PERSON OF THE WEEK: The commercial real estate (CRE) industry has experienced more than its fair share of ups and downs – but looking at today's market, it is often hard to determine whether things are looking up or looking down. To determine CRE's current direction, MortgageOrb spoke with Jake Clopton, president of Chicago-based commercial financing services firm Clopton Capital.
Q: What is your view of the state of U.S. CRE? Is this industry on the road to recovery, or are there still challenges to be faced?
Clopton: There are still enormous challenges being faced by the commercial real estate industry. The greatest of these challenges will be the number of commercial obligations to come due over the next few years and the lack of capital ready to meet it. Not to mention the state of much of the commercial debt out there – many of the loans looking for homes are underwater. This will put a lot of strain on the banks and institutions holding this debt as they try to remove it from their balance sheets.
CRE will have a tough time in the near future. Luckily, there are new players in the private sector that are positioning themselves to take advantage of the opportunities that will arise when banks are forced to migrate these loans off of their balance sheets.
With these challenges in mind, I would absolutely say that the market is on the way to recovery. There are sectors of the industry that are booming. For instance, take a look at assisted-living facilities. Developers cannot construct these facilities fast enough to meet current demand, and it will only get more intense. So, yes, the industry is recovering, but it is definitely a changed marketplace. There are still people out there that can't accept today's cap rates and financing requirements – but for those that can, opportunity abounds.Â
Q: Recent data has determined that the delinquency rate on commercial mortgage-backed securities (CMBS) has fallen for two consecutive months, although the drop was primarily due to loans being resolved with losses, rather than delinquent loans actually curing. What argument can be made to investors that CMBS represent a good investment?
Clopton: Commercial mortgage modifications are huge right now. Without modifications and delinquency workouts, a lot of the commercial debt out there would be toxic.
Right now, compared to other opportunities offered by the market, I do not see these types of securities as good investments. The risk that CMBS exposes you to isn't worth the spread over the 10-year Treasury that it is written to. If you're willing to go after low risk and low return, why not just buy Treasuries?
Q: There is an increasing shift among Americans from homeownership to renting. Can the multifamily sector within commercial real estate keep up with the new focus on rentals?
Clopton: Great question! There is an interesting situation going on in Chicago right now:Â bidding wars for apartments. This is something that this market has never seen before, and it is skyrocketing rental rates. Right now, an apartment I could have rented out a year ago is going for 20% more.
I don't see the market keeping up with demand, and a lot of that may have to do with the lack of construction capital out there. Construction lending is probably the hardest form of finance to arrange at the moment, and this is absolutely contributing to the lack of housing.
People just don't qualify for home loans the way they used to – that's a fact. What we need to see is a huge switch in rental and ownership costs. It needs to be cheaper to own than to rent no matter where you live. That's another conversation, but the switch from an ownership society to a rental society will absolutely drive rental rates up, and along with that will come the supply of real estate geared toward it.
Q: You have previously stated that there is a rise in mortgage rates due to widening spreads against benchmark rates. What impact will this have on commercial real estate?
Clopton: Widening spreads will increase rates for mortgages. This will make it more costly to borrow money, which will significantly impact the CRE market. Any given property will qualify for a lower loan amount because of the debt-service-coverage ratio.
Let's say we want to stay at your standard 1.25 DSCR. As you raise the interest rate on a loan, you also raise the monthly mortgage payments. The only way to combat that is to get a longer amortization or lower the loan amount. Since we don't have a lot of flexibility on the amortization, we simply are going to lower the loan amount. I don't see people contributing more out of pocket capital into any given transaction, so if you want to have a piece of real estate change hands, you are going to have to do so at a lower price.
If CRE properties qualify for lower loan amounts, there will be several effects. Refinances will be very difficult, buyers will have to bring more into acquisition out of pockets, property values could drop due to lower profitability, etc. There are dozens of ways this could affect the CRE market, and I can't see a single way that it would end up helping.
Q: Many people blame high unemployment for the problems facing the housing market. In May, however, Federal Reserve Bank of Atlanta President and CEO Dennis P. Lockhart blamed high unemployment for stifling the recovery of Atlanta's commercial real estate market. Can we blame unemployment for problems facing the national commercial real estate market?
Clopton: Think of it as the trickle-down effect. Unemployment affects everything, because it means people aren't making money, which means they don't have any to spend. In the end, every business relies on the consumer one way or another – and if those consumers don't have any business to give, then you are out.
Take the retail sector, for example. Most of the businesses are single condo stores: a haircut place, a party supplies store, pet store, etc. What happens to those businesses when there is high unemployment? They lose revenue. If they lose enough revenue so that their expenses outweigh the money they are bringing in, they will close their doors.
This means vacancy for the retail strip, which is a very bad thing for CRE. This scenario can be applied to anything from an office building to a manufacturing plant. When we are unemployed, everyone suffers.
