Institutions re-examine real estate

Real Estate Issues,  Dec 1995  by Ryan, James P

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As life companies have disposed of real estate assets, they have also tightened their underwriting standards. Delinquency rates have shown marked improvement, dropping from 5.25% in early 1994 to about 3.5% in the second quarter of 1995.

Today, life insurance companies are moving back into the mortgage market for larger loans in the $15 to $50 million range. The spreads on mortgages over like term treasuries still are very good compared to the spreads on bonds of similar rating.

Banks

In todays banking industry, big certainly means better. Most banks are either in the process of acquiring or being acquired. The focus is on creating market efficiencies by cutting expenses. Recently, Chase and Chemical merged. Today Bank of America and Nationsbank are in discussion about a possible merger, as are First Interstate and Wells Fargo. Banks have been moving aggressively to fill gaps in the mortgage market. They are writing shorter term loans with floating rates and recourse construction loans. Many are extending lines of credit to REITs and other pools of investment capital with reasonable loan-to-value ratios.

During the first half of the 90s, the real estate loans portion of banks' assets has grown from about $250 billion to about $289 billion, while loan delinquencies and REOs have declined. The banks have worked hard to improve their balance sheets. As the industry becomes more competitive and margins continue to get squeezed, banks will have to grow their asset base to improve earnings. As the real estate market recovers and new construction becomes more plausible, the banks will function as a control lever on the supply of new real estate. Their renewed focus on conservative underwriting should help discipline the market which will benefit all.

Real estate, like any investment, is cyclical. The perception that real estate is a dirty word is changing. Opportunity funds and REITs have led the capital market back into real estate and posted some excellent returns by taking some risks. The early funds focused on acquiring large loan packages of performing and nonperforming loans from the RTC and savings and loans. These opportunities have diminished dramatically. However, other opportunities still are very strong. Many institutions, particularly banks and insurance companies, are in a sales mode and need to reduce their real estate exposure. Therefore, some excellent buying opportunities are available.

Ten year treasuries currently are about 6% and average projected real estate yields (as measured by Real Estate Research Corporation) are 11.4% (as of June 1995), indicating a 540 basis point spread. This compares favorably to the normal spread of 200-400 basis points which indicates the returns to real estate are above the normal range. In other words, on a relative basis compared to other capital assets, real estate is undervalued indicating now is a good time to buy. Finally, inflation is projected to remain in check for the balance of this decade. This is good news for all, particularly the debt market. Lenders are returning to the market which is good news for borrowers. The key is that real estate is again becoming attractive in many different forms, equity or debt, private or public ownership.