Beyond the Obvious
Secondary-market financing success requires strong fundamentals.
Secondary-market real estate investors have reason to be concerned. The mortgage crisis has paralyzed the debt markets and the few remaining active balance-sheet lenders have taken their capital and flocked to the perceived safe haven of primary markets. However, despite the widespread uncertainty surrounding secondary markets, savvy investors can succeed amid the chaos, and lenders still have good reason to provide financing.
There is no formal definition of a secondary market. However, they are generally defined as geographic locations outside of major metropolitan areas with populations greater than 350,000 people. Typically, fewer institutional investors pursue assets in these markets. Several cities that fall into this category include Baltimore, Charlotte, N.C., Cincinnati, Cleveland, Denver, Detroit, Las Vegas, Memphis, Tenn., Minneapolis, Nashville, Tenn., Orlando, Fla., Phoenix, Portland, Ore., Sacramento, Calif., San Diego, Seattle, St. Louis, and Tampa, Fla.
These markets, which have witnessed both the highest of highs and the lowest of lows in a painfully short time span, now stand as the great unknown in commercial real estate.
During the days of can’t-miss financing and voracious competition for investments that set the tone for the previous boom, secondary markets played a prevalent role in investors’ strategies. Priced out of major metros, investors found solace in modestly priced but rapidly appreciating product located outside of the big cities. Growth in these markets was fueled by the lure of subprime adjustable-rate financing, which created a swath of new homeowners and new real estate developments in previously overlooked markets.
The past 12 months have drastically altered this strategy, helping turn some secondary markets into the bane of commercial real estate. The securitization markets evaporated overnight, rendering a substantial portion of the lending business inactive, while the entire credit rating system suffered heavy losses to its credibility. Previously the engine of wealth and expansion in the real estate industry, the once-robust finance industry was brought to its knees as the world scrambled to find some semblance of consistency in the capital markets.
The tenuous state of debt has emerged as the foremost roadblock to completing commercial real estate transactions today, as securitized debt is virtually nonexistent. The commercial mortgage-backed securities market now is trudging along at a snail’s pace, while collateralized debt obligations simply do not exist at all. On the fixed-rate side, debt service coverage ratios of 1.20 or higher are again standard. Meanwhile, loan-to-value ratios have dropped from 85 percent to the 65 percent to 70 percent range and spreads for first-mortgage loans have widened between 100 and 300 basis points.
The lack of available debt and scarcity of capital has forced a return to basic, fundamental real estate investment strategies. As a result, investors either must have stabilized assets with strong in-place cash flow or business plans that focus on creating value at the property level that can be firmly supported by market comparables. In either case, the real estate must be well located in areas with high barriers to entry, have experienced sponsorship, and have a viable exit strategy to the institutional marketplace. Those who follow this formula will be welcomed by the few lenders who remain active and able to execute in this market.
This philosophy has caused a drastic shift away from secondary markets back to proven primary markets with stronger fundamentals and less volatility. The bulk of value-add players now are sidelined, waiting for the markets to reach bottom. The few loans that are closing predominantly are stabilized assets in major markets.
This new age of conservatism also has extended to the type of product receiving financing. Due to the period of hyper-liquidity ushered in by the CMBS market in 2005–07, we witnessed a time of aggressive pricing that drove down yields. In order to attract more returns and satisfy investors, the financing market began chasing more-esoteric product types, such as condominiums and land entitlements. Though these products were quite seductive from a yield perspective, their beauty proved only skin deep as the markets shifted and these loans became pockmarks on the lenders’ balance sheets.
Opportunity Still Remains
Does this trend suggest that investors focused on secondary markets are out of business? Not necessarily.
Though momentum certainly favors more-stable properties in primary markets, a number of interesting secondary markets have emerged as viable value-add opportunities, even amid the deserted conduit market. Investors still can find opportunities outside the comfort zone of the major metros, but only if the right factors are at play.
Markets such as Phoenix and Las Vegas serve as case studies to illustrate the dangers of suburban sprawl and rapid expansion. However, cities with well-planned growth, such as Charlotte and various Pacific Northwest cities, are proving grounds for growth and opportunity. For example, multifamily remains strong across Portland, while the relocation of many corporations to Charlotte has been a boon to both the residential and commercial markets. Seattle is another market that has displayed steady and continued growth trends across various real estate product types.
Dynamic regional markets such as Seattle offer overlooked investment opportunities.
Despite the potential opportunity that abounds in secondary markets, investors still are experiencing difficulty in obtaining financing. Many lenders simply have checked out of the market and are waiting out the storm, while a lack of familiarity with secondary markets has deterred a number of large New York-based institutional players However, with the right relationships, certain lenders are equipped and motivated to execute deals in these markets.
So why would a lender look to secondary markets when the opportunity of major markets is more prevalent than ever?
One reason is directly related to the overall falloff in transaction volume. The lack of investment flowing into the real estate market has diminished financing opportunities, causing even well-capitalized lenders to look to secondary markets to place their capital. Others see secondary markets as a more-strategic opportunity, due to a number of key advantages that are directly attributed to the state of the capital markets. One key strategic advantage is establishing new borrowing relationships. While secondary markets may have fallen out of favor among the mainstream, individual value opportunities still exist and savvy lenders understand they can help local investors take advantage of market chaos and distress. The hope is that as borrowers grow and acquire other properties in more-favorable markets, the lender will be the first call for future transactions.
A number of balance-sheet lenders also are using secondary markets as opportunities to stand out and diversify their offerings. With most lenders simply opting to stay out of secondary markets altogether, more-nimble lenders can enter these markets with creative, structured solutions to help protect their downside but allow borrowers to obtain the required loan proceeds.
Ironically, another strategic advantage has resulted from the dramatic reduction in proceeds that lenders are able to provide. Investors who closed highly leveraged deals in the past few years now are facing maturity on their loans but do not have the equity to pay them off. This trend mirrors what occurred among homeowners with adjustable-rate mortgages following the subprime meltdown. This creates an opportunity for value-add players to buy properties at below-market value, refinance them, and position themselves for a strong, long-term investment play. From the lender’s perspective, they still can put forth lower proceeds on a lower purchase price, so it is a win-win for the borrower and the lender.
Understanding the potential advantages associated with secondary markets, those who turn opportunity into success in these oft-overlooked markets must remain acutely focused on the following areas.
Have a Sound Exit Strategy. The volatility of the capital markets has placed this maxim at the forefront of every investment plan. The asset must exhibit strength in the current market landscape and the borrower must have a well-thought-out strategy for capitalizing on it in the future.
Make Sure the Asset Is Institutional Quality. The ultimate objective for any acquisition in today’s market should be to obtain institutional-quality product. Properties receiving financing in secondary markets either must be of institutional quality or the strategy must be to improve it to institutional standards when it is fully developed.
Know the Market. One of the primary challenges associated with secondary markets is finding reliable market information, as few research groups pay detailed attention to them. Succeeding in the market requires a deep understanding of its various intricacies and a borrower who has experience in the region.
Prepare for Challenges. Despite the opportunities available, the market remains in upheaval, necessitating lenders to underwrite for any challenges, delays, or unexpected roadblocks both during and after the acquisition. The best way to mitigate volatility is to keep leverage levels low and have equity from well-capitalized institutional sponsors to ensure that if there is a misstep in the market or execution, the lender feels safe in its position.
The most important lesson learned in the past year is that strong fundamentals always should dictate strategy over relying upon financial engineering and compressing capitalization rates. Unfortunately, strong fundamentals and secondary markets rarely are mentioned in the same breath amid all of the trepidation among both lenders and investors. It is clear that the lion’s share of loans will continue to be financed in the primary markets. But don’t count out the secondary markets altogether. While location continues to play the most prominent role in commercial real estate investment, some balance-sheet lenders are finding that the most opportunistic locations may not be in the most obvious places.