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Why Vulture Buyers May Go Hungry

Distressed real estate opportunity funds, or vulture buyers, have been circling the commercial real estate industry for some time, pouring substantial capital into market space. But there is significant risk of this money not being spent.

Over the past two years, more than $1.4 billion of equity capital has been raised for this sector, according to published reports. When combined with leverage, that equates to almost $3 billion in buying power. This, of course, does not account for the millions of dollars being raised privately, which is not typically reported.

Many investors thought they smelled blood, harkening back to the good ole days of the Resolution Trust Corp. (RTC). Yet, there are stark differences in the real estate market today as compared to the RTC market of the early 1990s, which may prevent the reappearance of real estate market conditions of nearly 10 years ago.

Lower Leverage, Fewer Defaults

Assets financed in the early 1990s were highly leveraged, primarily with regulated capital. Those were the days when 105% financing was commonplace. Over the past 10 years, financial institutions have decreased their leverage and real estate equity has primarily come from private institutional investors. These equity holders are not motivated to “get out” of underperforming transactions as the government was in the early 1990s.

The real estate collapse of the early 1990s was seeded by the underwriting of the late 1980s. During that time, Savings & Loans were deregulated and underwriting standards became very aggressive. In addition, there was no standardization of underwriting across the industry. Individual lenders did it “their way.” Today, the commercial mortgage-backed securities (CMBS) industry has standardized how commercial loans are underwritten throughout the country.

A third and little discussed factor is the tremendous impact technological advances made in real estate underwriting. It is hard to imagine today's transactions taking place without the benefit of Excel, Argus and desktop computers, as was the case in the 1980s. These technological advances have served to make today's underwriting less susceptible to market fluctuations.

In addition, much of the 1990s sell-off was driven by overbuilding in the 1980s. Today, while vacancies are high, the market is not overbuilt. Rather, it is a case of weak demand. The current real estate market was built on real demand and the properties were fully occupied until the technology and telecommunications industries evaporated. Thus, since the buildings were once filled, building owners' and equity partners' outlook is more positive this time around. In the 1990s, owners “gave up” on buildings that were never leased. Today, building owners have more confidence they can re-tenant a building that was once full.

Lenders Learn Tough Lessons

Due to the high leverage lending of the 1980s, banks and Savings & Loans essentially became equity partners in commercial real estate in the 1990s. The real estate sell-off of the early 1990s was government mandated, driven by the RTC and the Federal Savings & Loan Insurance Commission (FSLIC) to weed out and downsize failing banking institutions. Thus, when problems arose, regulated institutions were the first to suffer.

Today, equity capital in commercial buildings is provided by well-capitalized private institutions capable of weathering the financial storm, and writing checks, if necessary.

In the early 1990s, interest rates were much higher than today's historic lows. In 1992, 30-day LIBOR (London Interbank Offering Rate) rates peaked at 4.3%, versus today's 1.1%. These higher rates put much more stress on already poorly performing assets. Today's low interest rate environment is a respite, allowing developers a chance to keep loans current until the economy recovers and occupancy and rates increase again. Therefore, as long as Federal Reserve Chairman Alan Greenspan keeps short-term rates low, distressed assets will be harder to find.

The real test for the commercial real estate market is right around the corner, as a recovery begins to gain steam and pushes short-term interest rates higher. All eyes in the commercial real estate markets will remain on Greenspan to do a “magic dance” of increasing rates at a slower pace than the recovery. In other words, can Greenspan help produce more jobs to fill buildings and apartments before rates climb too high? If the Fed chairman pulls this off, the vultures will have little to eat.

Jay Rollins is a senior vice president and managing director the structured products group, a balance sheet capital provider for Newman Financial Services, a subsidiary of GMAC Commercial Holding Capital Corp.

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