Deflation Risk in Income-Property Investments and Permanent Loan Portfolios: A 2008 Update

Real Estate Issues, Spring 2008 by Thompson, Marc

Note: These are the views of the author, and not necessarily the views of Bank of the West.

THIS ARTICLE UPDATES A PREVIOUS ARTICLE I WROTE for the Summer 2003 issue of Real Estate Issues (REI) under the same title.

Since then, I've observed that the amount of leverage and collateral value of income properties have inflated largely because of high liquidity stimulated by 40-year low interest rates and the proliferation of Commercial Mortgage-Backed Securities (CMBS). As a consequence, high-loan production among CMBS conduit lenders created a "hustle and flow" loan production process. The rapid growth in the CMBS market was, in part, the result of aggressive underwriting practices that led to a 186 percent increase in loans outstanding over a five-year period. The income-property industry leverage from 2002-2007 was not entirely due to CMBS: 94 percent is attributed to leverage growth in commercial banks.4 These banks also participated in this high-debt growth period, and will most likely be faced with the consequences of collateral value deflation in their loan portfolios. It is my contention that the combination of a high demand for investment real estate and favorable lending market conditions for investors created a significant credit bubble. As a result, a higher risk for deflation of income-property collateral values now exists for income-property investors and owners of income-property collateralized debt, including commercial banks.

In addition to observing and lending in income-property capital markets since 2003, I have pursued studies on adaptive complex systems at the Santa Fe Institute (SFI). The Institute's objective is to find simplicity in adaptive complex systems. Given the complexity and volume of economic data, I believe it has become more difficult for most market participants to determine where the capital and investment markets are heading. Studying complex market systems helps in understanding how markets behave, and in determining when the risk of a market correction is increasing, for the purpose of implementing effective hedging strategies.

PURPOSE

I write this article from the perspective of a career banker who works with income property. I have a vested interest in my bank and my borrowers to identify capital market issues and make recommendations to help both align for prosperous long-term growth. I hope this article will help lenders and borrowers avoid being exposed to a potentially negative capital market environment. I believe that if you understand the risk, you can hedge it. Experience also tells me that lender and investor exposure to problem loans and subsequent foreclosures can be mitigated by prudent loan underwriting. In addition, I have observed income-property real estate capital markets at both the systemic and process levels, and have made recommendations for process changes. Further research is needed to study ways of curbing "hustle and flow" loan production or capital distribution systems from naturally occurring in complex adaptive markets. But, I believe that implementing these recommendations will help stabilize real estate-collateralized capital markets in the future. The recommendations are attached as addendums for further review.

CHAOTIC REAL ESTATE MARKETS

As indicated in my 2003 REI article, the income-property real estate markets are adaptive complex markets, and susceptible to collapse. They are difficult to predict because they are non-linear, or subject to uncertain or chaotic outcomes. The only difference between chaotic stock markets and income-property markets is time scale. The difference in time scale is significant, with long cycle times for income-property real estate, and daily cycle times for the highly liquid stock market. As an example, I estimate that on average, it takes six minutes to decide to sell a stock and sell it on the stock market during an active trading session. By comparison, the sale of an income property will take an average of six months from the time a decision is made to sell and when cash is received at closing (in a good market). I estimate a six-month time frame since many income properties must be positioned to sell, and may also be subject to closing delays because of market inefficiencies, etc. Based on this six-month time scale, real estate investment cycles can range from 7-12 years. In California, the bottom of the last investment real estate cycle occurred from 1993-1996. I estimate that, nationwide, we are at the end of an 11-year investment real estate cycle collateral-value growth period. In the current income-property cycle, I expect to see U.S. income-property markets-both regional and national-deflate largely at the same time. I believe, based on my research, market observations and lending experience, that the U.S. income-property market is at significant risk of entering into a 2- to-3-year deflation period before collateral value growth is again realized on an aggregate basis.

OVERSTIMULATION BY THE FEDERAL RESERVE