Economic conditions and investment markets are strong going into the second quarter this year. The resurgence of commercial real estate demand has strongly influenced the success of capital markets in many markets and product sectors.
Moving into 1998, excellent investment returns have highlighted the expansion of publicly held financial vehicles such as REITs, CMBS and conduits. The one property sector that leads all others, in terms of returns, is multifamily with office and retail moving up in the rankings from 1997. According to the 1998 Landauer Real Estate Market Forecast, capital markets pricing has assigned values to the REITs well in excess of the value of their property holdings. Landauer reports 1998 as a year in which appreciation in property values may well surpass growth in stock price. Landauer notes the United States has enjoyed two long economic expansions since 1982. The report projects a mild slowdown in growth during 1998, with Gross Domestic Product (GDP) growth running in the 1.5% to 2.0% range for the year.
Capital markets are performing above 1997 performance marks at a solid pace and valuation numbers are excellent. The two financial vehicles that are performing strongly are CMBS and conduits with multifamily product being the favored property type so far in 1998. Of course, REITs are still at the top of the heap for performance and returns for all property sectors with the leaders being multifamily, office and retail.
According to the National Association of Real Estate Investment Trusts (NAREIT), the market share for REITs by sector has office (18%) and apartments (17%) leading all property types. As of the end of the first quarter of 1998, total market capitalization for publicly traded REITs is $142.5 billion thus far, with a strong balance for the year on the horizon. For equity REITs, NAREIT lists apartments as the largest group of REITs with 30 REITs having a total value of more than $24.6 billion. Office was second with 19 REITs totaling $24.16 billion, followed by lodging (14 REITs totaling $19.33 billion), retail strip centers (29 REITs totaling $13 billion) and industrial (14 REITs totaling $10.74 billion).
"We know what Wall Street is looking for as they sell securities to the secondary markets and what type of investments have the highest spreads going into the second quarter," says Howard Levine, president and CEO of Calabassas Hills, Calif.-based ARCS Commercial Mortgage Co. "The most competitive market of all commercial is multifamily. The spreads and yields are the lowest to the ultimate investor, but there is a reason. It is perceived as the safest of all securities because of the low default ratios and very few foreclosures. So you have to look at the big picture as to the net return after default."
Levine notes that multifamily performance has been outstanding for the past three to four years. "Because there is a shortage of product, there is a great demand for apartments throughout the nation. So given that fact, we originated multifamily product loans depending on the loan-to-value (LTV) and the debt service coverage," says Levine. "Values as low as 92 to 93 basis points over the comparable Treasury bills. A high ratio loan, like an 80% LTV with a 120 or 125 debt service coverage, will come in at about 128 points over the Treasury bill. No other type of commercial property can you get that kind of spread today."
"I know that we have seen real low spreads and cap rates in the 8% to 9% range. I think that on the conduit side, one of the things that is occurring is that many lenders are doing large pools, and we would hear a lot about the need to have 35% to 45% of the pool to be multifamily," says Hal Kendrick, vice president of Dallas-based AMRESCO, a commercial real estate finance group. "So I think multifamily is becoming slightly less critical to the conduit pool as to securitizations that are occurring right now. I think that has freed up the ability to do other product types more freely."
"REITs are going to have short periods where they will have sort of peculiar performances, but their fundamental long-term prospects are such that they will probably outperform other multifamily investment alternatives," says Frederick Carr Jr., principal at The Penobscot Group, a Boston-based research group specializing in REITs to institutional investors. "1997 was a good year, REITs probably outperformed other vehicles, although the multifamily sector wasn't necessarily the strongest REIT. The strongest sector probably was office REITs. You're going to have transition points, where the markets changes valuation multiples, but briefly you get different performances compared to the long run."
Wall Street has emerged as a major intermediary of new money into the commercial property markets. This ranks on the par with the influences leading the real estate industry into 1998. From a virtual standing-start a few years ago, publicly traded real estate securities - both debt and equity - have burgeoned to a quarter-trillion dollar market.
"We're seeing a huge volume of CMBS transactions right now, both prepaids and refinance. I think it has a lot to do with appreciation in multifamily, where people are either taking out equity or selling to an equity REIT," says Kurt Reimann, senior vice president of Berkshire Mortgage Finance's Capital Markets Group in Boston. "It surprises me how much multifamily volume we are seeing, especially in debt size, and every year I project it to be less - this year I'm surprised it's more. I think one of the hot topics for 1998 is that everyone has it in the back of their minds to sell to a REIT as an exit plan, and they are very focused on a prepayment mechanism."
>From a 1998 perspective, larger REITs are getting bigger quicker and are focused more on package transactions such as portfolios. "There has been a lot of consolidation, particularly public-to-public, where larger REITs are merging with smaller ones. I see more activity on the private company side, where they're evaluating an exit strategy of combining or selling their assets to publicly traded REITs," says David Olney, executive vice president of Berkshire Realty Investments. "I see a tremendous amount of activity where private companies are focused on a tax advantage strategy of doing an upward transaction. They're targeting the tax advantage of selling to a REIT and taking the operating partnership units back. In doing so, REITs are evaluating the prepayment feature on the debt. We typically try to stay in a 30% to 40% leverage ratio, and we are looking at portfolios that are 60% to 70% leveraged. Our interest is in prepaying as much of the debt as possible."
In comparison to spreads in the investment grade corporate market, spreads in the CMBS market lagged the tightening in the corporate market, creating an attractive swap opportunity for corporate buyers holding debt that has performed well thus far in 1998. Spreads in the CMBS market are unchanged or only slightly tighter since the beginning of the year. CMBS spreads remain 13 to 65 basis points wide to the levels registered in October 1997, according to SpreadTalk, a fixed-income research report published by New York-based Prudential Securities.
SpreadTalk notes the excellent prepayment protection afforded by these bonds as well as the strong underlying fundamentals in the commercial real estate market bode well for this sector going forward. Investors can swap out of 10-year, single-A industrials and move up in credit to triple-A CMBS and gain 29 basis points or swap into single-A CMBS for an increase of 59 basis points. A near-term concern for investors is a continued strong supply through the end of the second quarter. However, the report argues that, with only a few weeks left in this quarter, investors who buy now will watch their spreads tighten during the expected issuance lull from last month.
In looking at CMBS, other aspects come into play that lenders must review for investors. "Marketing is really the first screen in whether or not you want to be in any given marketplace. We're looking for moderate equity and the willingness of the principal to take the partnership unit, or large part of the equity. If it is a focused equity rating, you don't have need to bring cash to the transaction, because we're giving operating partnership units in exchange for the equity," says Olney. "You are also looking very hard at the amount of debt and the attractiveness of the debt. In the interest environment that we've been in, we don't want to lock ourselves in high coupon debt that is not repayable. The debt analysis becomes very important. We're doing a lot of Freddie Mac business right now, which is low leveraged, large transactions, and owners are doing the structure where they come in at 50% LTV first, and then some type of bridge financing for the remainder. This is prepayable or at least prepayable with a fixed - either a free or known set amount."
Of the four major product types keeping the lenders busy - multifamily, office, industrial and retail - financial groups favor some sectors more than others. "I would say our biggest demand and the most conservative loans are for apartments. Unequivocally, that's our leading product line and it represented 80% of our production in 1997," says Levine. "This year we expect it to be around 70% of our production. Our second best product would be office buildings and that's the next tightest spread. We could get those done at 140 basis points depending upon the strength of the 140 to 150 more than the Treasury bill. Our third choice would be retail, mainly shopping centers - neighborhood, suburban product that is well anchored."
"Because of the tightness and security in multifamily, we have seen cap rates move down actually into the 7% to 8% range. Part of that is driven by the rate that owners are paying in interest and the yield they can get today," says Peter Gessert, senior vice president of ARCS Commercial Mortgage Co. "Some people have said they will get a loan at in the 6% range, so a 7% cap rate still has a positive leverage position. Generally, we are seeing a lot of properties in the apartment sector down from the 10% range into the 8% to 9% range. It's completely market driven. A lot of it is also driven on the amount of interest that the borrower is paying on the principal. Many people just look at the return on their money, rather than what the risk is in the marketplace of their investment."
"I don't think that it will really negatively impact the market as along as lenders don't blindly begin to finance new construction. I think low rates are good for everybody," says Kendrick.
"We've done more loans this year than we've done in the past. There's a huge amount of refinancing that is going on right now. It's good for the properties and owners to carry very little debt. It's good for borrowers because they are enjoying greater cashflow in today's marketplace. It is also good for lenders because they are doing a lot of business and it does not cause, in and of itself, low spreads for more construction," says Kendrick. "We will start getting into problems if we overbuild in many national markets. That's right. Even when the spreads are higher, we're all competitive, but just at lower spreads. It is less strain on the economics of the property, better for the borrowers and better for us - because we're doing more business."
In the capital markets game, is bigger really better when it comes to the size of investment pools?
"It's better in that you get a better subordination level and you're able to put some higher LTV loans in a pool because they don't stand out as much, and that is how people are masking a lot of the fundamentals," says Kieran Quinn, president of Atlanta-based Column Financial. "What's hard today is the rating agencies have not really changed their underwriting standards very much, and they still haircut our cashflows to close at a near 10% cap rate. Five years ago, the rate was around 12%, and now it is closer to 7% to 8% rates. Interest rates have come down and our spreads have come down. We're looking at a 130 basis point debt service today on a 90% LTV, and two years ago it was a 75% LTV loan. With the interest rates as low as they are you can finance as much money as the customer wants and not have to take on any debt load."
REITs are moving at a pace that may state bigger is better. "Origination numbers for 1998 had a lot to do with major consolidation in multifamily. You know, they have been growing at a rate of 30% to 40% per year. The first quarter this year suggests that there is no slow down, and if anything an acceleration," says Carr. "I think there is going to be a slowdown, but it isn't going to be in 1998. You could see the market cap, the industry itself grow by another $30 million to $40 million. It's clear this year cap rates have come down for malls and the big deals this year will have very low cap rates."
Carr adds that some product vs. multifamily will have a leveling off period and will be in good standing.
"There are signs that maybe the cap rates for office are going to level off a little. I say that wisely because we are getting awfully close to replacement cost on these purchases, and that is going to be, or should be, some kind of ceiling on prices," says Carr. "As far as apartments, I would not expect a lot of change. I think in apartments it is going to be a function of qualitative standards, with Class-A product perhaps moving below 9% and Class-C product going above 10%."
The sheer volume of available capital is causing real estate investors to look at large properties in order to realize efficiencies in this competitive acquisition environment. "Bread and butter garden apartments, large properties are still No. 1, and Class-B grade apartments are excellent. We don't do a lot of Class-A because they want very high LTV and there is usually not a lot of history on the property," says Quinn. "Right behind the B and C grade apartments, we're seeing a lot of Class-A, suburban office product that have around 50 to 100 tenants, and that market is getting very tight vs. multifamily. Construction loans are coming at a more rapid rate for hotels this year, and we look at them on a regular basis."
Risk strategies are important when institutional investment groups look at portfolios and what sector of real estate to invest in for their clients this year.
"When it comes to the private or public side, we can offer the private investor the negative strategy, particularly if they are limited partners who are sitting on a property for six to seven years and are looking to see where their final exit strategy is going to be," says Reimann. "With the risk of just sitting there with negative capital accounts, all we can give them is a tax deferral with an exit strategy into an individual piece of real estate or a small portfolio. Many people come to us with negative capital when they have held their real estate for more than six years."
Two of the major concerns among lenders going into the second quarter are cap rates and the return on their investment. "I think it's through changing growth and market conditions that predicts what cap rates are going to do. Because there is a relatively constant sort of total return expectation, and that total return is probably in the low teens" says Carr. "The growth expectations can probably have a total return in the low teens for cap rates. I think that in the last couple of years you have seen growth expectations for apartments come down a bit and cap rates come up. There has also been some differentiation between old and new apartments - Class-A product has come up less than Class-B properties."
"Cap rates are the function of different markets areas, so you can't come up with an overall cap rate, we've seen the rates go down by 1% between before repositioning and after repositioning. If a property went in at 9.5%, it is 8.5% after the repositioning of the property," says Levine. "We're seeing some of these properties simply just increasing to match market values. They're B properties that needed the cosmetics, and with that comes the rent increases. Markets and rents have gone out of sight in some areas. Now people can see how the B market can squeeze out the money."
Besides the cap rate, many transactions have lower product classes and the financing must be structured with more than one loan based on the LTV.
"Anything above 80% LTV is typically Fannie Mae, but once you get above 85% and below the 120 debt service coverage, you're looking at two loans and it will probably become a Wall Street transaction. I would call it mezzanine financing - it is a combination of Wall Street and a conduit," says Levine. "I know the B and C apartment market is very good right now and, frankly, the B market has been the best performer even over the A product."
Levine acknowledges rents and cap rates are the factors why the A market has been outperformed into the second quarter this year.
"There has been more room for rent increases in the luxury market, and historically the cap rates have been lower to start out with because people like these kinds of properties," says Levine. "You're starting out with a lower cap rate on the A product, and the B product for the most part, based on the last five years of no construction, has the room for rent increases with improvements to the property. In other words, the repositioning of the properties - there's a lot more room for repositioning in the B category of properties."
Particular markets nationwide have increased their popularity with lenders, and multifamily has played a substantial role in the resurgence in some areas.
"The one market that surprised me the most was Detroit, where the area has felt a tremendous turnaround, and we have been very active in Michigan for the last three years," says Quinn. "Market conditions coupled with the stable automobile market have provided solid factors for multifamily deals in and around downtown. In some downtown locations, the suburban garden is outfavored by highrise - because they're absolutely irreplaceable in these downtown locations."
Even though many national lenders are focusing on REITs, a large number have increased their business in conduits and CMBS into 1998.
"The CMBS market has literally exploded over the last two years and conduits are favoring multifamily right now. The conduit pools have increased their numbers of multifamily properties in their mix and so, as a result, they aggressively compete for these loans with a lot of money being steered to the multifamily side today," says John T. Fenoglio, president of Houston-based Holliday Fenoglio and Fowler, L.P. "There is a lot of competition from the life companies and agency lenders, but the conduits are still very, very active and aggressive, and typically multifamily will be priced lower than an office building or warehouse loan. For a 75% to 85% loan on a good Class-A property the spread would be around 135 basis points, and we had recently competed very aggressively for loans against some national life companies."
Fenoglio notes the amount of loans that are available to customers drives the cap markets competition this year.
"We did a loan that was more than $70,000 per unit, and the competition for the deal was tremendous. In loan proceeds, the transaction was a 30-year amortization at 80% LTV. All the financial vehicles used this year are under a lot of pressure to compete for loans, and multifamily will most likely stay ahead," says Fenoglio. "Basically, we're seeing some 85% loans in the Class-B market, and 90% loans are really for the low-income tax programs in affordable housing. Some CMBS sources are offering 85% financing, and that is very aggressive for that type of vehicle. Simply, there is a tremendous amount of low cost capital available in today's marketplace, and many lenders are competing to get a lot of business."
The CMBS market has been moving forward to compete against REITs and conduits with $43 billion financed in 1997 and a projected $48 billion this year. As of the end of the first quarter, 10-year, triple-A spreads were at 75 basis points with the best sectors were long triple-AAA, triple-BBB and B bonds. The CMBS pace could reach nearly $60 billion for this year with the amount of deals that are being financed.
"One reason the volume is up on the CMBS market is it has a historical financing market, and a product class has to be established with equity deals coming in one year and rehab the next," says Olney. "So, everyone has had good finance in 1997 - multifamily, retail, office and so on - and hence we are seeing a lot of good volume in 1998. Particularly in the multifamily sector, you have had a run of three to four years of strong financials that is required for CMBS underwriting. However, this year will be a very competitive one. The mortgage rates coming into the market, coupled with the flexibility they have to offer and not having to underwrite to a REMIC, makes it a very competitive environment."
"Multifamily is a very viable conduit property type, and is extremely competitive and we have found it to be long-lasting as the product type of choice," says Mike Greco, CEO of WMF Capital Corp. "I believe that in the last 12 months we've seen, in addition to the regular flow of refinance opportunities, just a very good variety of types of multifamily products - acquisitions, rehabilitation and high LTVs. It's a catch-22, when your rates go down your LTV goes down because cap rates don't change much, and they're still at in the eight to nine range. You have not had a one-to-one relationship with cap rates vs. debt service coverage for some time, so we're more picky as underwriters."
Capital markets will continue to have a variety of products offered to compete going into the third quarter this year. REITs, CMBS and conduits will continue to stay strong in competition, while 1998 will be a solid year for multifamily with other sectors closing fast.
Capital Markets Risk Advisors Inc. (CMRA), a risk management consulting firm based in New York, has released results of a survey designed to assess progress of institutional investors and investment managers. Risk Standards for Institutional Investors and Institutional Managers was designed in order to better assess and quantify the influence that these best practices have had on the institutional investment industry and allow recipients to assess their own risk management progress. Respondents included institutional investors (49%), investment managers (37%), mutual funds (7%) and custodians (7%). The following are some of the highlights of the survey's findings:
* Nearly 75% of respondents plan to make an increased investment in people, systems and education dedicated to risk management by year-end 1998.
* While fewer than 6% of institutional investors focused on risk-adjusted returns 12 months ago, more than 40% plan to move risk-adjusted return measures for their investment managers in 1998.
* One concern in the findings is the lack of model risk management by institutional investors. As of year-end 1997, only 22% evaluated and monitored their risk, and 60% did not plan to address the issue this year.