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A cold front blows through capital markets

Amid recession and geopolitical turmoil, companies of all stripes are as conservative as Bill Bennett, the former drug czar and secretary of education. They're cutting back. They're having trouble paying bills, including rents on office, retail and industrial space. Although everybody wants to see the end of the recession, virtually nobody — least of all bankers — wants to start putting money into new growth initiatives until they're sure the worst is over. This vicious cycle makes a near-term recovery unlikely.

“You can just feel it,” said Richard Gatto, executive vice president of The Alter Group, a big developer based in Skokie, Ill. “No one in Corporate America wants to even think of growth or adding people. It's such a wait-and-see attitude that it's just frozen everyone.”

If this were 1991, the scenario would include a virtual shutdown of lending for real estate projects. But, so far, this cycle has been kinder and gentler because the industry didn't overbuild in the good years to the extent it did in the 1980s boom. Around the start of the current recession, in the second quarter of 2001, the national office vacancy rate was about 11%, compared with a peak of 18% during the recession of 1990-91, according to statistics from Northbrook, Ill.-based Grubb & Ellis Co. Lenders have adopted more rigorous underwriting practices, and equity capital is more difficult to raise via the stock markets and other sources. Still, there is some money available — for the best projects with minimal risk.

“Given that the industry has adopted appropriately more strict underwriting, there's lots of money still out there for the right deal,” said Peter Fioretti, CEO of Charlotte, N.C.-based Mountain Funding, a lender that provides private financing alternatives to developers and owners of commercial real estate.

So rather than a lock down in the capital markets, a stratification has taken hold: well-financed developers can obtain funding for projects as long as they are pre-leased to financially solid tenants — and usually at lower loan-to-value ratios than borrowers could get two years ago. Less established developers and speculative projects are pretty much out of luck.

Edward Shugrue, chief financial officer of New York-based mezzanine lender Capital Trust, attributes the relatively easy money in these hard times to the fiscal discipline of developers and REITs, who kept their balance sheets clean in the 1990s boom. That's why, he says, the industry has not yet seen many fire sales of distressed properties.

Over the past several months, properties that have been sold have gone at prices higher than Houston-based Hines, for one, was willing to pay. “We've been surprised,” said Charles Baughn, executive vice president at the company.

On the other hand, some properties carry the stigma of the collapsed high-tech investing boom. Fioretti points to a 100,000 sq. ft. building in Chicago that was outfitted for telecommunications tenants. As recently as mid-2001, he says, it was attracting purchase offers of about $15 million. Now, no one's interested. It's not so much a matter of price. Rather, buyers don't want to take a risk with the building's tenant profile — small telecom companies struggling financially to survive.

Financing options multiply

Another factor helping to ensure liquidity is that commercial real estate finance has grown vastly more sophisticated. In the past several years, instruments such as mezzanine financing, commercial mortgage-backed securities (CMBS) and equity infusions have emerged.

“Just a few years ago, borrowers could choose from only three or four standard mortgage programs,” wrote Jim Reichek, managing director of the Kushner Cos. of Florham Park, N.J., in an October paper on the topic. “Now, from Wall Street and the larger institutional banks to S&Ls, to Fannie Mae and Freddie Mac, to regional commercial banks and life insurance companies, the myriad of options has grown tremendously.”

Debt markets tighten, but open for business

Given the rocky equity markets, it's no surprise that most of the new money is coming in the form of debt. Even for publicly traded REITs, debt is where it's at. Through October, REITs in 2001 had raised a total of $12.69 billion in capital, and 64% of that, or $8.17 billion, was debt, all of it unsecured, according to the National Association of Real Estate Investment Trusts (NAREIT). In 2000, debt accounted for 73% of the $10.38 billion raised by REITs.

Karen Dorigan, chief investment officer of CarrAmerica Realty Corp., a Washington, D.C.-based REIT, noted that REITs with strong balance sheets and good credit ratings still have ready access to bond markets. They can also obtain financing from banks.

For example, CarrAmerica closed on a three-year, $500 million credit facility in June with a syndicate of banks led by J.P. Morgan Chase. The line carries an interest rate of 70 basis points over 30-day LIBOR (London Interbank Offered Rate), which is similar to the terms of the company's previous facility, according to CarrAmerica's third-quarter report. In fact, Dorigan said the terms are similar to the credit line set up two or three years ago, and that the company could borrow as much money on the same terms today.

Although interest rates that CarrAmerica and other borrowers are paying today are near historic lows, lending standards are more rigorous. Lenders are lowering loan-to-value ratios, requiring more pre-leasing and equity from developers, and drilling deeper into the credit quality of tenants.

For example, to obtain financing to build a speculative office building, lenders now typically require the developer to ante up 40% of the project cost in equity, up from 20% to 25% two years ago, said George Emmons, executive vice president at Key Commercial Real Estate, a Cleveland-based lender. But even with a 40% to 50% equity stake in a project, a developer today would find it difficult to obtain financing for a speculative office building. By contrast, a build-to-suit project that's guaranteed to be 90% occupied would require a developer to put up only 15% to 20% of the cost in equity.

Baughn of Hines said a developer/owner with a credible rent roll just six months ago could have borrowed 70% of a project's value. Today, that loan-to-value ratio would likely not go above 60%.

On the other hand, when it comes to the refinancing of existing buildings, investors have a tenant roster and a track record of performance at their fingertips, so they don't have to guess when a project will be completed or what tenants will occupy the building. If a life insurance company, for example, buys the mortgage of a building that was constructed for a big company like AT&T, that life company isn't gambling on a builder or developer. “They're looking right through the lease to AT&T,” Emmons said.

Little new construction

A meager amount of new building is expected over the next few months. Projects that will go forward are ones that are pre-leased to tenants with spotless credit and projects with quality sponsorship, Dorigan said. CarrAmerica, for example, has about $100 million in development under way, down from a peak of $500 million in 1999.

The type of development also has shifted dramatically. Three years ago, about 70% of CarrAmerica's development involved speculative space with little or no pre-leasing. Today, Dorigan said, 85% to 90% is build-to-suit or substantially pre-leased properties.

In addition to the nature of development, location also is critical in today's financing markets, according to Dorigan and others in the industry. “Washington, D.C., for example, attracts capital much more easily than a Dallas or Atlanta or other markets that have [experienced higher office vacancy rates],” Dorigan said.

Cushioned by the presence of the federal government, Washington, D.C.'s overall office vacancy rates have remained at about 3%, according to Colliers International, while vacancy rates in Atlanta and Dallas have hovered at close to 13% and 20%, respectively.

Liquidity isn't spilling into all sectors. For hotels and senior living centers, there is a veritable drought, according to Brett Smith, managing director of client management for the real estate capital markets business at Charlotte, N.C.-based Wachovia Securities. In a special report on the state of the hotel industry following the Sept. 11 terrorist attacks, NREI reported in its November issue that tighter lending standards have put new hotel construction on the back burner. The shaky economy also caused Irving, Texas-based FelCOR Lodging Trust Inc. to cancel its planned acquisition of Washington, D.C.-based Meristar Hospitality Corp.

However, Smith expects 2002 to be active. Low interest rates are spurring refinancing, and CMBS origination volume is surprisingly strong, he said. “Even with more scrutiny and tighter underwriting standards, a lot of volume is being pushed through the system. But the quality of the real estate is better; it's limited to the four major food groups,” said Smith, referring to office, industrial, retail and multifamily sectors.

Smith estimates the Wachovia Securities' CMBS origination in 2002 will exceed 2001 levels by 10% to 20%. This growth will be fueled by low interest rates. “There are good, quality transactions that need financing and owner/operators want to take advantage of low interest rates and lock it up for 10 years,” Smith said. “There are fewer people chasing those transactions today. Most people in the market are experts. There aren't a lot of novices out there.”


With loan-to-value ratios and leverage in general declining, developers and owners are increasingly turning to mezzanine financing, a relatively new capital-raising tool that came to prominence along with CMBS in the 1990s. Even in the economic doldrums of October and November, Capital Trust, the nation's biggest mezzanine lender, completed five deals worth a bit more than $100 million, noted Shugrue of Capital Trust.

In just a few years, mezzanine financing has become a significant source of capital in the real estate industry. In a report this summer, Prudential Real Estate Investors analysts Randy Anderson, Phillip Conner and Youguo Liang estimate that 10% to 15% of the nation's $4.5 trillion property market includes mezzanine financing as part of its capital structure.

On average, they estimate the mezzanine component of the capital structure represents between 15% and 20% of the property value. That means the total size of the mezzanine market is between $65 billion and $135 billion. The Prudential analysts further estimate that annual mezzanine originations going forward will be in the range of $13 billion to $27 billion.

That's a big business. Mezzanine financing, which carries a relatively high risk for the lender, fills the gap between equity — the most expensive money in a deal — and senior debt, the least expensive money. Lenders expect an internal rate of return on mezzanine loans to range between 18% and 25%. As borrowers encounter declining loan-to-value ratios, the liquidity crunch has created more of a need for “mezz strips.”

“We're seeing this in the refinancing market,” said Wachovia's Smith. “People can't pull out as much liquidity as they want on a first-mortgage basis, so they go to the ‘mezz’ market. Even at a solid yield for the mezz lender, there are still attractive levels of financing for the owner/operator, and it's certainly cheaper than equity.”

Mezzanine financing also serves as a useful tool to bring a property back to a more typical level of leverage. For example, Kushner Cos. of Florham Park, N.J., is mulling an acquisition of a property with a low loan-to-value ratio and an existing first mortgage that is prohibitive to finance, according to Reichek.

Kushner, which owns and manages more than 22,000 apartment units and manages more than 3 million sq. ft. of office, industrial and retail space, wants to put a substantial sum into improving the building. So, Kushner plans to buy the property using mezzanine financing and subsequently invest almost 20% of the purchase price to spruce up the lobby and hallways and add a health club. Kushner figures that in a few years, when the property stabilizes at an expected higher rental income, it'll be able to refinance the first mortgage and the mezzanine loan with traditional long-term financing, according to Reichek.

While current economic conditions favor mezzanine financing, the evolution of real estate finance also will fuel long-term growth in this type of lending. Shugrue noted that mezzanine financing is an example of the real estate industry's adoption of fundamentals and instruments that have long been employed in corporate finance. In the case of mezzanine lending and CMBS securitization, these are tools that price capital based on the risk involved, Shugrue said.

A CMBS is essentially a bond composed of numerous commercial mortgage loans. The bonds are sold in chunks, or tranches, based on risk. CMBS originators typically do not want to package loans that are below investment-grade quality, Shugrue said.

Conservative institutions such as life insurance companies can then buy the investment-grade parts of the CMBS, while more active, less risk-averse investors will buy bonds comprised of the mezzanine loans. Mezzanine investments are attractive to certain investors because they have claims that are subordinate to senior lenders but have priority over equity investors.

Taking the pulse of equity markets

In a scary market, the legally mandated dividends paid by REITs are a comfort to investors, said Bill Camp, a REIT analyst at the securities firm A.G. Edwards in St. Louis. That has helped stabilize REIT stock prices at a time when yields are scarce in the bond markets. REIT stock prices held up reasonably well even as the overall markets took a licking through most of 2001.

The combined market value of 183 publicly traded REITs as of Nov. 1 was $144.1 billion, compared with $138.7 billion a year before and $124.3 billion in 1999, according to NAREIT. This increase in market value proves that REITs have recovered from the rude treatment from investors during the stock market boom of 1999 and early 2000, when substantial capital flowed to sexier industries such as technology.

So with decent stock prices, REITs can sell stock in certain circumstances. However, REITs issuing shares need to use the capital to generate increases in earnings and shareholder value reasonably quickly, through such activities as repaying debt or increasing funding for the development pipeline.

“If there is a very compelling investment to deploy capital into, it might make sense to issue stock,” said Dorigan of CarrAmerica. “But you would need a ready and compelling use of the capital.”

In fact, CarrAmerica has been buying back shares, rather than selling. The company has repurchased some $250 million of its stock over the 18 months through September. Some REITs have completed secondary share offerings, but there hasn't been a REIT initial public offering since 1999, according to NAREIT.

Houston-based Weingarten Realty Investors, which builds and owns retail centers, raised $299 million through three equity offerings in January, May and November. The share price was higher in each successive offering. The company is using all the money to pay down debt, according to Securities and Exchange Commission filings.

Vornado Realty Trust, a diversified REIT based in New York, sold 9.8 million shares at $38.59 a share in November, raising $378 million. All told, through Oct. 31, REITs completed 42 offerings of common shares, raising $2.79 billion, and 18 preferred share offerings, totaling $1.72 billion, according to statistics from NAREIT. That's more than REITs raised via equity offerings in the same period of 2000, but it's down 30% from the same period of 1999 and down 77% from the corresponding period in 1998.

Privately held real estate investors increasingly are seeking to place their equity in a particular company rather than a specific project, said Fioretti of Mountain Funding. Private developers and owners need the money to grow, but generally they prefer not to have to approach smaller equity investors — such as wealthy individuals — for repeated, small infusions of capital.

For instance, in the fourth quarter, Mountain Funding invested equity in a home builder that generates about $20 million a year in sales. The home-building company needs the capital to achieve its plan to grow revenues to $75 million to $100 million in three to five years. Mountain Funding is also putting capital into larger companies.Fioretti said it recently invested in a firm that controls $2 billion in real estate to help that firm's principals expand the company and roll its portfolio into a REIT.

“That's what the market's looking for right now,” Fioretti said. “You wouldn't believe how many companies have come to us and said, ‘We need an equity infusion into our company.’”

Charles Davidson is an Atlanta-based writer

Lending by the Numbers

MBA Commercial Mortgage Banker Origination Survey
(For period covering third-quarter 2001)
Originations by Investor Type # Loans Amount
Avg. Size
Life insurance company 520 4,774,868 9,182
Fannie Mae 401 2,952,203 7,362
Conduit 282 4,679,299 16,593
Other 234 2,881,522 12,314
Freddie Mac 160 1,536,321 9,602
Commercial bank 141 1,182,630 8,387
FHA 91 478,183 5,255
Credit company 20 150,241 7,512
Pension fund 8 21,221 2,653
TOTAL 1,857 18,656,487 10,047
Originations by Property Type
Multifamily 855 8,358,888 9,776
Office building 298 4,281,381 14,367
Retail 261 1,820,063 6,973
Other 189 2,225,331 11,774
Industrial 188 1,181,862 6,287
Health Care 41 269,454 6,572
Hotel/motel 25 519,508 20,780
TOTAL 1,857 18,656,487 10,047
— Source: Mortgage Bankers Association

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