Over the Rainbow: Wall Street's future course

Our panel of experts meets in the Rainbow Room high above New York to discuss the The Street and its future.

Editor's Note: Recently we brought together a few of Wall Street's major players over lunch in the renowned Rainbow Room high atop the GE Building in Midtown Manhattan. The topic of discussion: How much has Wall Street influenced capital flows to the nation's commercial real estate market and what will be the extent of its future participation? Here is what our panelists had to say.

NREI: Is it a great time to be a borrower?

Paul McDowell: Absolutely. Capital Lease Funding does credit net lease finance, and that type of real estate is obviously some of the best real estate around. So the competition Frank (Keane) and I were talking about just a few minutes ago has gotten ferocious in the past couple of months. Real estate borrowers are particularly adept at playing lenders off one against the other.

If you're a borrower right now and you can't find a loan, then you've got something seriously wrong with your ability to access capital. It's there for every property type in abundance.

Greg Spevok: It's been at least 10 years since it's been this good for the borrower. You have to go back to the go-go days of the S&Ls to come near what it is today. It's also interesting that the borrowers are so much smarter than they were just a couple of years ago. They know the capital providers, they know all of the capital structures all of the various capital providers are able to give them, and they're shopping themselves, which is a little bit different than it used to be. They are aggressively shopping their own transactions. Maybe Internet access has fostered that. We've really perceived a big difference in borrower sophistication even over the last year I'd say.

Frank Keane: I agree with that. I think lenders are falling over each other trying to put money out. I think from the borrower's perspective, not only can you get cheap financing and high loan-to-value ratio financing, but also there is greater flexibility in the types of financing you can get vs. three or four years ago -- preferred equity programs, bridge financing. The underwriting hasn't slipped to the level that it was in the '80s, but certainly it's gotten more aggressive. The impact is most notable on the pricing. I'd like to be a borrower for sure (laughter).

Barry Lefkowitz: As a borrower, I would agree (laughter). As a borrower I think we're seeing a combination of two things. No. 1, we're seeing a great deal of capital available in the lending community to finance the kinds of things that we're doing, whether it be conventional mortgage financing or the other types of financing that are available to the larger capitalized public companies such as ourselves. The lenders to a certain extent are coming at us and actually seeking us out and are very accommodative in all respects of providing money to us.

I think in terms of credit criteria, they still are maintaining a fair sense of credit criteria in terms of what they'll underwrite and what they'll do. Which is a good thing. At this point in time, a lot of the people that are doing these things are lenders who went through the downturn, and I think it was a very worthwhile experience for everybody. It gives people a chance to understand what caused those failures and what caused those problems and how to structure around them. Right now I think we're at a pretty good balance in terms of the type of terms we can get. They're fair to lenders and they're fair to borrowers.

Richard Schoninger: I think it's a good time for borrowers, but I think it's a good time for lenders. The industry is a lot healthier, the industry's balance sheet has a lot more equity in it than it had in the past, and lenders have a much easier time on many loans accessing the information. Certainly on any loan for a public company, the cost of accessing information and the cost of maintaining adequate information on properties is much easier. You have the FTC and public regulators are doing a lot of your work, and the press and research community are a watchdog as well, and the rating agencies. I think we're all benefiting from this liquidity that securitization has given both the equity and the debt markets and it makes it easier to do our job, it makes it easier to evaluate and with that comes competition of course.

I think the one place where the borrowers are getting squeezed and aren't getting the benefit of the doubt is in the public markets with the rating agencies. There still is a fair degree of paranoia among the rating agencies in evaluating corporate debt on the REITs, for example, and I think we see many cases a BBB-rated company with all of the characteristics of an A-rated company or something like that, but it's certainly gotten better over the last couple of years. We still see some pretty interesting opportunities, and as an investor, which is the third piece of this borrower/lender/investor, buying below-investment grade corporate debt on some pretty exciting real estate. So I think it's a good time for all, and hopefully the markets won't get overbuilt and hopefully all this rapid information where capital can be turned on and turned off a lot faster and quicker because that's the way Wall Street thinks and lives, hopefully that capital when things get overbuilt in a part of the country or in an asset class, will keep down the real extremes of downturns we've seen in the past.

NREI: Aren't most of the Wall Street firms broadening their services, trying to be more things to more people?

McDowell: We saw the marketplace underwriting loans several years ago really as primarily real estate loans and because of the quality of the leases as opposed to the credit quality of the tenant. So we thought that if we could somehow enhance the leases to make them look a lot more like bonds then the focus would shift from the real estate to the credit quality of the tenant. So we do investment-grade credit tenants, so the idea is to try to convince the rating agencies and to get investors to understand that once we put our structures around it, what they're really looking at is the cashflow of the Wal-Mart or the Walgreens, and that the real estate is a secondary, although important, security for the loan. The key security is the credit of the tenant on its lease and that mortgage is there in the event that you've got to do a prearrangement for the bankruptcy of the credit tenant. We do self-amortizing loans, so clearly over time, the real estate becomes more and more powerful and you have to worry less and less about the ability of the credit tenant to make its lease payment because it's ultimately covered.

Spevok: I think vertical integration is the key to long-term success if you're going to be a big player in this business. On the debt side, we're part of the fixed-income desk at Bear Stearns. It's the largest fixed-income desk on Wall Street, and the debt business and real estate finance is an extension of that desk. We actually keep the investment banking side of real estate somewhat separate from the debt side, but there is constant cross-pollination across referrals for the lenders to that vertical integration. As an add-on to that, commercial real estate finance today and the securitization of these bonds mirrors what has happened over the past 15 years or so on the residential mortgage-backed securities side. A few firms started out securitizing pools of mortgages and eventually a few will come to dominate.

Keane: What we began to do 14 months ago when we set up shop at Daiwa was to recognize the product lines encroached upon by all of the major players very quickly. So credit lease funding was a necessary product type 12 months ago and now Wall Street and a lot of other firms are jumping on the bandwagon. Daiwa is focusing on the below-investment grade corporate credits to do exactly what Paul's doing, and that's because it's still a relatively untouched frontier and still requires certain elements to do that type of financing. But increasingly we're seeing the product types becoming commoditized and hence it's no longer necessarily a Wall Street type of business. The First Unions and NationsBanks and Wells Fargos of the world are taking the business away.

I would describe what we do as finding below-the-radar-screen types of products, exploiting them and recognizing that six months or 12 months from now even, they may no longer have the margins that they have today. We're a pretty small group and we intend to stay that way.

NREI: You have a new small-loan program where you're stressing quick turnaround...

Keane: That's exactly what we're getting at. That's an active market that was relatively untouched, the below-$1.5 million, primarily multifamily loans. In order to prosper in that business, you have to make an extremely quick and uncomplicated closing process. What we did was design a computer-driven underwriting package that's Fannie Mae-friendly and rating agency friendly. But that's exactly the kind of business we're talking about -- low-cost third-party documents, the whole thing for under $5,000. You have to do hundreds of these types of loans to make it profitable. It's a little different, a little funkier, and there's margin in the business, but we're recognizing that it won't be there forever.

NREI: Barry, how is life as a REIT today? And how did you get involved in the office market?

Lefkowitz: Originally we were a developer of office buildings. The biggest hurdle that we had to get over was whether we were going to be able to be an acquirer because traditionally we had never been an acquirer of product. If you look at where we stand today, we're at about 128 buildings, 11.8 million sq. ft. vs. 12 buildings and 2.2 million sq. ft. Over the last two years I think we've dispelled that rumor.

NREI: What kinds of financing have you needed or demanded from the Wall Street players?

Lefkowitz: One of the things that we did when we went public, we did a single-issuer, stand-alone REMIC securitization simultaneously with the equity raise that we did. That's a credit to Richard's (Schoninger) organization for pulling it off. It was kind of a novel financing. It was $144.5 million worth of real estate bonds rated from A down to BB. We took the A-pieces and sold them to the public for about $70 million and $74.5 million we kept. Prudential monetized those for us which allowed us to drive the acquisition process after we went public. We knew that it would be easier to obtain a credit facility then (August 1994) when we were the last guys through and everybody thought the REITs were not going to continue. So we said if we had bonds rather than trying to get mortgages on the various different assets, we could probably more easily monetize those which was exactly the case.

NREI: Richard, what is Prudential's niche, and how important are relationships these days in growing the business?

Schoninger: I agree with the comment that you kind of have to do it all over at least the middle term to be a strong survivor on Wall Street in this business. And we're trying to do it all. But we limit ourselves to the real estate securities business. What we get up every day to do is to create public relationships so that we can offer advice, offer debt and make equity for those relationships. That's what our mindset is. So we love to use our capital as bridge capital to help a company go from a private company to a public company, and because we have a pretty large equity distribution force, we've been third or fourth in REITs every year for the last few years in equity distribution, and we have two conduits, one with our parent and one where we're an equity partner in National Realty Funding which is a successor to our relationship with Midland. We have multiple exit strategies, so we will be aggressive on a bridge basis in order to help a company bulk up or have the characteristics to succeed in the public markets.

It's hard to find a better banking business than banking for public REITs. Their appetite for debt and equity capital is probably unmatched among all industries having to do with the high dividend payout ratios and their incredible growth rates. So it's very relationship oriented whereas a lot of other fine firms on Wall Street will look to the collateral of the property in making their underwriting decisions. We obviously have to do that, but we are very relationship focused. We're also differently structured, with most firms operating with separate debt and equity departments. The group I run is totally integrated, it does all of the equity, debt, financial advisory and M&A work for real estate company. There's only one side and only one P&L. In fact we also provide the real estate principal capital through Prudential Securities so it's fully integrated to try to grow and develop real estate bankers as opposed to product bankers, again to focus on what their client needs.

NREI: Everybody's doing conduits, but are they going to be around for a long time?

McDowell: I don't know if they're going to be around forever, but clearly they have an established niche in connecting the borrower to the capital markets. They seem to be the most efficient way to connect the two, so I don't see them going away in the near future. I think the smart money sees this as a trend that will only continue to grow. I think probably the number of players may contract because it's getting to be a commodity business, spreads are tight, you've got to be willing to absorb a pretty low margin and it's certainly in the credit lease area. So I think you'll see a bunch of players drop out, but as far as the volume of product moving through it, I think that's only going to increase in the years ahead.

NREI: What kind of deal do you have with NationsBank and why did you hook up?

McDowell: When we were looking around for long-term players as sources of capital for us to make loans, we thought that commercial banks were well suited to do that and NationsBank particularly as a very large construction lender and as a bank that's used to making commercial real estate loans, because for us, the velocity of originations is the most important thing, and one of the key things that helps the velocity of originations is the ability to get these loans through application and then closed in the shortest period of time possible.

I'm an issuer, so we've got no desire to have slack underwriting and then have loans go bad in a pool in six months.

NREI: The investors will come calling...

McDowell: That's exactly right. So we've got a lot of incentives to try to keep our underwriting pretty stiff. Going back to the question, NationsBank and commercial banks are used to flow funding loans rapidly. They're used to commercial real estate loans, they're not afraid of commercial real estate necessarily, and they are also used to operating on margins that some of the bigger investment banks are not as used to operating on. We thought that it was a good fit for us. We try to keep our operating overhead pretty low. They've got the capital and they've got the desire to stay in the business long term.

Spevok: I think that it's a certainty that for as long as one can reasonably forecast, securitized lending will continue to grow. Institutional investors demand these bonds, they're lining up to buy them. Still, there will be blips along the way. The real estate cycle will turn at some point, there will be some fallout from some firm from some bond that goes bad, it will cause a blip in the market, there will be a temporary short spike in rates. And then the beauty of this Wall Street process is that it will react very quickly to re-price. When that scenario happens, I think a lot of the smaller, middling players in securitized lending will inevitably be squeezed out. The cost of capital is relatively higher to the major fixed-income houses and unless you're doing something on the order of $1 billion a year it's going to be very hard to maintain the efficiencies necessary as prices continue to come down. Not everyone's going to have the staying power as these spreads tighten. Only these houses with very large fixed-income desks will have the ability to make money on very thin margins.

NREI: Where is the strike point where Wall Street says it's not worth the time and effort to do this anymore?

Spevok: Some firms who see this as a tangential business will exit, but I think those that are big in it now and who are getting bigger will stay in it.

Keane: I concur with most of what's been said. When we see the commercial banks getting the kinds of loans they are now, you know the product is being commoditized. The fixed-income distribution component of conduits dictates that we will always see a significant number of Wall Street players in the business. You have to have them there.

NREI: But will they be strictly distributors of product or will they continue to work on originations?

Keane: I think the two are integrated. There are innovative technologies that require you to have Wall Street involved. Having said that, the current spreads that are being achieved and the current margins that are being achieved also dictate that you can't have the number of players in the business that you currently have. I concur with Greg that only the serious Wall Street firms will be here. In fact we're seeing some of them right now buying the business, buying marketshare, doing business on terms that don't have the margins to justify them. I think you're going to see half the players you see today a year from now. The margins can't really get any lower than they are.

McDowell: That's what we said last month (laughter).

Keane: The pace of change over the last 12 months has been incredible.

McDowell: You go to all of these conferences and the conduits sit up there and say, 'We will not be underbid by anybody,' while the borrowers sit there counting the money.

Spevok: The short-term problem for the securitized lenders is that they're beating each other up on price, and some of them are not doing a good job distinguishing themselves in the marketplace with competitive advantages. You mentioned the small loan programs that you offer and that's a real competitive advantage that Daiwa has. It's not that it's a niche of product, it's a niche of process. That's how we sell ourselves. We try and differentiate among our mortgage banking clients the attributes of the service aspects we deliver. You can't keep beating each other up on price, that's a no-win situation for anyone.

Keane: That's why you're also seeing growth in bridge-loan lending on Wall Street.

Schoninger: There is multiples more competition on the debt side than there is on the equity side. Actually it's a warning sign. Now the margins are still big enough from our views that everyone's making a lot of money. But we expect that to change real quickly. There is huge infrastructure that's been set up on Wall Street, and we're all entrepreneurial and we want to work hard and get paid based on our bottom line and people don't want to sit on their hands. We see it in other businesses in the past, a huge effort to maintain an infrastructure if you're the managers of that infrastructure. As margins shrink you have to move to other businesses or adjacent businesses often with more risk. Right now everything's great, but if there are 15 people in the business and there are seven or eight survivors, nobody's going to go down easy and there's a lot of infrastructure that they're going to try to protect.

NREI: Why is there so much partnering on deals?

Schoninger: We're being paid to team up, for greater size of deals, adding to greater liquidity and smaller spreads. The economics at this point are pretty significant to team up with people who are your competitors.

NREI: The deal sizes have been driven up, with $1 billion being the new benchmark.

McDowell: There has to be some level of diminishing return there. I mean everyone's got their fixed overhead, which obviously the bigger the deal is the more profitable it is. You've got to pay lawyers only one time and it's spread over more loans. So that's obviously a big advantage. But there will come a point where it's diminishing returns. It's not going to be increasing forever. In two years I don't think the regular pool size will be $2 billion. I think you're getting up to the level now where they make economic sense.

Keane: We just did a deal with Merrill Lynch and GE Capital, a co-managed deal. The game plan was to try to get to $1 billion. We were just shy of that at $850 million collectively. That's ($1 billion) the strike point. The perception is once you get to $1 billion there is benefit to the rating agencies for subordination levels and its benefits on the execution and distribution side. But there's also a demand by the investors these days for more than one investment bank to be behind a deal in the aftermarket. That's one of the reasons you're seeing more than one investment bank on these deals.

Schoninger: But the bottom line is that we're being paid to do it. We have $600 million in loans right now. We like to lead vs. co for sure, like anyone else does. But we're thinking about it (partnering) seriously because you can make another point on $600 million by turning it into $1.1 billion or $1.2 billion. Maybe it's more, but it's $7 million or $8 million.

NREI: The major commercial banks in the business -- Wells Fargo, NationsBank, First Union, Chase, Citibank -- may see revised rules from Congress for new ways of getting into your businesses. What impact will that have?

McDowell: In commercial mortgage finance, they're already there. To the extent that they can move into equities, I suppose that will broaden their abilities.

Schoninger: Those things take a long time. How does it affect our CMBS business? I'm not sure because it takes so long to integrate. Bankers Trust buying Alex. Brown, it takes a while to integrate on the equity side and by that time I don't even know what happens to spreads on the conduit side or the CMBS side. Is it a business that will look exciting to them?

The thing that I worry about is looking at the commercial banks as our competitors. They have an incredible amount of capital and this is a capital game in many cases. That obviously concerns us when we look long term.

Maybe what we're all saying is at some point we'll recognize that it's going to mature, and there will be some bloodiness among the Wall Street firms as it enters another cycle.

Frank Keane, Managing Director - Commercial Mortgage, Daiwa Securities; Barry Lefkowitz, COO, Cali Realty Corp.; Paul McDowell, Vice President, Capital Lease Funding; Richard Schoninger, Managing Director - Real Estate, Prudential Securities; Greg Spevok, Vice President, Bear Stearns

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