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Market moves should bring adjustment, not confusion, says KC Conway

Bewilderment. It was the chief characteristic of the 2008-2009 financial crisis, and it seems to be making a comeback as markets top out and interest rates rise, according to my latest Fried On Business guest.

“We knew for two or three years before that the subprime problem was coming. There was a day of reckoning. We knew we were overbuilding houses. We knew home prices were going up too much,” said KC Conway, Director of Research and Corporate Engagement at University of Alabama, Culverhouse College of Commerce, and Chief Economist for the CCIM Institute.

“We knew we were going to have a disruption, but everyone just kind of held their breath, crossed their fingers and hoped it would never happen.”

Now, we’ve had a decade of quantitative easing and free money, and we knew that was coming to an end, too, he said. And everyone seems to have forgotten how to do business in a rising interest rate environment.

“What everyone is realizing and having to deal with is we’re going from decade of free money and low interest rates to one where we’re going to a normalized policy,” he said.

Remember, KC said, what the economy was like going into 2006, when the Fed was in a tightening cycle with 16 consecutive rate hikes. They ended with the 10-Year Treasury over 5% before they stopped.

“The fundamentals are in such good shape compared to what we went through 10 years ago. We don’t have subprime. We don’t have overbuilding homes. We don’t have overbuilding commercial real estate. We have solid 200,000 a month job growth. We have more labor capacity than people are giving credit for,” he said.

Add to that technological advances to account for anything we can’t fix on the labor front, KC added.

“I think the productivity is going to kick in. I think that we’re overreacting and trying to figure out how to transition from free money to a normalized monetary environment,” he said.

Bottom line: No matter the environment, we will find a way to get the financing right and the deals done, he said.

The banks, KC added, are in much better shape now that federal regulators have required them to rebuild their capital positions.

Also, a new designation for High-Volatility Commercial Real Estate (HVCRE) requires banks to hold 150% of capital for each new construction loan.

And more capital sources have returned to the market, he said. Securitization is back, albeit at half the previous volume. Life insurance money is out there for permanent loans.

“I think the fundamentals in the economy are good. The fundamentals in residential and commercial real estate are good. And I’m not worried that we’re going into anything close to what we went through in 2006 through 2009,” he said.

Here’s something else to think about: By 2016, we had fallen to record-low home ownership rates. Around 62%. Now, in the fourth quarter of 2017, the trend has reversed – and we’re back over the 64% mark, KC said.

“For those who are wondering when the Millennials will buy, they’re buying now. And they’re not just buying in the city, they’re buying in the suburbs as well,” he said.

KC told me he has brought back to life an index that he watched when he the chief economist at Colliers International. It’s the Bulls, Bears and Bewildered Index.

So far this year, 31 major economic reports have been released by various sources, he said. Of those 19 are bullish and 12 are bearish.

So much for the good news. Now, here’s something to watch regarding commercial real estate, he said. This was the canary, that coal mine sentinel, that croaked in 2010.

The folks at Trepp, who track all things related to securitization and permanent lending, have published a Loan Payoff Ratio. Normally, these 10-year loans pay off at a pretty high ratio, KC said. In January, that dropped to a shocking 25%.

In other words, only one in four borrowers could pay off the loan when it came due. Trepp found that most of the problem centered on large loans – your regional shopping malls, big hotels, big office building deals.

This is consistent with what’s happening in the market, KC said. In a rising interest rate environment, big financiers will be reluctant to commit if they think a better deal is right around the corner.

This drop in the Loan Payoff Ratio happened in 2010, and it’s a warning sign that says large loans are having trouble even as smaller loans continue to perform.

“This is what locked up liquidity in 2009 and 2010 when large loans couldn’t pay off and we saw securitization shut down,” he said.

But KC said he’s pleased to see that the new Federal Reserve chairman, Jerome Powell, comes from a private-sector business background and also has experience at the U.S. Treasury. That experience could be valuable in the event of another financial system hiccup, he said.

So, what’s down the road? And what is the best move for the Average Joe?

Interest rates will continue to rise to a 3% 10-Year Treasury by spring and 4% by this time next year, KC said. There may even by a 0.5% hike at the Fed meeting in March.

For commercial real estate industry folks, KC had this advice: “We need to dust off our old tools on how we deal with rising interest rates. One of them is a technique called the band of investment.”

That is, to blend debt costs with equity costs, developing a cap rate from the cost of capital. Cap rates need to move up 150 basis points in the next 12 to 18 months, KC said. You should make sure the income of your property can increase to offset the fall in value.

This was a gem of an interview. Click here to listen to the whole thing.

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