Ready for the Rebound

Lender Restraint Helps Keep Markets Stable.

Today's debt market is highly competitive: Hundreds of players are trying to provide debt capital to commercial real estate in an environment that has very little product. This lack is due to low mortgage turnover; little debt was issued in the early 1990s, so debt capital providers don't have much to refinance. Also, developers have been relatively restrained in producing new product.

The lending arena now is vastly different from the real estate slowdown in the early 1990s. Today's borrowers are stronger and have better balance sheets. Lenders are significantly better collateralized today, because they employed more-conservative underwriting standards during the past decade. Construction lenders demand equity and pre-leasing, and permanent lenders are analyzing tenant credit and lease expiration distributions and creating exit strategies. Leverage also has remained moderate. Newly underwritten first mortgages now top out around 65 percent to 70 percent loan to value. Risk is more appropriately priced, and delinquencies are at historic lows.

However, the biggest distinction between today's lending environment and that of a decade ago is that lenders are now more successful in transferring equity risk back to the equity holder. They've also made better qualitative distinctions in asset selection and pricing. This trend toward segmenting debt's risk and reward is likely to continue and become more sophisticated over time.

Who's Buying?

During the last 25 years, the average real return of institutional or pension fund real estate after inflation was 5 percent, which looks very appealing today. Real estate is outperforming stocks, stoking people's motivation to invest in it.

Last year, eight of the top 10 retail property buyers were real estate investment trusts. Public and private buyers equally split regional mall acquisitions, with public buyers getting class A malls and private buyers, class B malls, mainly for their high cash return.

Hundreds of private individuals purchased half of all significant multifamily sales across the country last year, but institutional investors are flooding the market. Unlike the past, institutional owners now are reducing their office holdings and increasing multifamily investments for their steady cash returns.

Institutions acquired only 15 percent of the industrial properties sold in 2002, a drop of 15 percent from 2001. Replacing them as buyers were partnerships, 1031 exchanges, and individuals moving into the industrial marketplace.

Nationally, fierce competition exists for central business district office properties with long leases, particularly in New York and Washington, D.C. Suburban markets are much less competitive.

Today's Debt Market

Life insurance companies lent $21 billion last year to the real estate industry and are expected to increase their allocation to mortgage lending this year. As of year-end 2002, life insurance delinquency was 0.25 percent, and forecasters estimate that life company average delinquency may go as high as 1.5 percent this year. Still, that is a vast improvement from the 7.5 percent delinquency in 1992. Today's 42-year low interest rates are restraining many defaults.

Other lenders are aggressively pursuing mezzanine financing and subordinate debt tranches such as B notes to boost production. To meet these programs in this supply- and volume-constrained environment, conventional whole loan and portfolio lenders are gravitating toward larger, more-structured transactions. They are growing their own deals by issuing either forward commitments or construction/permanent financing and also by joining with competing lenders.

Today's more-rational segmentation of risk and reward allows portfolio lenders to be more logical in their pricing. Typical mortgage A and B notes are going up to a 70 percent LTV, and mezzanine comes in from 10 percent to 15 percent and up. It's estimated that mezzanine financing originations in this marketplace could reach $25 billion, which is a significant piece of the market.

The Securities Market

The commercial mortgage-backed securities market is the largest provider of capital on an annual basis because it introduces commercial real estate as an asset class to the mutual fund industry. The mutual fund industry is growing at an average rate that is two to three times faster than the rest of the financial services sector, and the CMBS market is growing at twice the rate of residential loan securitization. At that pace, roughly 65 percent of all loans within the next 12 years could be securitized in some way.

Wall Street is the biggest player in this market because it is nimble and has the capacity to securitize unlimited transactions since it doesn't have a balance sheet. So even though banks have a greater scale on a percentage basis, Wall Street goes for unique transactions that have high risk and reward potential.

Up until now defaults have been below expectations, but the recovery on losses is much lower than expected. So the actual costs of recovering defaulted loans and acquiring and maintaining properties have increased.

On average, conduit loans are distinct from life company loans in that they are higher leveraged. Borrowers wanting the absolute last dollar seek conduit loans, while those mostly concerned about a safe yielding execution at a lower rate tend to go into the life company market. As a result, the defaults and losses in the conduit market are about 50 percent to 60 percent higher than the life company market.

The Equity Market

In the last few years — 2002 in particular — despite fairly active fund flows, new REIT issuance stagnated due to high levels of access to debt and equity capital for which they have no use. Many REITs are selling properties in non-strategic markets and are taking advantage of decreasing capitalization rates. Consequently, many REITs are just rotating their capital in and out of new acquisitions, funding them with dispositions, but not issuing new equity or net incremental debt.

Yet REITs are issuing new equity and debt when they have use for the proceeds. Last year REITs issued almost $10 billion in new unsecured debt, and this year started out fairly strong. As secured mortgage notes come due, REITs are issuing new unsecured paper to increase their unencumbered portfolios.

Recently REITs dramatically have outperformed the S&P 500 (see chart). In 2001, REITs were up 12 percent compared to the S&P's almost negative 12 percent. Last year REITs were still positive at 4 percent, compared to a negative 22 percent in the broader equity markets.

As cap rates decrease, REITs encounter difficulties buying competitively because they don't have the ability to leverage as the private sector does. Thus, many REITs are partnering with private companies to get higher overall risk-adjusted return and the benefit of positive leverage.


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