Market analysis

Where's the Money?(1)

Only the Best Deals Can Find Available Capital This Year.

So far this year, commercial real estate as an investment is outperforming the yields in other asset classes -- with one disturbing trend. Since last year, there has been a disconnect between the desires of capital market investors who are looking to pour more money into commercial real estate and the availability of property that meets their investment criteria.

Although a tremendous amount of capital is entering the commercial real estate finance market, most of it is chasing narrow niche properties with quality tenants and sponsors in top-tier markets. Stringent underwriting criteria is exacerbating this trend. To illustrate this, think of the market as a triangle, with class A property at the apex, class B property in the middle, and class C property at the base. Next, envision the available market capital as an inverse triangle. Overlap the two figures and it becomes apparent that too much capital is chasing relatively few top-tier deals and too little capital is available for class B and C property transactions.

The next 12 months probably will mirror present conditions -- too much money chasing too few deals. Investors likely will encounter difficulties in fully allocating their funds. Despite this trend, a slight broadening of investment criteria is occurring in 2002, and significant amounts of capital are available and waiting to be invested.

Performance of Primary Lenders Five main types of lenders serve the commercial real estate industry -- commercial banks, life insurance companies, pension funds, Wall Street commercial-mortgage backed securities issuers, and government-sponsored entities -- and most are willing to loan money for quality investments.

Commercial Banks. Commercial banks are the dominant players in the financing arena, controlling 41 percent of the market with $730.8 billion in outstanding commercial mortgage assets in fourth-quarter 2001, according to the U.S. Federal Reserve Bank.

Banks' commercial real estate portfolios currently are benefiting from low, short-term floating interest rates. Rates are so low that these lenders aren't experiencing payment problems in their portfolios, as the low rates enable borrowers to cover their debt service obligations in spite of problems they may have stabilizing their properties by either leasing more space or filling tenant vacancies. Banks' deposit bases also are growing, generating more capital to be deployed in commercial real estate through money market funds.

Banks are targeting commercial real estate for investment on two fronts. First, they are keeping performing loans on their books. As short-term loans -- their traditional niche -- expire, they are moving vigorously on rates and terms to keep their capital invested. Second, they are investing in stable projects in which adequate cash flow exists to cover debt service in today's low floating interest rate environment.

Banks are reluctant to lend on speculative construction or new development projects, contributing to the overall health of the commercial real estate industry. Most lenders now require a minimum of 25 percent equity for new developments, and, similar to other lenders, they require a comfortable level of preleasing.

Life Insurance Companies. In 2001, life insurance companies increased their commercial mortgage assets by 1.9 percent over 2000 with $221.6 billion of outstanding debt, according to the Federal Reserve.

Life insurance companies continue to flex their muscles and have become very aggressive in their pricing by reducing the spread over Treasuries for the transactions they want. Their allocations are large and growing, but their focus is on high-quality asset deals in top markets. Similar to most large lenders, they emphasize quality, not size.

Default rates on life insurance loans are at an all-time low, and there is little difference between the default rates on the four major property types, reflecting the benefit of investing only in quality assets.

Pension Funds. Pension funds still are reluctant to enter the commercial real estate market as a provider of debt, but they remain a stalwart equity provider. Their allocations to commercial real estate are growing due to the underperformance of other asset classes. Many pension funds are considering the use of modest leverage to free up additional equity to acquire even more assets.

Although they buy stabilized, quality commercial real estate, pension funds won't provide joint venture equity for new development. In recent years, pension funds have invested in real estate opportunity funds, but they have been disappointed with the return on these investments and generally are reallocating their investments to direct asset acquisitions.

Wall Street CMBS Issuers. Wall Street conduits funded about 18 percent of the total commercial real estate debt in 2001 with $314.7 billion in loans outstanding, an increase of 31.1 percent over 2000, according to the Federal Reserve.

Investor demand for CMBS financing is very strong, and Wall Street conduits actively and aggressively are funding lower-quality assets and deals, filling the void left by life insurance companies and commercial banks.

However, their investment activities are driven by the underwriting evaluations of the B-piece buyers, or those who buy the riskiest pieces when individual deals are aggregated and sold to the market as bonds. B-piece buyers generally exclude from investment pools individual deals that don't meet their credit underwriting standards, thus influencing the conduits' appetites and pricing for particular assets and deals.

As a whole, Wall Street conduits' first-quarter 2002 volume was down approximately 25 percent from the same period last year, reflecting the dearth of refinance opportunities. They recently broadened their product offering to include short-term floating rate loans in an effort to compete more directly with commercial banks.

Government-Sponsored Entities. The Federal National Mortgage Association, known as Fannie Mae, and the Federal Home Mortgage Corp., or Freddie Mac, remain the top low-cost capital providers to multifamily properties nationwide. In 2001, these government-sponsored entities had $34.7 billion of commercial mortgages outstanding, an increase of 24.8 percent over 2000, according to the Federal Reserve.

Overall, their investment portfolios are performing well. The only question is whether the portfolio performance reflects the favorable performance of their underlying assets, or if it can be ascribed to financial engineering.

Outlook for the Future What will it take to spark demand for more capital? At present, a significant reduction in long-term interest rates hasn't occurred in response to the general economic decline. A drop in the 10-year Treasury bill likely would spur activity.

But in the interim, if short-term interest rates increase, the financing climate will decline, and rates likely will increase before demand for more capital increases.

On the bright side, as long as expected returns on alternative investments, such as stocks, remain low, earning an average 7.25 percent return on a commercial mortgage will continue to look attractive and draw more capital to the commercial real estate industry.

Thomas A. Jaekel and William F. Wein

Thomas A. Jaekel is managing director of the Merchant Banking Unit at Cohen Financial in Chicago. Contact him at (312) 803-5885 or tjaekel@cohenfinancial.com. William F. Wein is managing director of regional offices in the Capital Markets Unit at Cohen Financial in Chicago. Contact him at (312) 803-5117 or bwein@cohenfinancial.com. Investor Preference Regarding specific property types, investors are finding multifamily the most attractive investment and office the least attractive in the current economic climate. Multifamily. Investors are finding it difficult to compete with the amounts of capital and the terms offered through government-sponsored entities the Federal National Mortgage Association, known as Fannie Mae, and the Federal Home Mortgage Corp., or Freddie Mac. Retail. Investors prefer the secure returns on grocery-anchored neighborhood shopping centers -- period. Industrial. Much of the available industrial property is single tenant, and many lenders are shying away from the risks associated with single-tenant properties. Office. Investors are finding it too difficult in today\'s financial climate to underwrite absorption and rollover costs that consist of tenant improvements, leasing commissions, and operating deficits.

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