Rates giving borrowers bit of excess stomach acid

Antacids must have been flying off the shelves in recent weeks.

The stomach discomfort wasn't caused by fewer people getting jobs in April than in March. In fact, the opposite was true.

April jobs data, released this month, was quite good, showing that the economy is putting more people to work than expected.

But that good news has led to a turbulent uphill ride for commercial-mortgage rates, producing a bit of excess stomach acid for borrowers.

Rates are now in the 5.35 percent to 6.25 percent range for five-and 10- year mortgages, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Besides having to pay 0.50 to 0.75 percentage points more in interest rate today than 30 days ago, borrowers who are seeking maximum leverage may be in for a rude awakening.

With rates up, loan dollars are getting cut because of a lack of adequate debt-service coverage. Debt-service coverage is an important guideline for lenders, as it shows how much cash is available after paying property expenses for borrowers to make loan payments.

Generally lenders like to see the property's cash flow after expenses cover the debt service 1.25 times. This has rarely been an issue during the past two years, but with the yield on the 10-year U.S. Treasury now at a 22-month high, loan-to-value is less of an issue than debt-service-coverage ratio.

Borrowers aren't the only ones with queasy stomachs in this interest-rate environment. With rates spiking, publicly traded real-estate investment trust investors are dialing in sell orders. REIT stocks tend to lose their luster when U.S. Treasury yields increase. Indeed, the NAREIT Real-Time Market Index has fallen approximately 15 percent in the past month.

The downward trend in REIT shares has had little effect on the commercial mortgage-backed securities (CMBS) market. In fact, RBS Greenwich sold a $2.6 billion offering April that was the fourth-largest securitization ever and the largest mortgage bond sale since 1998.

So which investor is right? Should we be running from real estate or happy with current cash returns?

Like most real-estate investment answers, it depends. Few individual investors are involved in purchasing CMBS, whereas most publicly traded REITs have a large number of such investors. While stocks and bonds are fairly liquid, the average individual who wants exposure to commercial real estate is going to buy REIT stocks, not bonds.

Bond investors are looking at a fixed return over a certain period, at the end of which your principal is returned. REIT stocks are an imperfect solution for those seeking exposure to real estate, mixing bondlike yields with stock-market liquidity.

An alternative real-estate play for individuals that has gained popularity recently is private REITs and real-estate funds. The investment opportunity has many bondlike features, but unlike bonds, there's an opportunity for real-estate appreciation at the end of a seven-to 10-year investment term.

Critics point to the heavy upfront load paid to financial planners and brokers, ranging from 9 percent to 16 percent. Another downside is the lack of liquidity. But others point to the intended nature of the investment and how the load, when spread out over a long investment horizon, is not significant, especially if real-estate values go up.

Louis Rogers, a nationally respected expert on private real-estate offerings and a lawyer with Richmond-based Hirschler Fleischer, represents one of the country's largest private REIT groups, known as Triple Net Properties LLC and its affiliates. While Rogers agrees that the investment is not for everyone, he points to his client's 14 percent net average annualized returns from 1998 through April.

He's bullish. "The negative correlation to the stock market is a positive," Rogers says.

Andrew Little is an investment banker with John B. Levy & Co. He can be reached at alittle@jblevyco.com

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