NEW YORK — Real estate money managers are more in love with leverage than ever, but the relationship could soon be a problem for institutional investors, according to a new study by Deloitte & Touche USA LLP.
"Borrowing is edging up and not going down," said Dennis Yeskey, principal at Deloitte Financial Advisory Services LLP, New York, a consulting subsidiary of professional services firm, Deloitte & Touche USA LLP. "It's a troubling trend."
The ratio of income to debt on real estate is not within ranges that would lead to rampant defaults on loans; it is not yet in the "red zone," Mr. Yeskey said in an interview. Problems will start when income cannot cover the mortgage payment.
"Debt offerings are growing in number and volume, while debt service coverage ratios and underwriting quality are being placed under increasing stress," the study noted.
The overall debt service coverage ratio — the net operating income divided by the mortgage payments — has been between 1.45 and 1.3 for the first half of the year depending on the property type, Mr. Yeskey said. A debt service coverage ratio of 1 is the break-even point, while 1.25 is a fairly narrow cushion, he said.
"A drop below 1.3 or 1.4 is cause for concern," Mr. Yeskey said. "Although no panic is necessary."
And the trend of adding more debt to property is not likely to dissipate, Mr. Yeskey said. For example, when private equity firms privatize real estate investment trusts, one of their first moves is to greatly boost the amount of leverage. Since REIT portfolios generally have debt of 40% to 50%, the new owners will often split up the portfolios and increase the leverage to between 60% and 70%. Increasing leverage is adding more risk to institutional investors' real estate portfolios, he said.
At the same time leverage is climbing, cap rates — the net operating income divided by the value of a property, expressed as a percentage — are compressing and driving down returns, Mr. Yeskey said in the interview.
Higher prices paid for real estate in many sectors are tempting owners to sell and reap huge financial rewards, but the high cap rates are making it harder to reinvest profitably, the study said.
And real estate's star status is losing its luster; the difference between purchase cap rates and 10-year Treasuries has fallen below 250 basis points. In August, the average cap rate for apartments was 6.08%, down from 6.33% in June; the cap rate of offices in central business districts fell to an average of 6.47% from 6.7% in August.