Real Estate Capital Markets Update

October 13, 2006
Volume 8, Number 11

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Welcome to the next update of ULI's Real Estate Capital Markets Web site. Updates are divided into four sections: public real estate securities markets, public real estate debt markets, private real estate equity markets, and private real estate debt (mortgage) markets. In each section, we feature Real Estate Capital Markets Scoreboards detailing selected performance indices for each of the real estate capital markets.

To expand site users' knowledge and understanding of the real estate capital markets, we will publish "knowledge" papers describing underlying market mechanics. In addition, we have provided links to other Web sites that provide related and relevant information. Click here for links to other Web sites.

Frequently Asked Questions (FAQs): In addition to knowledge papers, we will publish answers to FAQs about the real estate capital markets. To go to FAQs, click here.

Glossaries of frequently used terms can be found at the end of each update. We also have identified selected Web sites that provide glossaries and/or real estate term search engines, click here.

Click here to view back issues of Capital Markets Update.

We want this site to be both useful and responsive to users, and we encourage you to e-mail comments and suggestions. If you want to send me an E-mail, click stephen@uli.org, add your comments, and click "Send".

Special Comment: “Correction in Housing”

“The Federal Reserve Chairman, Ben S. Bernanke, said the United States housing market was in a ‘substantial correction’ that would lop about a percentage point off economic growth and would restrain the expansion next year. ‘There is currently a substantial correction going on in the housing market’, Mr. Bernanke said. The decline in residential housing is one of the ‘major drags that is causing the economy to slow’.

Special Comment: Want to Learn about Investing In Infrastructure?

Do you want to learn more about the “New, New” newest thing in real estate? If so, you may want to consider attending the seminar which Institutional Real Estate, Inc. is hosting. The seminar, which is scheduled for November 1-3, 2006 in Chicago, features sessions on the fundamentals of investing in infrastructure, political and economic factors and issues, and case studies and analysis of completed transactions.

For further information, please visit Institutional Real Estate’s web site at www.irei.com.

Special Comment: Want to Learn Just a “Little” About Infrastructure

Visit Deloitte’s web site at www.deloitte.com and listen to Deloitte Insights Podcast entitled “Reinventing Government: Delivering Infrastructure Through Innovative Partnerships”.

Special Comment: Federal Reserve Board October Beige Book Economic Survey

Economic conditions remain substantially unchanged as compared to the Federal Reserve Board’s previous economic survey. The New York District reported stronger growth while the Philadelphia and Dallas Districts noted slowing growth; the balance of the District’s reported either moderate or mixed conditions. Highlights of the report, as reported by Moody’s Economy.com Dismal Scientist web site, included the following:

• Major themes from the report include: weaker housing markets; moderating wage and price pressures; and strong consumer spending.
• Increased tourism spending helped to offset declines in housing-related spending and automobile sales.
• Service industry growth was strong across most Districts.
• Factory output increased in eight of 12 Districts; the only weak spots were reduced demand for housing-related products and domestic automobiles.
• The impact of weaker housing and residential mortgage markets is being offset by stronger commercial construction and lending.

Special Comment: What’s Next for the Federal Reserve Board?

Not sure is the market’s response as Federal Funds Futures neither “leans up nor down”. The consensus view is that no change occurs on October 25^th as the Federal Reserve waits for a clear indication as to future trends in inflation and the like.

Source: Moody’s Economy.com Dismal Scientist (www.dismal.com)

Special Comment:  Notes from “The PunchLine…”, a publication of Brookville Capital

“Fine Tuning”

“The markets are obviously betting on a perfect balancing act. At least three distortions or exaggerations need to be modulated over the next few years, and none have good precedents in their favor. The first is the extraordinary housing boom in the U.S. It is becoming clear that the volume of activity and the acceleration of prices will be difficult to replicate anytime soon. And the past several years have seen high levels of U.S. consumer spending support a boom in China’s exports and growth as well. The China explosion is also at the cusp of slowing as policy makers in China and elsewhere appreciate the awkwardness of this strange and extraordinary push, that is so obviously supported by a certain currency alignment and continued rapid growth in the U.S. Related to these two is the third exaggeration or distortion—the amazing run up in commodity markets and energy prices, in particular. Well supported by seemingly powerful fundamentals on both the demand (i.e., the China boom) and the supply side (i.e., capacity shortages), financial investors have also aggressively amplified price movements of commodity-related assets. As a result, the modulation of these three excesses over the next few years may turn out to be more a complex and inter-related development that will be more difficult to predict than is generally assumed.”

“Weary Households?”

“We know from big builders that cancellation rates are rising. The cancellation rates ‘has roughly doubled over the last year’ and is ‘more serious at the big companies.’ Lennar Corp., the No. 3 U.S. homebuilder, said its cancellation rate was running at more than 30%. Net new orders fell 5 percent in the quarter ending Aug. 31. Cancellation rates rose to 29 percent in the April-June quarter at D.R. Horton, Inc., the second-largest homebuilder, and deteriorated further in July according to the company. That compares with an historical average rate of 16-20 percent.”

“The DNA of Business”

“CEOs take a dim view of the U.S. economy…More top U.S. chief executive officers believe the economy is going to deteriorate over the next six months than expect improvement, according to a study of 70 top CEOs released [recently]. A joint study released by the Business Council and the Conference Board found that 45.6 percent of top CEOs forecast economic conditions to get worse over the next six months, while 41.2 percent believe conditions will improve. That marks the first time in the survey’s two-year history that the largest segment of respondents expected conditions to deteriorate and is a sharp increase from the 16 percent of respondents in February who saw conditions worsening.”

“Lloyd’s Wall of Worry”

The following appeared in the September 2006 issue of Institutional Investor. We received a number of favorable reactions to “Lloyd’s Wall of Worry” and will maintain the “Wall” as a regular feature in ULI’s Real Estate Capital Markets Update.

“Long a part of Wall Street lore, the Lloyd’s Wall of Worry (a trademark of Khaner Capital Management) is a quick, handy way to gauge the emotions of investors. As interpreted by money manager Lloyd Khaner, a low wall, with seven or fewer blocks, indicates a complacent, even overconfident market: Time to take profits. A high all, with 15 or more blocks, suggests a squeamish market: Look to buy at bargain prices. In the middle range, reading the wall gets tricky; knowing not only where the wall stands but whether it’s headed up or down is the key.”

As of September 2006, the wall is comprised of 15 blocks (at the higher end of the range).

“This Month’s Wall: The market was upbeat and relatively restful in August, thanks to defanged inflationary fears and a show of strength from British intelligence which foiled a major terrorist plot to bomb several airplanes in mid-flight. Still, other pressing concerns caused the Wall to rise for the third straight month. At 15 blocks it is now officially in the high zone. Any more unsettling news—say, oh, a pungent whiff of recession—should brings us into the land of opportunity, the magical place where we can buy growth stocks at value prices”.

The Worries:

1. U.S. economy: “looks like a soft landing.” Just what my brother said when he pushed me out of a tree in first grade.
2. Interest rates: Does Big Ben’s pause toll an end to hikes?
3. Inflation: Not rampant, but still spreading like mildew in a wet basement.
4. Oil prices: Attention all tree huggers: $75-plus oil puts us five bucks from the big decision: kick-start our nuke plants or defrost Alaska.
5. Consumer spending: Struggling to keep its head above water as it fights off $3 per gallon gas.
6. Housing prices: Going south like a duck in winter.
7. Iran: Building financial friendships faster than it is making ideological enemies.
8. Corporate earnings: It’s harvest time, and so starts the annual third quarter vigil. As investor’s wait for October’s earnings guidance, the trick is to be on the tractor and not under it.
9. U.S. dollar: Is the greenback going the way of poor Pluto?
10. Volatility: Prolonged exposure to market swings can cause dizziness, irritability, hair loss, sudden death, or in extreme cases, loss of capital.
11. Stock option pricing: Backdating options, a.k.a. rewriting history, would be shrewdly Orwellian if it weren’t so obviously stupid.
12. Middle East: Add one more year to the 3,000 in history of hate and mistrust.
13. Terrorism: There will always be an England, thank god. But what about the rest of us?
14. Hurricane season: Still learning from Katrina—and Spike Lee—the market this year worries more than ever.
15. North Korea: Overdue for a tantrum.

Looking ahead:

• U.S. midterm elections: Can a fired-up blogosphere split Congress and thrust us into fiscal responsibility?
• Unemployment: In the sweet spot now, but keep a tally of those daily layoff numbers.
• China: The bull in the bull market.
• Consumer confidence: For realz?

Public Real Estate Securities Capital Markets

We are about to start (quarterly) earnings season again and expectations are high, especially as industry-wide fundamentals continue to improve and (at least) short term interest rates have stopped increasing.

Given real estate investment trust year-to-date returns—up almost 23.0%, it is not unreasonable to contend that some of this quarter’s better than anticipated earnings is already “baked into the cake” and that stocks will react marginally once hard news is delivered. More to follow as earnings are released.

Private Real Estate Equity Capital Market

A picture is always worth a 1,000 words. To prove this statement, the following “picture”, courtesy of Real Capital Analytics and Citigroup Investment Research, describes the “Spread Between Aggregate Capitalization Rates and 10-Year Treasury Yields, from October 2000 to the Present”, portraying rather vividly a point we and many, many others have made over the past year—that the risk premium accorded to real estate investment has been getting smaller. What this chart says is that capitalization rate compression—the willingness to accept overall lower returns is just one side of the story. The other half is that investors are willing to accept lower risk premiums (over Treasury yields) even though the real estate business in and of itself is not demonstrably less risky.

Source: Real Capital Analytics Inc. (www.realcapitalanalytics.com)

Public Real Estate Debt Capital Markets

U.S. issuance of CMBS during the first nine months of 2006 equaled $132.9 billion, an increase of $21.7 billion, or approximately 20%, as compared to the first nine months of 2005.

Non-U.S. issuance equaled $60.0 billion during the first nine months, an increase of $10.0 billion, or 20%, as compared to the first nine months of 2005.

The pipeline of deals in the works both inside as well as outside the U.S. remains steady, arguing that issuance in 2006 will exceed 2005’s record level. The non-U.S. pipeline is especially strong and includes the following transactions expected to price in 2006: 

Private Real Estate Debt (Mortgage) Capital Markets

According to data published by the Mortgage Bankers Association, commercial Mortgage-Backed Securities have replaced commercial banks as the primary permanent lender to the commercial and multifamily real estate industry. Commercial banks still play a crucial role as the current sole provider construction loans. The following chart describes 2005 market share for commercial and multifamily mortgage originations (by volume of originations):

Commercial Mortgage Market Survey

“As revealed by our bi-monthly survey and conversations with lenders, 5 and 10-year fixed rate CMBS spreads continue to price at the same levels observed when the yield curve flattened and Treasury yields fell in late August. Since then, swap spreads have held in the 53 to 55 basis-point range. With all other quotes unchanged, only one lender surveyed indicated a tightening of CMBS spreads. The lender attributed the 3 basis-point spread decrease to “end of the year push.” Some lenders tend to price more aggressively to win deals as they work to achieve/exceed origination goals for the year.”

Capital Markets Update is published monthly by ULI-the Urban Land Institute, 1025 Thomas Jefferson Street, N.W., Suite 500 West, Washington, D.C. 20007-5201. Richard M. Rosan, President. © 2006 by ULI-the Urban Land Institute. All rights reserved. Printed in the U.S.A. Editor: Steve Blank. Publications cited in Capital Markets Update are not available through ULI. They can be obtained from the sources listed.