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Wading Back In After the Fall

Institutional investors vow to ramp up their lending volume in 2010, but market forces present obstacles.

With the economy in the early stages of recovery, life insurance companies feel it's safe to re-enter the commercial real estate lending market on a limited basis. But with a lack of stabilized, quality properties coming onto the market, the big question is whether they will be able to invest the money they've amassed in a timely fashion.

During the Mortgage Bankers Association's annual conference for the commercial/multifamily industry held in Las Vegas in February, executives from six major life insurance companies participated in a panel discussion titled “Portfolio Lenders After the Fall.” The big news? They have a combined $20 billion available to invest in commercial real estate in 2010.

“We think it's an attractive time to be lending at this point in the cycle,” says Mark Wilsmann, a conference panelist who heads up MetLife's $35 billion real estate portfolio. “It's a relatively attractive time from a return perspective in that yields are higher for mortgage lenders in this environment than they were in 2006 and 2007 when everything was so frothy.”

That outlook marks a stark contrast from a year ago when insurers were idle. “Last year, they weren't doing anything. I talked to one insurance guy who said his goal was to save at least $30 billion in cash on his balance sheet,” said Kieran Quinn, panel moderator and vice chairman of Walker & Dunlop, one of the largest mortgage brokers in the apartment sector. The company services over $12 billion of commercial mortgages.

Time to deploy

This is asset allocation season for institutional investors, a time when they must decide how much of their war chest they want to invest in stocks, bonds, real estate and other asset classes. This diverse group of investors includes life companies, pension funds, real estate investment trusts and even foreign investors.

According to Quinn, institutional lenders have begun to relax their loan-to-value (LTV) terms from a range of 50% to 60% in 2008, to 70% and above in the first quarter of 2010 for permanent financing on stabilized properties. Quoting interest rates ranging from 5.9% to 6.5%, lenders are making nearly 300 basis points over 10-year U.S. Treasuries.

Wilsmann agrees that LTVs of 70% to 75% are becoming the new normal, at least for the healthier assets that have not experienced any distress.

“Now that values are hitting bottom and beginning to stabilize, you're going to gradually see people be comfortable lending at a little higher level, but it's still going to be conservative underwriting,” says Wilsmann.

Another major institutional investing group, pension funds, have historically allocated between 6% and 10% of their total assets under management to the real estate sector. Recently, investors have experienced a reversal in the so-called “denominator effect.”

When the stock market tanked in 2008 and early 2009, the total value of pension fund investments dropped as well. But because real estate values initially didn't fall as much, real estate investments as a percentage of overall investment portfolios actually increased. That denominator effect forced many pension funds to dial back on real estate to stay within their 6% to 10% allocation range.

Now, thanks to the recent rebound in stocks, many funds find themselves underweighted in real estate, including the largest public pension fund, the California Public Employees' Retirement System (CalPERS). Its $13.5 billion real estate portfolio represents 6.9% of the fund's total assets, down from its target of 10%.

What's more, real estate values have fallen dramatically in the last two years. Since their peak levels at the end of 2007, investment returns on office buildings, for example, fell 23% by the fourth quarter of 2009, according to CB Richard Ellis-Econometric Advisors.

However, the research firm projects that property values will rebound, increasing by 3% to 11% in 2011. Many investors believe that real estate returns could benefit by potentially higher inflation and interest rates ahead.

“Real estate is an important part of a diversified portfolio,” says Katy Durant, who chairs the Oregon Investment Council, which has $65 billion in total assets under management and invests on behalf of the state of Oregon. “[Real estate] is especially important now as it will be an inflation hedge, which is sure to occur once we finish this deflationary period, and with the level of national debt rapidly increasing.”

Contrarian point of view

Not everyone is convinced the talk is turning to action, however. “We're seeing a lot of interest from institutional investors about wading back into real estate, but interest has yet to translate into what I would call significant commitments,” says Stephen Quazzo, CEO of Transwestern Investment Co.

The greatest challenge facing every investor today is a continued lack of deal flow. “The real story for 2010 is that it's still going to be a slow year, and there's still a lot of uncertainty about values,” says Quinn of Walker & Dunlop.

The deal logjam has led to a backlog of funding commitments. Institutional investors have plowed billions into private equity funds targeting commercial real estate, and much of that capital has yet to be deployed due to a lack of available properties.

“That limits any sense of urgency to deploy additional capital in commercial real estate,” says Sam Chandan, global chief economist and executive vice president with New York-based researcher Real Capital Analytics (RCA). “Many institutions have made allocations, assigned that cash to funds that can invest on their behalf, but are finding the opportunities thus far have been limited.”

Investment sales volume for office, retail, industrial and apartment properties fell from a peak of $522 billion in 2007 to $146 billion in 2008 and just $52 billion in 2009, according to RCA.

Flight to quality

Institutional investors typically eschew risky, or so-called “value-add” and “opportunistic” investments, preferring the comparatively safer havens of “core” funds designed to invest in stabilized Class-A buildings in primary markets.

Recently the Kansas Public Employees Retirement System committed $100 million to a new core property fund launched by Chicago-based Jones Lang LaSalle.

“The flavor du jour is long-term, stabilized, high-credit-tenant properties with steady cash flow in place,” says David Steinwedell, the former managing partner at Austin-based AIC Ventures and president of Atlanta-based Wells Fund Management.

“When those deals come to market, they're actually bid up pretty well. Capitalization rates, or the initial returns based on purchase prices, for core real estate have moved from 8.5% in the summer of 2009 to around 7%, so that type of stuff has a lot of demand.”

Essentially there is a flight to quality. “It's the typical institution mentality. If you're going to come back into a market, you're going to take the safest route first,” says Steinwedell, who is launching a new investment fund, Stoneforge Advisors, based in Austin.

A good example is the Illinois State Universities Retirement System. The pension fund is trying to raise its allocation target for real estate from 2% to 6% over the next few years.

With $12.4 billion in total assets under management, the Illinois State Universities Retirement System in January committed $100 million to the UBS Trumbull Property Fund, which employs a conservative investment strategy. The move comes on the heels of the pension fund's $105 million investment in the UBS fund in November 2009.

The flight to quality also brings with it an expectation of lower yields. “Everything has been ratcheted down regarding return expectations,” says Mike McMenomy, global head of investment services with CB Richard Ellis Investors in Los Angeles.

Among opportunity funds, expected returns have dropped from 20% and above during the go-go days to between 15% and 18% today, according to McMenomy. Expected returns on value-added properties today range from 12% to 15% and between 7% and 8% for core investments.

Greg MacKinnon, research director at the Pension Real Estate Association, has observed a similar adjustment in investor expectations.

“There has been a realization that expectations of a 20% to 30% IRR [internal rate of return] only comes with an increased risk profile. The poor performance of many highly leveraged strategies during the downturn has brought that point home with a vengeance,” says MacKinnon.

All of which is leading to what Chandan sees as an “increased bifurcation” of the market into two tiers: high-quality assets versus distressed assets and loans.

“There will be a real separation in the quality from the best assets to the worst assets. That's not something that occurred in 2006 and 2007. There was little differentiation in pricing,” says Chandan.

Given that dynamic, bidding for high-quality assets is expected to remain strong. For larger assets up to $250 million “the competition for the assets we seek is quite fierce,” says Wilsmann.

Tsunami or trickle?

Given the dearth of high-quality properties on the selling block, many institutional investors have shown an increased appetite for distressed assets or loans, so-called “opportunistic” investments.

Unfortunately, the opportunities have been scarce. Instead, lenders have adopted a new strategy best characterized as “a rolling loan gathers no loss,” preferring to hold onto troubled assets rather than dump them on the market.

For now, federal regulators are reluctant to entice financial institutions to make major adjustments. In October 2009, the Federal Deposit Insurance Corp. (FDIC), which regulates nearly all U.S. banks, adopted a policy “supporting prudent commercial real estate loan workouts.”

Opinions are mixed on when, or if, the FDIC will apply more pressure to force local banks to purge their real estate assets. For now, its latest policy statement — which many pundits believe is simply a restatement of an existing policy — allows banks to keep their performing loans in place.

This approach helps banks avoid having the loans classified as “adverse” solely because the underlying property collateral dropped in value.

Given the current stalemate, rather than a tsunami, most market observers believe the flow of deals will be more like a steady stream once the taps open.

“If there is a surge, it will be in the last half of 2010 and 2011,” says Scott Lynn, president of Dallas-based Metropolitan Capital Advisors, a commercial mortgage broker that arranged about $125 million in deals in 2009. “That's when there will be a bigger push for banks to get the assets off their books.”

Lynn notes that regulators also are giving all real estate loans much more scrutiny today than they did during the boom times. “You have to have a really good reason to do a real estate loan.”

Institutional investors don't have that worry, and continue to look for ways to put their capital to work in the real estate markets. “You're seeing a change with institutions,” says Michael Newman, CEO of Chicago-based Golub & Co., a national development firm that owns the John Hancock Center and other Class-A office and multifamily properties.

“Institutions were not talking for the last 18 months. Now there's talk and that's leading to a few things getting done. Am I overwhelmed? No. But you're seeing things starting to happen,” adds Newman.

The lack of opportunities to acquire strong-performing assets could lead many institutions to single-tenant, net-lease deals on retail and industrial properties, says Ken Hedrick, director of Tulsa-based Stan Johnson Co., which specializes in brokering national net-lease deals.

Net-lease transactions typically involve the purchase of a single-tenant property where the tenant has a high credit rating. The tenant agrees to pay the rent and all taxes and operating costs. These deals tend to align themselves with institutional investors' conservative underwriting standards.

Investors may also embrace more non-traditional avenues, including injecting fresh capital into existing projects as well as loan note purchases, says Clifford Booth, president of Westmount Realty Capital, a value-add opportunistic investment firm in Dallas.

“One thing is for sure,” says Booth. “It's a new world and we threw the rule book out the window.”

Ben Johnson is a Dallas-based writer.

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