Cost of Capital Proves Volatile for Borrowers

Gary E. Mozer is principal and chief executive of George Smith Partners, a Los Angeles-based real estate investment and mortgage banking shop. Last year, George Smith Partners arranged for more than $4.1 billion in commercial and multifamily financings in 262 transactions, tapping 78 different capital sources. Deal sizes ranged from $3 million to $350 million.

Mozer has always had a penchant for the numbers side of the business. He earned master's degrees in both real estate and finance from the University of Wisconsin, and a bachelor's degree in computer science and mathematics from the University of Michigan. NREI interviewed Mozer about the overall health of the debt markets today and their impact on commercial real estate lending activity over the next six months.

NREI: The Federal Reserve cut the federal funds rate by 50 basis points on Sept. 19. What's the net effect on commercial real estate financing?

Mozer: For permanent acquisition financing, it took a little pressure off the market. But there are so many kinds of loans, I am not sure 50 basis points will make much difference in that mix. Additionally, borrowing for acquisitions is at the long end of the curve, while the cut in the fed funds rate was at the short end of the curve. Short-term rates may fall, but long-term rates will come down less.

It will make a difference in bridge loans when LIBOR (London Interbank Offered Rate) goes from 5.80% to 5.15%, as was the case in the second and third weeks of September, partly due to the rate cut and the anticipation of the cut.

NREI: Are you encountering tougher underwriting standards and better documentation today among lenders in light of the problems in the subprime market?

Mozer: For acquisition debt, they are only lending on cash flow in place, not on putative future rent gains. The loan-to-value ratio on the senior loan has decreased. Lenders want more equity down. You used to be able to get 85% loan-to-value (LTV) and an interest-only loan. Now you have to get a 75% LTV and 30-year amortization. They won't give you an interest-only loan anymore.

Previously, on permanent 30-year amortizing loans lenders wanted 80 to 90 basis points over U.S. Treasuries. Now it is close to 200 basis points.

NREI: Some say the Fed action will cheapen the dollar further. How will that affect the strategy of foreign buyers?

Mozer: You see a lot of foreign capital. Some of the foreign buyers are putting down big chunks of equity and using their own institutional resources to borrow money, especially the German buyers. You are seeing buyers from everywhere: Irish money, Spanish money, oil money.

NREI: Previously, some buyers would achieve 95% LTV by getting a mezzanine loan. Is that still the case today?

Mozer: The majority of the mezzanine paper has dried up. It is a lot more expensive. Before, you could get mezzanine money at interest rates ranging from 8% to 12%, with no points [origination fees]. Now it is in the range of 16% to 18%.

NREI: How long until the credit market unfreezes?

Mozer: About six months from when it started, or from August, so I am looking to the first quarter of next year. Buyers have to know what their cost of capital is. Right now, it bounces around by 50 basis points from week to week, and a commitment by a lender can change from day to day.

NREI: What's your outlook for building valuations? The buzz is that commercial real estate will take a 10% to 15% hit in value — not so bad, given that many properties have doubled in value in the last five years.

Mozer: That's not so bad, unless you bought lately. Because many buyers were so leveraged, they have zero equity left in many buildings. The honorable ones will stay in, but we are already seeing some owners turn over the building to the junior equity partners (mezzanine lenders in some cases). It is not in their exit strategy to baby-sit a building for the next five years. In the tertiary markets, values will probably fall more than 10% or 15%, and in the primary markets it will be less.

NREI: Some say neither buyers nor sellers are willing to blink, and that standoff is freezing transactions. From your experience, who will blink first?

Mozer: I think the sellers have to blink. The buyers need 6% cash-on-cash returns (annual yield on equity invested, after all expenses). The industry cannot attract capital for less than that.
Benjamin Cole

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