Will Rogers once advised: “Buy land. They ain't making any more of the stuff.” Stock market casualties are finally heeding this good advice, switching their bets from the Dow Jones to tangible assets, and retail properties seem to be one of the most popular games in town.
Money — lots of it — continues to flow to retail real estate, according to industry finance experts, who don't expect this to change even if the stock market stabilizes. “Money is as plentiful as it's ever been,” says Howard Sipzner, CFO for Miami-based Equity One Inc., a community center-focused REIT, noting that his firm recently closed a $50-million equity fund. “Wherever you look, spreads are down in real estate because there's an excess supply of money.”
Reza Etedali, senior vice president of retail sales for Irvine, Calif.-based Sperry Van Ness, concedes that if the stock market improves, it will take capital away from real estate. “But there is so much capital out there, that even if we lose 30 percent to 40 percent, there still will be plenty of demand.”
Even so, lenders contend they are making loans based on strict guidelines, saying top considerations are quality of location, credit-worthiness of tenants — anchor or not, capitalization rates, and sales and occupancy costs. Richard Walters, president of Irvine, Calif.-based advisory firm Faris Lee Investments, points out: “The perception of safest is grocery-anchored centers. Everyone has to eat!”
Mark Sixour, a senior broker in the Houston office of Boston-based Holliday Fenoglio Fowler LP, notes, however, that financing is not difficult for non-anchored centers with good quality tenants and low debt-to-income spreads. He says that lenders also want to see occupancy costs at 12 percent or below, so there is potential to eventually bump rents.
The Foreign Connection
Currency trends bring REITs money from overseas.
A weaker dollar is intensifying the flow of foreign capital to U.S real estate assets. Howard Sipzer, Equity One CFO, notes that foreign investors from markets with lower thresholds, like Australia and European nations, are always seeking opportunities for joint ventures with U.S. companies. But activity is likely to pick up now with the added opportunity for a favorable currency play. Additionally, he says that REITs will increasingly take their stories abroad. “REITs will bring in foreign institutions, just like we do (U.S. institutions) here now. It's a natural evolution for REITs. There's lot of opportunity to attract that additional source of money.” And U.S REITs are returning the favor. Simon Property Group and The Mills Corp. are both investing in European properties.
The Wild Card
Will interest rates go up in 2004?
High demand has driven values up and cap rates down, decreasing the spreads between debt service and income. Therefore, a rise in interest rates might cause lenders to tighten the purse strings and have a cooling effect on the marketplace. Finance experts do not expect interest rates to rise dramatically — at least not until after the 2004 presidential election. But all agree that it is not a matter of if rates will rise, but when and by how much. Paul McDowell, CEO for Capital Lease Funding, contends that interest rates shadow the bond market and he suggests watching bonds to see where interest rates will go. “We won't see 200 points next year, but may well see 100.” Mark Wolf, vice president at Johnson Capital, an Irvine, Calif.-based real estate investment advisory firm, expects LIBOR to remain stable for 12 months and then move up quickly. He predicts the 10-year Treasury to move to between 4 percent and 6 percent next year, with rates most likely going to between 4.25 percent and 4.75 percent early in the year and moving to 5 percent by the end of 2004.
Borrowers choose between floating and fixed debt.
Even with interest rates certain to rise, some borrowers still choose floating-rate debt over fixed loans. Richard Walters, president of Faris Lee Investments, says that variable-rate loans make the most sense on properties that will be repositioned for resale over the next few years. He explains that fixed rates come with penalties, which don't apply on variable debt. “If a tenant has two years left on a lease, there's an upside to go variable.”
Investors also are looking for ways to cash in on rising interest rates. One of Walters' clients, for example, recently acquired Desert Crossings, a $65-million power center in Palm Desert, Calif., with six different loans, locking in a 5.3 percent fixed rate for 10 years. Walters explains that this strategy provides the flexibility to sell off pieces of the asset when interest rates rise and get higher than market price because the loans can be assumed at the 5.3 percent rate.
A Loyal Following
Real estate investors will remain faithful to the sector.
While industry experts concede that an upward shift in interest rates might slow market velocity, they predict values will hold and the bulk of investment capital will continue to flow to real estate assets. Reza Etedali of Sperry Van Ness suggests that the NASDAQ debacle triggered a paradigm shift in the way investors view assets. “People in their fifties and sixties aren't going to reinvest in stock,” he says. “Their mode of operation is asset preservation and control.” Richard Walters of Faris Lee Investments, agrees, pointing out that investors looking for a safe haven for their money are realizing that real estate is a fixed asset that is not controlled by CPAs and investment bankers. “Capital flow to real estate will be there because there's nowhere else for it to go.”
Public assistance is required to get most new mixed-use projects off the ground.
Mixed-use projects, despite their popularity, pose the biggest challenge for developers seeking financing. That's because on the debt side, lenders have a degree of comfort with either retail or residential, notes Bobby Turner, managing partner and co-chair of Los Angeles-based developer Canyon-Johnson Urban Fund LLC. “When you combine the two property types, they're like ducks out of water.” Turner — whose firm focuses on urban mixed-use, infill projects near transit hubs — says that education about the merits of mixed-use is helpful, but it depends on where you are in the cycle. “If residential is strong and retail weak, one asset class may make it workable, but it requires us to do as much pre-leasing as possible and increase creditworthiness by finding quality tenants.”
Canyon-Johnson sometimes forms public-private partnerships with government agencies on projects that have political support, but no financial sponsor. But Turner says a project's merit, not public funding, is the deciding factor. Without public support, though, new development concepts have a hard time getting done, says Jim Hughes, an attorney with Holland & Knight LLP. “Funding is a problem you have with anything new,” he says, pointing out that Hollywood & Vine, a Canyon-Johnson project with 100,000 square of retail space and 300 apartments, probably would not have been built without redevelopment money. Hughes says that if city governments can string together a number of successful projects, lenders will become more comfortable underwriting them.
Mark Wolf of Johnson Capital says local and regional banks are most receptive because they are most familiar with this project type and the local environment. Fannie Mae and Freddie Mac will consider them too, if the concentration of retail is not too high.
Wolf says Southern California's strong multifamily dynamics are helping banks justify financing this product type. Even so, developers often have to employ creative strategies to get these deals done. Steve Strambaugh, CFO of Aliso Viejo-based Shea Properties, a commercial real estate developer/owner, found it easier to finance its Waterford Place project in Dublin, Calif., by splitting the retail and residential components between two owners and securing two loans, instead of one for the whole project.
Lenders Become Owners
From joint venturing to buying properties outright, institutions and banks are becoming more than just capital sources.
The retail market's overall strong performance is enticing lenders to become owners. Recently, JPMorgan Fleming Asset Management formed a $150-million joint venture with REIT New Plan Excel Realty Trust to acquire more centers. Paul McDowell, CEO for Capital Lease Funding, says that lenders are becoming owners for the same reasons others are investing in real estate. “It enhances their equity returns: if rents rise, you get to participate in that.”
Mark Wolf of Johnson Capital notes that U.S.B. Holding Co. also is buying, but he contends that the movement of lenders to ownership presents a conflict of interest: “Coming in with low-cost money hurts the market. Buyers should own, and lenders should do loans.”
“Lenders feel like owners by the way they're underwriting loans,” adds Richard Walters of Faris Lee Investments. “A mezzanine lender with 90 percent of a property financed is already the owner. They're looking at the last 10 percent and thinking ‘maybe we should be there too.’ The equity side is where the risk is and why lenders typically don't take that risk,” he says. “What New Plan did was smart,” matching itself with a domestic lender. But lenders typically are not good owners. There has to be staff and resources in place to manage property.”