Can capital markets rise above `soft landing?'

Uneasy times, consolidation take their toll on financial marketplace, but some players seize the day.

Consolidation and efficiency. These appear to be the key trends in the nation's commercial real estate capital markets moving forward into 2001 and the foreseeable future, according to a cross-section of leading industry players.

The pending "soft landing" of the nation's economy is wreaking havoc with many capital providers these days, while others, including Wall Street players and the top commercial banks, have just ended 2000 with a bang, generating an estimated $22 billion in commercial mortgage-backed securities (CMBS) transactions in November and December alone. That's a healthy way to cap off the year, but since some big deals were postponed into the new year, does it really portend great things to come?

Certainly many eyes were sharply focused on the mergers and acquisitions action among the nation's commercial banks last year, making 2000 the unexpected "Year of the Merger." Consider Chase Manhattan's recent $33 billion blockbuster buy of J.P. Morgan & Co.; Credit Suisse First Boston's $12.2 billion acquisition of Donaldson, Lufkin & Jenrette; UBS Group's $11.8 billion purchase of PaineWebber Inc.; and Citigroup Inc.'s $31.1 billion buy of Associates First Capital Corp.

The impact of these deals alone, although initially not appearing all that dramatic on the surface, serves as a bellwether that consolidation is the name of the game, and the trend shows no sign of letting up anytime soon.

In one of the biggest office transactions of the year, Chicago-based Equity Office Properties Trust, in partnership with Lehman Brothers, acquired 1301 Avenue of the Americas in Manhattan for $715 million. Located near Rockefeller Center, the 46-story building is 100% leased. With the acquisition, the company owns nearly 5 million sq. ft. of prime Manhattan office space.

To find out more, National Real Estate Investor asked a number of leading industry players for their opinions, and they weren't shy about giving us an earful.

A four-quadrant overview According to Rick Carlson, managing director of Chicago-based Deloitte & Touche Real Estate Services, the four financing quadrants - private debt, private equity, public debt and public equity - are operating in different leagues.

In the private debt market, Carlson says solid market fundamentals will keep most traditional institutional debt investors active, while dividends should remain strong and steady. "Commercial banks will maintain their dominance of the real estate debt markets," he says.

"However, given the mature real estate markets and strong underwriting, issuers of commercial mortgages will continue to focus on higher quality and smaller projects," he says. Too much dependence on rotating credit, short-term mezzanine loans and mini-perms could spell trouble if interest rates rise, the economy reverses and lending for new construction slows.

On the private equity side, Carlson says pension funds continue to struggle with the role of real estate in their asset allocation strategies. "While total investments in real estate continue to increase, the percentage of real estate assets in their portfolios is now less than 2%," notes Carlson. He predicts that pension funds will continue to invest in private, commingled funds and separate accounts. However, they will maintain a stronger appetite for alternative or opportunistic investing.

On the public debt market side, Carlson expects volumes for 2001 to be similar to those of last year. And he emphasizes that the segment's continued maturity bodes well for the future of the CMBS market.

"Low volumes and high interest rates will continue to put pressure on margins," says Carlson. "However, the growing sophistication of buyers continues to improve the overall loan quality of the issuances. The small number of B-piece buyers will continue to exert disproportionate influence on the quality and pricing of issuances."

Surprisingly, one of the strongest performers of 2000 was the public equity market, where REITs outperformed the broader stock market for the first time since 1997, generating steady, solid and reliable rates of return. The REIT market also was calmer than the highly volatile stock market.

"In 2001, REITs will emerge as a solid alternative for investors seeking less spectacular but more stable returns - provided these investors are not already trapped in investments they can't liquidate without sustaining heavy losses," says Carlson. "Having successfully repositioned themselves as income investments rather than growth investments, REITs can count on their strong funds from operations (FFO) to fund dividend payments that eclipse those paid by even blue-chip stocks."

Others agree with that assessment, including Jacques Brand, managing director of real estate advisory and finance in the real estate investment banking section of New York-based Deutsche Bank Alex.Brown. He notes that REITs have strongly outperformed the S&P 500 this year, delivering a near 15% return.

"In 2001, the fundamentals will continue to be strong in real estate property markets and capital markets," says Brand. "We expect to see more consolidation in public real estate markets with larger players buying smaller to medium mid-cap companies, and we also foresee some smaller public companies going private, continuing the trend we saw in 2000."

The past year was a busy one for Deutsche Bank. During 2000, Deutsche Bank acted as administrative agent and co-arranger for a $500 million revolving credit-term loan for Toronto-based TrizecHahn Office Properties Inc. Among TrizecHahn's prominent holdings is the Sears Tower in Chicago. The bank also is representing TrizecHahn in the expansion of its telecom hotel business In Europe.

Whole `lotta action going on For most people who stand on the front lines of the financing scene, it's all about the action. According to George Smith, chairman and CEO of Los Angeles-based George Smith Partners Inc., the influx of mezzanine debt and institutional equity sources is at a fever pitch. Smith should know. He has personally arranged the financing and sale of more than $4.5 billion in real estate since 1968. One of the company's biggest projects is Sunset Millennium, a mixed-use development on the Sunset Strip in West Hollywood, Calif. The company arranged $95 million in financing for phase one, which includes a 107,000 sq. ft. retail center and the redevelopment of the Playboy office building. Future components of the project will include a 370-room hotel, 300,000 sq. ft. of office space and 155,000 sq. ft. of boutique retail.

"I cannot remember any time when there were so many players in this sector," says Smith, who estimates that there are more than 40 players and $12 billion of capital in this arena. "This tends to be smart and entrepreneurial money seeking higher yields. As the field has broadened, niches are being established, pricing to the risk," he says. "Examples are several insurance companies that want to lend leveraged dollars on stabilized properties where borrowers are locked in or have loans subject to high prepayment penalties and low first-mortgage, loan-to-value [LTV] ratios. Their yield expectations are in the low teens and generally will lend to overall LTV ratios of 80% to 85%."

Smith says the other end of the spectrum features high-risk equity and mezzanine debt sources that can provide capital up to 97.5% of total cost. "They are seeking returns that range from just above 20% to as high as 35%, depending on the property type and risk profile," he says.

Looking farther ahead, Kieran Quinn, president of Atlanta-based Column Financial, an affiliate of Credit Suisse First Boston, predicts the top capital providers in 2001 will continue to be the same principal players as those from 1997 to 2000.

"There will be fewer players involved in commercial lending, but fortunately the few remaining are significantly larger than they were in the mid-'90s," says Quinn. He expects there to be three major players on the investment side - Credit Suisse First Boston, Lehman Brothers and Morgan Stanley Dean Witter. Deutsche Bank, UBS and Bear Stearns will be close behind, he says. On the commercial banking side, he expects the merged J.P. Morgan-Chase and Bank of America will be major players. First Union National Bank and several regional banks such as Wells Fargo and KeyBank also will play significant roles, he predicts.

"The two major changes I see coming in 2001 are that the regional banks will be less active than they have been in the past," says Quinn. "The Fed [Federal Reserve] has been looking at the high percentage of loans that are made by the regional banks, and we all know that on an industry-wide basis the commercial banks have financed almost 50% of all commercial real estate loans."

According to Quinn, the big unknown variable is the participation of the life insurance companies, but he predicts the landscape for them is going the same way as investment banks and commercial banks. "There will be fewer life companies but the ones remaining will be larger," he says. "The foreign life companies are gobbling up small- and medium-sized companies, and in some cases very large U.S. life companies, and many of them are shifting their focus from direct mortgage lending to CMBS bond purchases."

Andrew Little, an investment banker with John B. Levy Co. in Richmond, Va., says many insurance companies are stuck at relatively wide spreads because alternative, fixed-income investments, such as corporate bonds, are pricing at historically fat spreads.

"CMBS has gained more acceptance in the fixed-income arena, particularly down the investment-grade chain, and is pricing more tightly, on a relative basis, than corporate bonds," says Little. "CMBS liquidity has increased dramatically because there is less `event-risk' such as a corporate merger or breakup, and it is viewed as a safer, short-term investment harbor. This combination of factors will help conduits compete favorably against the insurance companies in the coming year."

Still, Steve Pumper, president of Dallas-based Transwestern Property Co.'s owner advisory services group, says the life companies and banks will hold their own. "Insurance companies and banks of all sizes will be the capital providers but, like last year, will be conservative and selective as they sort through borrowers," he says. "In major cities, European capital will be available, also on a very selective basis, focused on markets with barriers to entry."

According to Stacey Berger, executive vice president of Kansas City, Mo.-based Midland Loan Services, a wholly owned subsidiary of PNC Financial Services Group in Pittsburgh, securitization will continue to have a major influence on the moves made by all commercial mortgage finance industry players in 2001. "Commercial mortgages originated for securitization will be the predominant long-term product for banks, finance companies and Wall Street," he says. He expects the majority of long-term commercial mortgages originated by insurance companies will be created in a securitizable form.

"Commercial mortgage-backed securities will be the dominant source of commercial mortgage debt," says Berger. "CMBS is cost-competitive and has performed very well in a stable interest rate environment."

A slowdown ahead? One big barrier to entry just might be a steadily slowing economy, and with it a potentially dramatic impact on commercial real estate finance. "An economic slowdown will make everyone more conservative - which means less capital to real estate," says Joe Franzetti, director in the commercial mortgage finance group of New York-based Salomon Smith Barney.

"To the extent the slowdown manifests itself in delinquencies and defaults, I would expect that many lenders would head for the hills," says Franzetti. "Capital will get more scarce and expensive, and borrowers will get squeezed with less cashflow and higher borrowing costs - which probably means lower values and more credit concerns. So in the short run a slowdown will result in people realizing that trees do not grow to the sky, and the brakes will get slammed on lending programs."

If a slowdown occurs, and lenders and bondholders are not decimated as happened in the last recession, this could be a positive development, adds Franzetti. There could be an appreciation for the ability of the market to discipline itself, an affirmed faith that conduit lending holds up and greater confidence across the board that real estate is a cyclical business within a definable scope, rather than one characterized by boom and bust.

Another potential benefit of a slowed economy could be lower interest rates, observes Smith of Smith Partners. "The question is, have the capital markets already factored in these expectations? A slowdown may mean a slowdown in certain sectors of demand - more retail space, high-tech occupancy requirements, etc. Housing, particularly multifamily, should remain strong," says Smith. He adds that a slowdown may simply mean a return to stabilized and sustainable expansion rather than the 5.5% growth rates that overheated the markets.

CMBS tops a big milestone According to Quinn, the CMBS world will break the magic $300 billion mark in the first quarter of 2001. "CMBS has become a fixture in the world of fixed income, and all major money managers are tracking CMBS and are using it to round out their investment portfolios," he says. Major investment and commercial banks have increased their commitment to research and secondary trading. Most notably, he adds, the volume of secondary trading has increased in 2000, and there has been a very active market for both buyers and sellers.

"The confidence level on the part of CMBS buyers that they will receive multiple bids whenever they want to trade their positions has reduced liquidity risk and enabled new CMBS offerings to go out at slightly tighter spreads," says Quinn.

There have not been wide swings in spreads for CMBS, which Quinn considers a very significant trend. "Keep in mind that the low point for spreads was reached in the spring of 1997 at roughly 70 basis points (bps) over Treasuries for AAA CMBS, and the high point was approximately 190 bps over Treasuries in the fall of 1998," he says. "For most of calendar 2000, AAA CMBS traded in the 140 to 165 bps range, and for the second half of the year that spread was even narrower."

Franzetti says another key CMBS development is the tendency for there to be multiple players in each deal, because no lender can generate enough product on its own. "Single-property or fusion deals will become more prevalent as REITs will find the mortgage market a safer haven than unsecured debt," he says. "Deal size is more likely to remain the same, if not smaller."

Since there is an administrative burden to multiple-handed transactions, there is a natural tension about the number of loans, loan size and multiple players, he says. Due to these factors, the market can expect more scrutiny from servicers as the market looks to its inevitable downturn.

Overall, industry observers are predicting, just as they did in early 2000, that demand will increase in 2001 for more floating-rate deals, where opportunities will be available in higher-risk turnaround properties.

And Franzetti says that CMBS deals will continue to all look alike as investors prefer transactions that are similar to other deals in the market. "As a result, conduit lenders are going to look inwardly to revamp their operations to maximize efficiencies and profits," he says.

Last November, for example, Bank of America, decided to close more than 10 of its regional conduit operations in secondary markets to focus on its primary markets.

"Therefore, the focus will be on process and not products," says Franzetti. "This will further encourage consolidation in that if you cannot participate efficiently, you may not participate at all. The Internet will play heavily here, as it will create operating efficiencies as opposed to online originations that are a major source of product."

Efficiency moves to the fore By most measures, it's becoming apparent that firms that play the financing game with the most process efficiencies will be the eventual winners.

"Domestically, where many U.S. markets have been on the rise for years and debt liquidity is abundant, attractive opportunities are increasingly becoming limited," says Joan Lavis, senior vice president of marketing at Stamford, Conn.-based GE Capital Real Estate.

"We think that capital providers will need to offer more than just money to compete. The e-business juggernaut continues to roll," says Lavis. "GE Capital has made a huge commitment to automate its business, enabling it to provide customers with greater transparency and reduce cycle time in transactions," he adds

"By embracing the Internet, we have become more efficient and cost-effective in our processes," says Lavis. "Today we are completing deals in one-quarter of the time it used to take, thanks to digitalization. If capital companies are to even survive, let alone thrive, they are going to have to be constantly on the leading edge of the digital movement."

Going digital will help GE realize its global ambitions as well. "On a global basis, we are going to make more investments overseas - mostly equity - where we see big opportunities. Currently, more than 50% of our earnings are generated from outside the United States, and we expect that number to increase," says Lavis. "We have well-established footholds in Europe, Asia and Mexico, with strong asset management capabilities positioning us nicely in markets with still rising cycles."

Michael Greco, CEO of the Charlotte, N.C., MortageRamp, and an industry veteran who has held senior positions with both First Union National Bank and WMF Capital Corp., also is positioned to grow his online business through streamline procedures.

Recently MortgageRamp secured $50 million in a second round of funding from a prominent group of investors.

"Top [capital] providers will be those that can provide a total financial solution," says Greco. "That is, one-stop shopping for debt, equity, construction and mezzanine financing."

Another leading online player, New York-based, is meeting the New Year with a new equity private placement business through its broker-dealer subsidiary, CapitalEngine Securities Inc., in the early part of 2001.

"The purpose of this new program will be to raise equity capital for high-quality deals by selling privately placed securities to high-net-worth individuals on behalf of our clients," says Benjamin Milde, COO and board member of CapitalEngine.

"The Equity Private Placement program will be set up to originate, underwrite and place equity ownership in commercial real estate for properties in the general range of $50 million to $200 million," adds Milde Property types and food groups

OK, so the markets are getting more efficient in this time of need. But what types of commercial properties will be the darlings in the year ahead? By nearly all accounts, apartments will lead the way, followed by office, industrial and retail sectors.

"Since apartments are currently enjoying extraordinary performance nationally and the expectation for overbuilding in most markets is negligible, lenders will continue to aggressively solicit this segment of the commercial market," says Howard J. Levine, president and CEO of ARCS Commercial Mortgage Co. in Calabasas Hills, Calif. "Moderate rehab for repositioning of underperforming properties will continue to generate upside potential for astute developers."

The recent "Emerging Trends" survey released by Lend Lease Real Estate Investments and Pricewaterhouse Coopers, both based in New York, also rank apartments as a top buy in 2001, along with downtown office buildings and industrial properties.

On the apartment front, Levine says that Fannie Mae DUS and Freddie Mac Program Plus lenders will continue to gain market share on their competitors.

"In the multifamily financing area, Fannie Mae and Freddie Mac will continue to dominate because of their superior execution and availability of secondary financing," says Levine. "Conduits and life insurance companies will aggressively compete for other commercial loans."

Ultimately, Franzetti echoes what so many other industry insiders have observed the past few years - profit margins have compressed for lenders and are not likely to widen.

The result is that the lack of profit and the reduced margin for error in lending has taken all the creativity out of the market," says Franzetti. Lenders cannot afford to be different or imaginative when they are not being paid relative to the risk. "As a result, conduit lenders will be more inclined to focus on the four major food groups of property types, which will be conservatively underwritten," he says.

And that's the bottom line.

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