Posts tagged Peter Linneman
Please enjoy an excerpt from the Fall issue of The Linneman Letter by Dr. Peter Linneman, PhD, Chief Economist for NAI Global and Principal of Linneman Associates. Mr. Linneman will also be the featured speaker of the upcoming 2017 NAI Florida Forum.
“How “at risk” are different property investments to an economic downturn? To address this question, we examined a variety of simplified investment profiles. Specifically, we simulated the returns for an 8-year hold period for 3 hypothetical multifamily investments: a class A property with a low yield and high NOI growth in a Gateway market (“Gateway A”); a class A property with a mid-range yield and medium NOI growth in a secondary market (“Secondary A”); and a class B property with a high yield, but low NOI growth, in a tertiary market (“Tertiary B”). We chose to model multifamily because of the simplicity of mark-to-market rents, though our insights can be generally applied to other property types. Each investment is analyzed for a Base Case with constant (but different for each property) NOI growth. For all investments, we assume a purchase price of $100 million, cash flow margins of 83% of NOI (reflecting on-going capex), and exit transaction fees of 3%.
The Gateway market A investment has a going-in cap rate of 4%, NOI growth of 4% per annum for 8 years, and an exit cap rate of 4.5%. The Secondary market A investment has a going-in cap rate of 6%, NOI growth of 2.5% per annum, and an exit cap rate of 6.5%. The Tertiary market B investment has a going-in cap rate of 7.5%, NOI growth of just 1.5% per annum, and an exit cap rate of 8%. For each property, we overlay 3 leverage scenarios: no leverage, 50% LTV, and 75% LTV. This yields a total of 9 “Base Case” scenarios. In both the 50% and 75% LTV scenarios, we assume 10-year debt with a 3.5% interest rate and 30-year amortization.
We also simulated how returns and (interest and debt) coverage ratios are affected by reduced NOI growth due to a cyclical downturn. We refer to these 9 scenarios as the “Realistic” scenarios, as NOI never grows smoothly upward forever. These scenarios assume -6% NOI growth in years 3 and 4 (that is, an aggregate 11.6% NOI decline spread over 2019 and 2020) of the investment horizon. Thereafter, the originally modeled growth rates resume through year 8. In total, we simulated 18 investment scenarios and their corresponding return profiles: 3 different investments, with 3 leverage ratios and 2 economic environments.
While highly simplified, this analysis is fairly realistic and provides insights on the impacts of leverage, property type, and the economy. As to leverage, as long as original pro-forma growth occurs, increased leverage increases both the equity IRR and the equity multiple. For example, the Gateway A property generates an equity IRR of 5.2% with no leverage, 6.3% with 50% leverage, and 8.5% with 75% leverage, while the equity multiple increases from 1.4x to 1.6x to 2.0x over the 8 year hold.”
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“The Linneman Real Estate Index (LREI) monitors the supply of real estate capital, as proxied by the aggregate flow of commercial real estate debt (the numerator), with the fundamental demand for space, as measured by nominal GDP (the denominator). Excluding the net real estate equity flows from the numerator modestly understates capital oversupply situations and overstates an undersupplied market. The LREI captures whether debt for commercial real estate is growing more quickly or slowly than the economy. When the index is rising, it means that mortgage debt available for commercial real estate is rising more rapidly than the economy, and vice versa. The index is set to 100 with a base year of 1982, when the supply of real estate capital was roughly in balance with demand.
The index rises when mortgage debt rises more rapidly than the economy grows (“easy money”), and declines when money is tight relative to economic growth. The LREI peaked at 171 in 2009, but steadily declined before hovering between 136-139 from 2012 through 2014 as the Financial Crisis reverberated. The index increased to 143 in the first quarter of 2016, a clear indication that a new capital cycle is underway. As banks expand their mortgage lending, the era of massive real estate deleveraging has come to an end. Our research shows that, historically, the best investment periods for real estate have occurred while the LREI is declining or in the first 2 years of rising.
The LREI tends to run in long cycles, and we believe we are still in the early phases of another capital boom. We expect lending to outstrip the growth of the economy, resulting in huge capital flows to real estate for the next three years. This bodes well for prices over the next couple of years. The risk is that if you are looking to sell 3-4 years from now, you could hit the side of the mountain. When capital is being taken out of a capital intensive business, values go down far more than NOI goes down. If you are a long-term holder (10-30) years and can see your way through the valleys, you will do quite well, but if you are a 2-3 year holder, note that we are actually entering a dangerous window. That is, yes, there is a lot of capital flowing, but investors could find themselves having a difficult time exiting if the capital cycle reverses in 3-4 years.”
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“Wall Street is in a panic, supposedly worried about a rising dollar, slowing Chinese growth, plummeting oil prices, a U.S. recession, and increasing interest rates. While these supposed rationales are more cover stories than real reasons, this panic caused stock prices to fall by 12% between year-end 2015 and February 11th, hitting a low not seen for two years. And as Wall Street jitters caused a flight to safety, 10-year Treasury yields fell by 20 bps and mortgage spreads widened by 100-200 bps. In addition, nervous lenders pulled back on mortgage origination growth, especially for commercial mortgagebacked securities (CMBS), and loan proceeds fell by 5-10%.
Yet while Wall Street is in a complete tizzy, Main Street continues to move forward: consumer confidence remains largely unchanged near its historical average; the economy continues to add jobs at a healthy pace; wages are growing faster than inflation; unemployment claims are low; the unemployment rate and the duration of unemployment are falling; and consumer spending remains solid. Thus, while Wall Street fears apocalypse, Main Street merrily dances onward.
This disconnect raises the question, “Who is right: Wall Street or Main Street?”
To find out the answer and read the rest of the excerpt, CLICK HERE.