machine learning, briefly, is a form of artificial intelligence that is able to improve itself as it ingests more and more data. Deloitte has deployed this technology, augmenting its existing platforms to improve document review in the audit space, according to Craig Muraskin, managing director of Deloitte's U.S. Innovation group.

The technology can extract relevant terms and conditions from unstructured data such as contracts and leases. It's a major leap forward from more traditional e-discovery and related tools that could only be applied to structured documents such as invoices. The technology potentially can and will be applied to an array of sectors, Muraskin says. “It has the potential to help companies prepare for the lease accounting and revenue recognition standards.”

Another tech play is coming from start-ups that are turning their attention to commercial real estate. Oakland, CA-based Roofstock recently launched an online marketplace for investors interested in single-family rentals. The properties are all currently leased and professionally managed and the site comes with tools to evaluate the properties and perform due diligence. It even accepts e-signatures.

“Investors routinely purchase about one million homes annually, but the existing channels are antiquated and don't adequately serve buyer and seller needs today,” says Roofstock cofounder and CEO Gary Beasley.

Both of these developments are arguably good news for the industry ' save the consultants and brokers that might be out of a job because of the respective technologies. Both also have the ability to shift demand and supply in their respective areas, especially as use grows.

Capital Market Disruption

The more obvious area of disruption right now is in the financial arena. In January 2016, commercial property prices declined by 0.3% ' the first drop since 2010, according to Moody's/RCA Commercial Property Price Indices' national all-property composite index. “This is a significant milestone that signals that a shift in sentiment among investors is underway,” said Tad Philipp, Moody's New York City-based director of CRE research.

The major markets are also showing signs of price deceleration, dropping by 0.6% in January. This price drop can be traced back to the growing difficulty in securing financing, Mueller says, and a legion of financial intermediaries support him in this view.

Commercial mortgage-backed securities (CMBS) financing has become very difficult to raise, in part due to the volatility of the past few months and in part due to the uncertainty about how U.S. and global regulations will impact CMBS. The risk-retention rule under Dodd-Frank will go into effect at year-end, but for all practical purposes CMBS deals will start accounting for it starting around June or July of this year. Basel III, meanwhile, has put forward a rule change for banks' fixed-income trading books that imposes a big capital requirement on secondary market makers. Another Basel III requirement that went into effect in 2015, creating a new category of acquisition, development and construction loans called High Volatility Commercial Real Estate, is starting to have an impact on the availability of construction finance as regulators begin to enforce the measure.

Meanwhile, companies will be diverting much-needed financial and IT talent to comply with the U.S. Financial Accounting Standards Board and International Accounting Standards Board's aforementioned leasing accounting and revenue recognition standards. Even with the best in AI-based tech, these standards are so comprehensive that their compliance will suck up a company's resources and its executives' time and attention for years.

As luck would have it, even a regulation favoring the real estate industry ' the loosening of the Foreign Investment in Real Property Tax Act (FIRPTA) ' is being counteracted by the strong U.S. dollar. To give one example, Canadian investors net take-home under the new FIRPTA decreases by 15% under the current Canadian/U.S. exchange rate, according to Mueller.

But Opportunities Still Beckon

Of course, that push-pull, or cause-and-effect factor, is characteristic of all business cycles, everywhere, and will be for all time. The textbook case exists only for the textbooks and the teachers that cite them.

Consider the growing sophistication in affordable housing finance. In part, it's due to financial providers such as Walker & Dunlop (W&D) realizing that with the turmoil, the global equity markets and freeze in the CMBS market, now is a great time to dig in deeper to guaranteed sources of finance, Fannie Mae, Freddie Mac and HUD. For that reason, W&D expects an up-tick in the company's HUD business this year. HUD's construction program, in particular, will likely attract borrowers as construction finance contracts in response to the Basel III regulation. Construction loans will be a significant portion of W&D's HUD production this year, CEO Willy Walker predicted in the firm's earnings call early this year.

True to his word, the company later reported that it helped a borrower execute a “first” in HUD-based financing: the acquisition and rehabilitation of an older Section 8 property using a tax credit pilot program coupled with the Government National Mortgage Association's tax exempt taxable swap structure. Specifically, W&D worked with HUD to convert the Moderate Rehabilitation Section 8 contract to a Project-Based Rental Assistance contract under the Rental Assistance Demonstration program. The structure meant borrower Scott Canel & Assoc., a Chicago-area law firm, was able to avoid the higher costs of going through HUD's 221(d)(4) program ' that is, its mortgage insurance fees for new construction or substantial rehabilitation. The taxable swap component lowered transaction costs even more and secured a lower rate. The end result: a $7.6-million loan for Glen Oak Towers, a federally subsidized high rise for senior citizens, in Peoria, IL.

Another lender diversifying its portfolio in response to changing trends is Prudential Mortgage Capital Co. (PMCC). It originated a solid $14.6 billion in loans in 2015. That amount included a very surprising $1 billion in agricultural debt and equity investment ' one of the highest volumes for this asset class in the firm's history.

In general, agriculture real estate as an asset class has been gaining traction thanks to the growth of the handful of pure-play real estate investment trusts (REITs) and the related timber REITs. But those companies are fairly recent developments, compared at least to Prudential's 100-year or so presence in the agricultural lending market. The unit, called Prudential Agricultural Investments (PAI), is a $3.9-billion entity that invests on behalf of Prudential's general account and third party investors. PAI has a total of eight institutional accounts and the market value of its portfolio exceeded $488 million as of Sept. 30, 2015. PMCC will be investing a similar amount or more in the agriculture space in 2016, says CEO David Durning. “Agriculture is a very attractive asset right now and we're looking to take further advantage of our capabilities in this space.”

Agriculture is a great diversifier within Prudential's larger real estate portfolio, meaning its cycle doesn't correlate with more typical CRE asset classes of office or retail, for example, Durning explains. And right now, agriculture's cycle for the U.S. is poised for long-term growth. The world, for all the recent volatility in the global markets, is getting richer ' or, rather, more people are entering the middle class ' and as they do so, they want higher quality food and related products. “The U.S. is best suited to provide it,” Durning says.

Hunt Mortgage Group is also expanding its financial offerings, according to James Flynn, executive managing director and Chief Information Officer. Hunt Mortgage, though, is among the rare breed of companies that are following a long-established business plan while ignoring current market trends. “Our goal is to become a full-service CRE finance provider,” Flynn says.

It just so happens, in other words, that some of its moves, such as establishing an affordability finance team, are complementary to what is happening in the market. Other steps are clearly more for the longer term, such as the green or sustainable financial expertise it is also developing and the conduit platform it established with the goal of securitizing its loan originations.

Some Things Remain the Same

When Jim Murphy, now managing director of NorthMarq Capital's Boston regional office, was starting out in his career, the industry was quite different. One of his first deals, in the 1970s, was to evaluate New York City's Park Plaza for a possible refinancing on behalf of MassMutual.

The room rate was $49 per night back then and interest rates were starting out at 8%. Murphy concluded that the proposed project ' the addition of several more hotel rooms ' just didn't pencil out, considering the costs involved. MassMutual turned down the deal. Murphy didn't regret his decision ' not that the Park Plaza is anywhere remotely considered to be a risky bet today.

Murphy is getting set to retire soon, but he worries for his friends and colleagues who will still be in the trenches. The fundamentals are fine and the slow-rising interest rate environment is optimal for the industry. But in other ways, “the industry is changing so fast right now, it can be hard to spot the risks,” he says.

By the same token, he adds, the fast pace of change is also opening the door to new opportunities. For example, it will be a happy day when technology finally solves that perennial customer service/communication problem of CMBS servicing.

“Change is not necessarily bad,” Murphy relates. But it's better if that change is anticipated.

Erika Morphy is a freelance journalist and blogger who reports on business, technology and finance issues. This article also appeared in Real Estate Forum, an ALM sibling publication of this newsletter.