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Let's Make A Deal

Lehman Brothers offers high-leverage debt deals and a host of other products.

The commercial real estate business at Lehman Brothers may not be set up as a separate subsidiary or have a different name or even a floor to itself in Lehman's Wall Street headquarters, but the company does a tremendous amount of real estate business. It also does a great deal of transactions in retail -- a segment of the market that should get even more attention from Lehman this year.

"Retail is clearly one of the key real estate areas in which we will be increasing our activities in 1998," says Mark Walsh, a managing director. The company already dominates common stock issuance in the regional mall sector with five deals totaling almost $500 million over the past three years.

In 1997, Lehman funded more than $12 billion of commercial mortgages, including $3.6 billion of conduits, $1.6 billion of large fixed-rate loans, $1.1 billion of floating-rate term loans, $3.5 billion of floating-rate interim loans and $2.6 billion in lines of credit. With $21 billion in lead managed transactions last year, the firm has been the No. 1 underwriter of commercial mortgage-backed securities for four years running.

And, according to Commercial Mortgage Alert, the newsletter that tracks CMBS activity, Lehman was the third largest conduit securitizer in 1997 with $1.882 billion in deals and the second largest conduit/large loan program securitizer with $3.308 billion.

A hub in the middle of a wheelAs a firm, Lehman Brothers chose to organize into three global areas: fixed income, equity and investment banking. Real estate is one sector that lends itself to all three disciplines.

Lehman's real estate activities fall under the bailiwick of three longtime managing directors. Ray Miklulich, for the most part, handles "traditional" investment banking functions, client relationships and product origination; Michael Mazzei takes care of commercial mortgage-backed securities; and Walsh heads up the Principal Transaction Group, which involves high-leverage debt deals and some equity investments. The lines between the three are for the most part transparent.

"Lehman bankers are like a hub in the middle of a wheel. They can pull things from the menu that are appropriate to any client at any given time," says Miklulich. "Equity, mortgage debt, high-yield mortgage debt, high-yield unsecured debt, corporate bonds, lines of credit or bank loans."

Lehman also is a major financial adviser in merger and acquisition activity, both overall around the world and within the real estate sector. Among the major real estate transactions it advised on last year were the $1.8 billion acquisition of PHH Corp. by HFS Inc., the $906 million merger of Horizon Group and Prime Group Realty Trust, the $622 million sale of Associated Capital Properties to Highwoods Properties, and the $570 million purchase of RF&P Corp. by LF Strategic Realty Investor L.P.

Distressed debt, high leverage To be successful in the commercial real estate business, financial companies need to be fast afoot, since the market is in a constant state of flux. Lehman's Principal Transaction Group is a good example of Wall Street making market adjustments.

The group got its start five years ago when Lehman purchased $2 billion worth of distressed debt from Westinghouse for $1 billion. Eventually, Lehman acquired more than $12 billion of distressed debt. Most of that has already been recapitalized and repackaged into CMBS at a significant profit to the firm.

Prudent risks in the distressed debt business, however, are scarce, so the Principal Transaction Group figured the next real opportunity would be in operational plays. Lehman is not a real estate operator, but it does in effect improve distressed assets by financing and recapitalizing them.

"This has proven to be a very successful business for us," Walsh says."We are making loans to sponsors who are buying real estate, improving the real estate and selling it. At initiation, these are high-leveraged loans, but when sponsors execute their plans, they are being refinanced through long-term, fixed-rate deals or by selling the asset to a REIT."

This type of deal is part of Lehman's high-leverage debt program. It can be best understood in a $50 million deal Lehman did with a sponsor who wanted to buy six Incredible Universe stores, which were closed when the Tandy Corp. shut down its nationwide chain.

These were large stores, but the sponsor already presold and preleased some of the sites. In one case, he leased a store to Sears; for another unit, he was selling it to a developer who wanted to transform the location into a telemarketing center. "We really made the loan knowing the sponsor cinched his exit strategy," Walsh says.

"In this era of retailing where retail itself is evolving," he says, "good sponsors are redeploying retail properties in the United States for better uses."

Lehman does not do high-leverage debt for deals less than $5 million, but the topside is almost unlimited. "If a deal came in that was $300 million, depending on the characteristics, we would consider it," says Walsh. "If it was a complete turnaround situation, even though the deal might be a little large, we would take a look."

One-stop shopping Last year, Lehman did about $2 billion of high-leveraged real estate debt deals, which was up from the year before. It is expensive capital, so why come to Lehman for it? The answer: higher leverage.

At a commercial bank, a sponsor may get only about 60 percent to 65 percent of the asset value, but with Lehman's program, the sponsor can get upward of 90 percent. So instead of having to raise equity from numerous sources, which is costly and time-consuming, he can do it one place. The sponsor still must raise equity, but he can get much of it in one-stop shopping -- senior and mezzanine financing in one loan.

While these loans may look risky, Lehman reports that in over 95 percent of the deals, sponsors have executed their plans. "The loans are lucrative and we are well into the money," Walsh notes.

The Principal Transaction Group also does equity investing in real estate, often in conjunction with a combination of senior and mezzanine debt. Recently, Lehman purchased and then sold the landmark building at One Times Square in New York, a major retail building with significant external signage -- including the famous ball atop the building that drops every New Year's Eve.

While equity is an important product, Walsh doubts that Lehman will boost this financing tool very much next year. "I would be happy if we kept close to what we did last year, but that may be hard given the cycle," he says. "The real estate market is getting choppy. We have to continue to be careful and align ourselves with good sponsors."

On the corporate side of equity, Lehman is among the world's largest underwriters of equity and equity-related offerings, including IPOs, secondary, block trades and convertible securities. Last year, Lehman raised $13 billion in more than 100 equity transactions. On the real estate end, the company ranked second as the lead manager of real estate equity issuance.

Lehman helped raise capital for such companies as: Arden Realty, $359 million; Bedford Property Investors, $222 million; Berkshire Realty Co., $110 million; Capital Senior Housing, $140 million; CapStar Hotel Co., $563 million; General Growth Properties, $150 million; Great Lakes REIT, $102 million, Innkeepers USA Trust, $144 million; Liberty Property Trust, $437 million; Pennsylvania REIT, $103 million; and Prentiss Property Trust, $320 million.

'Deal of the Year' The real estate sector where Lehman has made perhaps the most dramatic impact is in CMBS. As the No. 1 underwriter of CMBS for the past four years with a total of $17 billion in issuances from 1994-97, the company last year held almost 25 percent of the market with $5.6 billion in issuances.

Every year, Lehman does at least one landmark transaction. In 1996, it was the $1.9 billion Confederation Life transaction, the CSSA and Institutional Investor's Deal of the Year. Last year, it was the $1.4 billion Lehman Brothers 1997-LL I securitization, the largest loan transaction and another Deal of the Year.

In 1997, Lehman also did a joint conduit transaction with First Union that brought to market a $2.24 billion securitization. (Lehman contributed approximately $1.1 billion to the pool.) Lehman expects conduit originations to continue to be a larger component of CMBS, as banks consolidate and do less and less direct real estate lending.

Walsh credits his firm with being a longtime leader in real estate, and is proud of Lehman's wide range of debt and equity product offerings. "For a mid-cap real estate company with a number of different strategic and financial goals," he says, "Lehman is almost the only one that can offer one-stop shopping.

"Steve Bergsman is a Mesa Ariz.-based freelance writer.

One area of real estate that has attracted Lehman's attention is retail, despite the fact that it has less "sex appeal" than other forms of property.

"The highs and lows of retailing are not that drastic," says Michael DeMarco, a Lehman senior vice president. "In comparison, the highs and lows in office building are somewhere between exuberance and catastrophic. We believe retail is a great sector to represent in either raising equity capital or providing debt capital."

>From Lehman's point of view, retail is an exciting place to be, says DeMarco. "The department store chains are all doing well, and discounters have come back. Retailers today are leaner, healthier and more driven toward serving the consumer needs.

"Lehman has done much financing in this sector, adds Ray Miklulich, a Lehman managing director. "A lot of regional malls are still held by pension funds through advisers, but consolidation will continue. Growth in malls and shopping centers isn't as dramatic as in other sectors, so people are going to find they are better off selling those assets to companies that are successful."

Lehman generally eschews working with big department-store chains, preferring to deal with mid-size owners of real estate who are acquiring and repositioning assets.

Mark Walsh, a Lehman managing director, notes that many investors shy away from retail because ill-conceived properties can be almost worthless.

"There are many opportunities out there to buy underperforming retail from people who failed in their execution," he says. "The challenge is to find the sponsor who has a better plan. They all think they do, but you can't be sure."

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