In researching this article, I came across an e-mail from Jeff Reder of Urdang Capital Management that contained the perfect analogy for the current commercial real estate investment market: the movie “Jaws.” The opening scene is Amity Island — clear skies, gentle surf, and warm water. People flock to its beaches in huge crowds, just like the real estate investment market pre-credit crunch. There is no fear about going too far out in the water, no concern about riptides or shark attacks. It is one big beach party that everyone wants to join.
Next, cue the all too familiar and haunting Jaws theme — “something hideous, something so deliciously evil that came to vanquish the tranquility and shatter the peace.” As the shark heads for the shore, frantic beach-goers stampede out of the water, and the party is over.
Similarly in real life, the free-flowing debt markets dried up, and now throngs of commercial real estate investors, both sellers and buyers, line the shore, watching and waiting. They could be standing in the sand for quite a while. A mid-August Real Estate Alert survey of the top 20 real estate brokerage companies showed sales of office, retail, multifamily, industrial, and hotel properties fell by 66 percent through midyear 2008 from the previous year. Yet during this same time period, more than $85 billion of significant deals closed, according to Real Capital Analytics. So unless everyone was closing with cash, how were these deals financed?
Finding the Money
The chart “Sources of Acquisition Financing” shows a dramatic shift in the capitalization of real estate acquisitions, the most striking of which is the use of assumable debt. When the beach party was in full swing, assumable debt had no advantage because better loan terms always were available. Now, while assumable debt is probably not the method of choice, it certainly can be a means to an end. Most permanent, fixed-rate loans are assumable; however, an assumption typically has to be pre-negotiated. Another shift, which signals the emergence of more-aggressive sellers, is the re-emergence of seller financing. The current level of seller financing has not been seen since the early 1990s.
Beach party or no beach party, the key to any leveraged buy strategy is the first mortgage. Once secured or assumed, there is mezzanine and/or equity capital available to complete the capital stack, but nothing works without that first piece. With that thought in mind, the following alternatives may be sources of acquisition financing in the current market.
Sources of Acquisition Financing
All property types, as a percentage of acquisition price
Wall Street. Until mid-2007, no other capital source could compete with Wall Street’s commercial mortgage-backed securities in either interest rate or proceeds. Today there is no better example of the shift in lending patterns. The ranks of CMBS lenders are being decimated by fallout from the ongoing financial turmoil. Lehman Brothers and Merrill Lynch are both gone — one in bankruptcy and the other being acquired. Two of the remaining players, Morgan Stanley and Goldman Sachs, have made application (and been granted approval by the Federal Reserve) to change their status to bank holding companies.
Earlier this year, expectations were that CMBS lending slowly would start to resume late in the year, but the ongoing events effectively have dashed any hope that the CMBS sector will rebound soon. So, when the CMBS market does revive, what will it look like? A small but growing segment of observers thinks securitization is finished and will never return. However, most market participants still believe it will eventually re-emerge in a revamped and scaled-back form.
National Banks. For a time, national banks filled much of the void left by the CMBS market meltdown; however, to paraphrase a recent Seeking Alpha article, that loud sucking sound is the Federal Deposit Insurance Corp. taking over. A huge amount of uninsured deposits is sitting in banks. As depositors become more concerned about the amount of money they are insured for, more money will be moved from bank to bank, affecting liquidity and the banks’ ability to make new loans. In April, the percentage of banks reporting tighter lending standards already was near historic highs and rose even higher in July. More and more national banks are not making new loans, or they are reserving them for existing relationships. Instead, they are concentrating on managing and even shrinking their commercial real estate exposure. As anecdotal evidence, it was heard that a new executive recently hired at a national bank had his compensation tied to the number of loans successfully moved off the balance sheet.
International Banks. Over the long term, international banks believe in the U.S. markets and want to have a strong presence in them. New international banks continue to emerge, particularly from Germany but soon to be joined by an influx of Chinese banks. Currently, international banks remain active, particularly for large loans. However, they are not immune to the subprime mess and remain cautious, as evidenced by their decline in activity post-credit crunch. They remain in the market for good, quality real estate loans, but for those less-stellar loan requests, the attitude seems to be, why take on a commitment that U.S. banks turn down?
Specialty Finance Companies. These companies fill a niche for bridge financing, which is just what the term implies: financing that gets a property from one point to another. The best example is an asset that is not stabilized but needs to be financed until it is either sold or sufficiently stabilized to underwrite for permanent debt. Banks can fill this niche, but they typically want a full guaranty, whereas many finance companies will loan non-recourse. In addition, some specialty finance companies do have permanent debt products; however, in pre-credit crunch days more attractive permanent debt often was available from other sources. Specialty finance companies that use their own balance sheets and are not originating for the CMBS or collateralized debt obligation markets are seeing quite a bit of business for whatever product they may have to offer and can be excellent debt capital sources.
Regional/Community Banks. As with the national banks, regional and community banks also tend to favor existing relationships, which explains their post-credit crunch share decline. However, there is some good news in this market segment as some of the smaller regional banks are under-allocated in real estate and are trying to fill the void left by national banks. Of course, they do not have the capacity to do bigger deals and they also like to loan close to home. They can be a good source of capital in tertiary markets.
Insurance Companies. Being primarily balance-sheet lenders, life insurance companies have benefited from the credit crunch, actually increasing their market share. Always among the most cautious of lenders, they rarely win deals strictly based on proceeds. However, because they hold loans on their balance sheets, if they like a property, they can win the deal based on the best combination of rate, proceeds, and structure. Unlike Wall Street, which had an unlimited appetite for loan business, insurance companies have allocations that can be used quickly, effectively taking them out of the market until a new allocation is provided or loans are paid off. The types of loans sought by insurance companies vary with the one constant being good, quality collateral and sponsorship. Some insurance companies will not look at loans in tertiary markets, but many will. It is a question of matching the loan with the right insurance company.
How can an investor locate the right insurance company for a smaller loan? Use a local mortgage banker. Most insurance companies limit their access through their correspondent relationships, meaning they will not accept loan business from individuals. As unfair as this may seem, insurance companies have found the correspondent relationship to be the most efficient, cost-effective way to get loans completed.
Government-Sponsored Agencies. Other than Countrywide Financial, the nation’s biggest mortgage lender, the two names most closely associated subprime mortgages are Fannie Mae and Freddie Mac. Also known as the Federal National Mortgage Association and the Federal Home Loan Mortgage Co., both are also major players in the multifamily markets. In the first half of 2008, Fannie Mae’s investment in multifamily housing totaled $20 billion, an increase of 30 percent over midyear 2007 production. Freddie Mac purchased a record $44.7 billion in new multifamily business transactions in 2007, a 55 percent increase over the 2006 volume.
Both Fannie Mae and Freddie Mac have been experiencing painful losses stemming from subprime mortgages. Like Countrywide, Fannie Mae and Freddie Mac were both deemed too large and too critical to the state of the economy to fail. However, unlike Countrywide, which was sold to Bank of America, the Federal Housing Finance Agency has been appointed as conservator of Fannie Mae and Freddie Mac. In addition, the U.S. Department of the Treasury has agreed to provide capital as needed to ensure the companies continue to provide liquidity to the housing and mortgage markets.
Even with the conservatorship, Fannie Mae and Freddie Mac can remain major players in multifamily financing. There have been statements of support for both multifamily programs. Currently, loan-to-values max out at 80 percent on a 10-year, fixed-rate loan. Subject to a minimum debt service coverage ratio of 1.25x, current interest rates on a 10-year loan are priced at ±260 basis points over the 10-year Treasuries for an all-in rate of 6.50 percent. Both Fannie Mae and Freddie Mac will lend in major markets, as well as smaller markets.
Other Capital Sources. Pension fund commitments to commercial real estate fell 29 percent in the first half of 2008 to $12.8 billion with most of the commitments going to value-add, high-yield debt and opportunity funds. Only 11 percent was committed to core assets. Declines in the stock and bond markets have decreased or slowed growth of the asset base of some pension funds. As asset sizes decline, the proportion of real estate assets grow even if the actual investment level doesn’t change. That has caused some pension systems to reach or exceed their real estate allocations, curbing their ability to make commitments.
Other funds actually are increasing allocations, including California Public Employees’ Retirement System, the State of Oregon Public Employees Retirement System, and San Francisco Employees’ Retirement System. There is less appetite for new construction, as investors do not think they are being rewarded for construction and lease-up risk when compared to other commercial real estate opportunities on existing properties.
Contrasting the declining pension investment is the tremendous growth in high yield funds. Real Estate Alert’s annual survey has identified 471 funds active or planned, up 23 percent from a year ago, seeking to raise an aggregate $318 billion in equity, a 35 percent jump over last year. If they achieve their goals they will have in excess of $900 billion of purchasing power when leveraged. Nearly every fund is seeking returns of 15 percent or more. Terms like rescue capital and workout equity have become part of their vernacular in marketing pitches.
Pension Fund Strategy Commitments
($ in millions)
($ in millions)
|Fund of funds||75||100|
Source: Real Estate Alert
Top Real Estate Commitments, Midyear 2008
By public pension funds
($ in millions)
|Lone Star Funds(Fund 6)||1,217|
|Blackstone Group (Real Estate Partners 6)||825|
|Morgan Stanley (Real Estate Fund 7 Global)||550|
|Macquarie (Global Property Fund 3)||341|
|Rockwood Capital (Real Estate Partners 8)||315|
Source: Real Estate Alert
Swim or Tread Water?
Constrained capital markets, concerns about the economy, and uncertainty about appropriate capitalization rates have made for a general reluctance to dive into the transaction waters. No one can be sure about what else lurks out there. “We’re gonna need a bigger boat,” said Roy Scheider as Martin Brody in “Jaws.” That may be true in today’s market as well: To navigate these waters, investors need to be prudent and look for the right opportunities. For example, Amity Island would have been a solid distressed purchase after the shark ruined the tourist economy. Once the shark was blown up and people felt safe about getting in the water again, values would have rebounded nicely — a classic value-add play.
No one expects transaction volume to come roaring back this year. Currently, investment sales are at or near late 2001-early 2002 levels with a large bid/ask gap. Buyers do not know how to price risk and sellers are pretending nothing is wrong. In the near term, it is very likely that things will get worse before they get better. Without being forced, owners are not going to sell in the current market. With the lack of inexpensive capital, ultimately there will be a resetting of prices. As cheap debt financing dries up, prices have nowhere to go but down, and institutional buyers have to address their return requirements and where they can get financing. It all comes down to the risk premium to the asset. Until the market senses there’s a bottom, there is not going to be a lot of investment activity.
A normal commercial real estate market includes the four Cs — clarity, conviction, cash, and closings. This market seems to be lacking all of them. But even without clarity, opportunity is possible. An excellent example is the savings and loan crisis: The market had motivated sellers and courageous buyers with some cash. Those with cash and conviction closed on some truly unbelievable investments.
We find ourselves in a greatly changed marketplace and if we are to decide to swim or tread water (or even enter the water for that matter), it is critical to recognize what can be done.
- The capital markets are shrinking and deleveraging, so plan accordingly. More equity will be needed and less aggressive lending will rule the day.
- Life companies have money but are overwhelmed with business. The investor will need time and patience to transact. Life companies and GSAs cannot fill the hole left by the withdrawal of the CMBS participants.
- To successfully acquire, develop, or refinance, we must all pursue the “art of the possible” and get ahead of the deleveraging curve. Set your expectations and capital stack realistically. Screen any deal early so you will know how to transact and what proceeds are available. If there is an equity gap, define what is needed and how to obtain it. Think proactively and not reactively.
- To find capital in this market, you need to cast a wide net and look under every rock. Old reliable sources may be at capacity so you’ll need to expand your universe of capital sources.
- It takes longer to transact as response times are slower and due diligence and feasibility are more thorough.
- There is a huge supply of money targeting distressed real estate and repositioning plays. Target your acquisitions accordingly.
The commercial real estate market today is more intertwined with the capital markets than it was 20 years ago, but the current situation is far less dire than during that time. To use another movie analogy, the S&L crisis was “The Perfect Storm.” On a scale of one to 10, it was a 12. The current crisis is maybe a six (which is up from a three when I first started to work on this article). Unlike the S&L crisis, outside of some condominium development, this market did not come into this period with any serious oversupply and while it may not know where to go, there is capital. The markets will work through the economic slowdown, the credit crunch, and what will be the ensuing price correction, and investors will continue to raise funds and look for opportunities. While a downturn certainly can be painful, investors understand the nature of real estate cycles and they take comfort in knowing that what goes up must come down, but that another upturn lies ahead.