It's a Mad, Mad, Mad, Mad Market
Closing deals today requires more equity, less leverage, and a little luck.
A 1963 classic comedy, “It’s a Mad, Mad, Mad, Mad World” follows the wacky pursuit of $350,000 in stolen cash. The film opens with a colorful group of strangers stopping on a desert highway to help bank robber “Smiler” Grogan, who has just careened off the road in a spectacular crash. With his dying breath, Grogan tells the bystanders about “three hundred and fifty Gs” hidden under a mysterious “big W.” Grogan then dies, literally kicking a bucket. The witnesses immediately begin arguing over how to divide the money, sparking a wild race to be the first to claim the prize.
Getting past the symbolism of that mysterious big W, let me ask a couple of questions. If the ultimate prize is success in today’s commercial real estate market, how do you plan to get there? Like the characters in the movie, do you blindly chase after something that will never pay off or do you become a student of the current marketplace, switch gears, and pursue opportunities that will work?
Where We Are Now
How we got here is well documented. The real question now is, where are we? Is commercial real estate on the edge of a precipice? If pushed, how far does it have to fall? Ultimately, the answer depends upon the economy and, by extension, the credit markets.
Fundamentals. Currently fundamentals are dramatically weaker across most major property segments and markets. Price declines of 35 percent to 45 percent or more are expected, exceeding those of the early 1990s. Rent declines and vacancy rates may approach those of the early 1990s as well.
However, it is important to remember that the current downturn is demand-shock-induced in contrast to the early 1990s oversupply-induced downturn.
In addition, commercial mortgage-backed securities collateral performance is deteriorating. The total delinquency rate is close to its 2003 peak and likely to exceed 3.5 percent by year-end. The potential exists for delinquency rates to reach 6 percent by 2010. By way of comparison, peak delinquency rates in the early 1990s were 6 percent to 7 percent.
But the greatest danger facing CMBS is maturity-default or extension risk, not term-default risk. A large percentage of CMBS loans made from 2005 to 2008 will not qualify for refinancing due to tighter underwriting standards, price declines, and declining cash flow.
Transactions. Deals are the heart and soul of commercial real estate. If tenants don’t lease, buyers don’t buy, and sellers don’t sell, the commercial real estate market grinds to a halt. The bid-ask gap remains firmly entrenched; however, cracks are beginning to appear. The ratio of offerings to closings is off the charts for all property types. (See “Supply/Demand Imbalance.”) The growing imbalance between the supply of assets on the market for sale and investor demand is exerting downward pressure on prices. Many sellers are rapidly morphing from pressured to distressed, while buyers remain content to wait.
A new report from London-based research firm Preqin shows private equity real estate funds plan to allocate $93 billion for investment in distressed real estate and debt. The catch? It might not happen until the latter part of 2009 because of the widespread expectation that commercial real estate prices will continue to fall throughout the year.
Many government programs have launched since the economy began melting down last year. (See “TARP and Beyond.”) The numbers are staggering and tough questions are being asked: Will these bailouts work? What will they cost?
No one knows the answer to the first question. To date, bank lending is actually down. One big problem — symptomatic of a bureaucracy — is that the right hand does not know what the left hand is doing. So while the Treasury is pushing money through the front door and telling the banks to lend, the bank regulators are coming in the back door saying, “Don’t you dare.”
The answer to the second question is probably the same as the first: No one really knows. The most recent guess is $3 trillion.
Lastly, hovering over the bailout is the specter of inflation. It is impossible to create this much new debt and not cause inflationary pressure. Within reason, inflation and real estate get along quite well together; however, if inflation gets out of control it could choke the economy’s recovery.
Current Capital Market Trends
A client of mine likes to say, “My car doesn’t have a rearview mirror.” In other words, you can’t look back. Today’s market conditions are 180 degrees from where they were even 18 months ago, so it is important to concentrate on what can be accomplished today. Here are some of the current capital market trends.
• With the implosion of the CMBS markets, deleveraging rules the day. How can demand for all commercial real estate debt be squeezed into the available supply?
• There is a renewed emphasis on cash flow and debt coverage versus valuation. That begs the question: What is the correct cap rate for a transaction?
• Debt yield has returned, calculated as net operating income/divided by loan balance, which is a better indicator of loan performance.
• Positive leverage counts: A cap rate should be greater than the mortgage constant. Negative leverage only works with confidence of appreciation.
• Maximum leverage of 65 percent is now the norm. The market has reverted to the adage, “He who has the gold makes the rules.” Government-sponsored entities for multifamily lending are a notable exception.
• Loan recourse has returned along with a predisposition against cash-out refinancing.
• There is a need for real “skin in the game.” Joint venture deals where an institutional partner brings 95 percent of the required equity are a thing of the past. Lenders require loan sponsors to personally invest at least 20 percent of the equity required to complete a transaction.
• Internal rates of return are generated more by current cash flow than residual value.
Now the Good News
In the world of commercial real estate finance, times are tough. However, all is not doom and gloom; there is good news. Here’s a look at the current sources of capital.
Government-Sponsored Entities. Fannie Mae, Freddie Mac, and Federal Housing Administration/Housing and Urban Development are actively lending money to apartment owners. Compared to other property types, rates, leverage, and amortization are exceptional. On refinance and acquisition loans, Fannie Mae and Freddie Mac offer leverage up to 80 percent of value and, if you have the lead time, FHA/HUD can go up to 85 percent of value. FHA/HUD remains one of the few games in town for new construction.
Life Companies. Most have money to lend. For instance, the Houston office of Grandbridge Real Estate Capital represents 20 life companies as a direct correspondent and, of this total, 16 are in the market actively looking for opportunities. While exceptions can be found, for the most part the loans will fall within the following parameters:
• 65 percent maximum leverage;
• 7.0 percent to 7.5 percent interest rate;
• 25 years amortization;
• $500,000 to $20,000,000+ loan proceeds; and
• 2- to 20-year loan terms.
Regional Banks. I recently met with a small bank in the Houston area that had a $5 million loan limit, but would lend as part of a syndication up to $10 million. It was looking at loans of up to 70 percent of cost. Small banks are excited about today’s lending climate. They are able to make good-quality loans that otherwise would be gobbled up by their larger brethren.
Equity Funds. As an industry, private equity has suffered some severe losses. However, these funds are nothing if not entrepreneurial. They see an opportunity in the coming months to pick up distressed assets at great prices relative to the peak. As pointed out previously, they plan to allocate $93 billion for investment in distressed real estate and debt in 2009 with most coming in the latter half of the year. A Real Estate Alert special report on high-yield funds lists a total of 466 funds with $312 billion to invest. The vast majority of these funds fall into the opportunity and value-added classifications.
Where Do We Go From Here?
Regarding the commercial real estate capital markets, it will help to remember the following caveats.
• More equity will be needed, and less aggressive lending will rule the day: Get ahead of the deleveraging curve.
• Time and patience are required to complete deals — lenders with money are covered up with deals.
• Set all expectations and the capital stack realistically.
• Pre-screen all deals: Know how to get deals done and what proceeds are available.
• If there is an equity gap, define what is needed and how to obtain it.
• Think proactively, not reactively.
We all relate to the frustration of the times, but at the end of the day, we only have control over our own actions. To survive this downturn and emerge stronger, commercial real estate professionals must practice “the art of the possible.” Take control, study the current market, and pursue opportunities that will work.
Let’s Talk About Value
The Moody’s/REAL Commercial Property Price Index is based on data from the MIT Center for Real Estate and industry partner Real Capital Analytics. For February, the index measured 150.63, a decrease of 0.6 percent from the previous month. The index now stands 21.2 percent below the level seen a year ago and is 21.5 percent below the peak measured in October 2007.
However, this is an aggregate index; the table below differentiates property types and locations. The table is from Moody’s Investor Services and is based on the same data as the CPPI graph. It shows value changes by property type and region.
Change in Value,
by region and property type
1 Year earlier
2 Years earlier
1 Year earlier
2 Years earlier
1 Year earlier
2 Years earlier
1 Year earlier
2 Years earlier
Ratio of offerings to closings
Source: Real Capital Analytics