I’ve noticed a growing trend this year in commercial real estate that investors and real estate professionals need to be aware of. It is particularly acute in the apartment market; other property types have not yet gone to the same extreme but are slowly heading in that direction.

I believe the apartment market transitioned this past year into what I like to call the “Silly-Stupid” Phase. Most real estate pundits would rather describe it more objectively as Phase II – Expansion, specifically in the “high rent growth in a tight market” (see chart below). I have no objection with their analysis. That’s exactly where the apartment market is today.

But the problem with their analysis is that it doesn’t describe the emotion of the market. The chart below more accurately reflects the apartment market as somewhere between “Thrill” and “Euphoria” on the emotional roller coaster ride.

You can almost hear in the background a big brass band playing “Happy Days are Here Again.” And for good reason. Rents have increased dramatically in the last year, interest rates remain historically low and developers have been slow to meet the demand. This all bodes well for the apartment market. Except for a few small submarkets, I really don’t see the market as a whole shifting into Phase III – Hypersupply within the foreseeable future, nor do the pundits.

The Silly-Stupid Phase is characterized by two factors:

  1. Cap rate compression. Increased demand for acquiring apartments, especially high-quality assets, is causing asset prices to overtake their property values so says the Real Estate Research Corporation (RERC). “The relationship between the value versus price of commercial real estate is precariously balanced,” said Ken Griggs, RERC president. “Our analysis showed upward pressure on pricing without a corresponding increase in value.”  Why?  I think there are a lot more buyers than there are sellers causing investors to buy assets at silly-stupid prices.  In order to justify the prices offered they are basing their analyses on inflated pro forma projections.
  2. Lender aggressiveness. What I have observed in recent months, and what my lending peers have confirmed, is that we are experiencing outlier lending institutions (usually small banks) providing rates and terms that are significantly better than market. They aren’t competing for the business, they are buying it. We are also seeing larger financial institutions beginning to offer rates and terms that are reminiscent of the years prior to the Great Recession: Interest only, higher LTVs, lower DCRs and compressed spreads on interest rates. Why? What I think is happening is lenders, both large and small, have ramped up to do more loan volume this year and have been surprised they haven’t met their quota. In order to get more loans closed they are willing to offer “blue light specials” with mixed results.

So what does this mean for the commercial real estate investor? Should they stop buying? I don’t think so and here’s why:

  1. The Silly-Stupid Phase does not appear to be ending any time soon. Rental rates do not appear to be leveling off.  This phase could easily continue through 2015, into 2016 and beyond. Finding good deals in the market is not as easy as it once was, but it’s not impossible. There always will be sellers who poorly manage their properties and with a buyer’s new vision and turnover in property management can take a property to the next level.
  2. This is a great time for investors to sell those properties in their portfolio that they bought at the top of the market in 2007. I believe in the Greater Fool Theory: I’m going to sell my property to a greater fool than I was when I bought my property. Now’s the time to dump those properties and get maximum value. It’s your turn to sell at the top of the market to someone who thinks they know better than you do how to make your property zing. Let them try.

I have two pieces of advice for those buying. Lending terms are very aggressive right now. Take advantage of all the blue light specials except for one: Don’t overleverage your newly acquired property. But do lock in long term rates, the longer the better. When the market turns, and it eventually will, don’t be caught with a property that no longer cash flows because vacancy has crept up and the property was leveraged to the max. Remember the lesson of the last recession, “Pigs get fat, hogs get slaughtered.”

Source: A bigger role for banks in commercial real estate lending, by Forbes Contributors, forbes.com, September 14, 2014.

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