Cap Rates and Commercial Real Estate Default

Commercial real estate mortgages are different from residential mortgages in a number of dimensions. One of the most important is term: while residential mortgages are generally self-amortizing, commercial mortgages usually have "bullets" or balloon payments arising from terms that are shorter than amortization schedules. For instance, a commercial mortgage might have a ten year term with a 40 year amortization schedule.

Many of these commercial loans are currently due or will soon be due. Many of them are performing well, in the sense that buildings, even after rent reductions, are producing sufficient cash flow to cover debt service. But because expectation have changed, capitalization rates have risen. This creates a problem.

Real Estate may be valued similarly the way stocks are values using the Gordon Growth Model. Income gets capitalized into value via a capitalization rate, which has two basic terms: a required rate of return, or discount rate, and an expected rental growth rate. The formula for valuation is simply V = Income/(r-g), where V is value, r is the discount rate and g is the expected growth rate.

Five years ago, a high quality office building would have a cap rate of 5.5 percent. The ten year treasury rate at the time was around four percent, so the 5.5 cap rate might have reflected that four percent rate plus a three percent risk premium less a 1.5 percent expected growth rate in rents (4+3-1.5).

Now, the ten year treasury rate is around 3 percent (actually 3.24 at this writing), which would tend to push down cap rates. but risk premia have widened, and rents are expected to fall. Suppose the risk premium is now 5 and rents are expected to fall one percent per year (they don't change that much from one year to the next because long term leases are in place). Now we get a cap rate of 3+5+1, or 9 percent. This would imply property values falling by (1-5.5/9), or a little less than 40 percent. This may overstate what is happening--as best as I can tell, values have fallen by about 1/3.

Consider a loan originated 5 years ago at a 5.5 percent cap rate and a 70 percent LTV. The loan to value ratio would have been conservative, and yet if the loan had no amortization (certainly a possibility), the building owner would be upside down, with a loan due greater than the value of the real estate. These are the properties that are extremely difficult to refinance, and may produce the next credit crisis.

Of course, had the mortgages been self-amortizing without a bullet, many of the loans would not have turned into problems.