Back to Basics
With CMBS gone, borrowers must apply the fundamentals of financing.
How can commercial real estate borrowers obtain financing and survive the capital markets mess? Is there a secret handshake to get a loan application or a password for a term sheet? In reality, the answer is far simpler: Bring in a good deal with reasonable financing expectations.
Forget the Past
In recent years, borrowers obtained cheap capital from lenders who sold their underwriting souls to close deals and earn fees. Pricing was the same whether the asset was urban multifamily infill or industrial condominiums in tertiary markets. In fairness to the lenders, they already had made a pact with the conduit devil — all they had to do was collect fees and pass along deals, so who could blame them?
In turn, borrowers discovered that they could make quick flips on assets because loans had no structure. Prices were being driven higher not by fundamentals, but by the increasing availability of low-cost financing for any asset, regardless of quality or sponsorship.
All of this was made possible in large part by the commercial mortgage-backed securities market. But the sad truth is that CMBS are not coming back — at least not in the form to which we have all become accustomed. Although the model is viable and there is a very appropriate market for CMBS, it will take years for the market to right-size. When it returns, it will have much tighter standards and realistic pricing matrices and no longer will be all things to all borrowers.
However, there is an upside to the down CMBS market. While the securitization markets will never see the same volume levels as before, the reality is that the market does not need the CMBS volume of the past decade for two reasons. First, property values have decreased and loan proceeds against those new values have decreased as well, representing up to a 50 percent reduction in debt capital needs. Second, in the past several years the same properties and portfolios have traded multiple times, thus overstating the CMBS numbers for more-normalized market conditions.
Even so, there remains a void left by the once-steroidal CMBS market. Ultimately, as commercial real estate owners begin to capitulate (either in the form of substantial write-downs or foreclosures) and the market begins to right-size, more capital in the form of mezzanine loans and preferred equity will help to restructure overleveraged deals and bridge the CMBS gap in the capital stack.
While the securitization markets are at a standstill, portfolio-oriented lenders are the white knights, providing both liquidity and flexibility in structure. But these lenders are looking at fundamentals, risk, market growth (or lack thereof), sponsorship, and substantial equity contributions. It took a while for lenders to stop feeling sheepish about asking for such things and even longer for borrowers to stop feeling insulted for being asked for these basics. However, we now are seeing a marketwide change in perception and perspective that will help to heal the industry.
For this transformation to happen, and for commercial real estate borrowers and buyers to survive in 2009, they must recognize the following concepts.
Fundamentals Matter. The industry needs to move away from the financial engineering of the past to a market based on real estate fundamentals with strong underwriting and discipline. Borrowers must return to basic underwriting principals that rely on solid business plans and exit strategies that are not dependent on hypothetical market growth assumptions. Lenders no longer will recognize magical revenue increases and infinitely decreasing capitalization rates that are simply unsustainable.
Operating Track Records Count. Lenders no longer accept résumés that simply state “30 percent plus internal rate of return track records in the last 10 years.” While it was easy to perform in the last decade without adding value, borrowers must show that they have substantively improved net operating income from operations in their track records and prove they are well experienced in their specific product types and geographical markets.
Borrowers Must Be Well-Capitalized. Borrowers must have significant equity to contribute to deals. Not only are loan proceeds down across the board, but the alignment of interests by having substantial “skin in the game” is more important than ever. The days of sponsors putting little to no money in deals are over.
Capital Costs More. Spreads will be high compared to recent times, but effective rates will be reasonable on a historic and absolute cost basis. Borrowers will need to stop scoffing at new pricing levels for both debt and equity. Instead of harping on capital sources for their desire to actually benchmark appropriate levels of risk versus reward, real estate buyers need to understand that the problem is in real estate pricing — a tough pill for many to swallow since it means admitting that their own portfolios have lost substantial value.
In summary, debt capital availability will be scarce throughout 2009 as CMBS remains on life support, banks continue to be sidelined as they restructure in an attempt to survive, and other institutional investors struggle with capital availability as their portfolios have been annihilated by the equities markets. This in turn will keep loan spreads wider, thus negating the dramatically low levels of the base indices.
Borrowers will have to seek out sellers who are realistic in their pricing expectations. Many are calling this distressed, but for most it simply should be labeled reality. Lower pricing, good quality assets, and longer-term hold capability are the only ways to offset rising cap rates, increasing capital costs, and moderating fundamentals — all of which are not fleeting nuisances but long-term realities. If borrowers can follow this path, finding loans even in this environment will not be a problem.