When the price is right

These days, money is doing a delicate dance where commercial real estate is concerned. The slowing economy has pinched many an investor, and with it, many new development plans have been scotched.

But surprisingly, real estate is weathering the storm nicely. Unlike the early-1990s depression, supply and demand have remained fairly well in check across most property types; and the free-flowing capital supply that was so prevalent then isn't around now to exacerbate the slowdown.

Another telling sign of the times: REITs are back. The predominant perception last year was that REITs were dead, but what a difference a few quarters can make. REITs are now issuing millions in new debt for the first time in years, and their merging mentality will create new monied players in the years ahead.

And then there's the commercial mortgage-backed securities (CMBS) market. It, too, was all but given up for lost in 2000. Things really weren't so bad, and this year is looking at least the same, if not a bit better.

Still, there is reason to tread carefully. Perhaps New York-based Ernst & Young sounded the note of caution best in its annual update on the CMBS market: “The most pressing issue on everyone's mind is the imminent end of the good times in real estate, the inevitable down cycle that may finally be upon us. Excruciating diligence in underwriting commercial mortgages has never been more appropriate.”

Key trends: debt vs. equity

Stacey Berger, executive vice president in the Washington, D.C., office of Midland Loan Services, believes three key debt trends are driving the capital markets today.

“First,” he said, “the CMBS market continues to expand, offering the most attractive alternative for long-term, fixed-rate, non-recourse debt. Second, despite competitive pressures of a slowing economy, loan underwriting has actually remained quite conservative. And lastly, we have seen more sources of mezzanine and bridge capital through the first half of the year, with lenders looking to bridge the gap between debt and equity.”

Youguo Liang, managing director at Parsippany, N.J.-based Prudential Real Estate Investors, agrees that the debt players are in the driver's seat. But even with improved debt-market discipline and better information flows from the property and capital markets, the slowing economy increases the risk today that capital availability, primarily through the debt markets, will become overly constrained.

“The CMBS market continues to expand, offering the most attractive alternative for long-term, fixed-rate, non-recourse debt.”
— Stacey Berger Midland Loan Services

“Debt-capital providers have become even more conservative as conditions in the corporate credit market have deteriorated with the weakening economy,” Liang said. “Loan-to-value ratios have been falling since the mid-1990s, and lenders have become more selective in the terms they are willing to offer borrowers and the property types against which they are willing to lend.”

If providers turn off the cash spigots, a liquidity crisis would rain down. But it also would increase the opportunity for alternative capital sources, including mezzanine financing, to fill the capital market void, just as the public equity market did in the early 1990s when REITs began their explosive growth.

Thomas Jaekel, managing director in charge of Chicago-based Cohen Financial's merchant banking unit, sees plenty of volatility in both the debt and equity markets right now. “On the debt side, the traditional yield curve was inverted during the first quarter, with 10-Year Treasuries below short-term interest rates,” Jaekel said. “This inversion led to an increase in long-term, fixed-rate financing.” In fact, about 70% of Cohen Financial's first-quarter business was fixed rate, as opposed to 40% fixed and 60% floating for 2000. Jaekel expects the recent interest-rate reductions to keep short-term rates lower, and with them, the shift back to more floating-rate transactions.

Gaylord L. Toft, managing director of investment services at Chicago-based Transwestern Commercial Services, says floating-rate debt has already started to gain popularity.

In many cases, despite the historically low cost of long-term, fixed-rate debt, borrowers have been opting for floating-rate debt since either they expect rates to continue to fall, or they hope not to be borrowers for long, Toft said.

“They opt for the flexibility of pre-payable debt, avoiding the potential for penalties with long-term, fixed-rate borrowing, due to yield maintenance requirements, often planning to return to the equity or for-sale market in the near future, with the hope that equity demand and prices will soon turn up,” Toft explained. “Or they wish to be able to convey assumable, pre-payable debt, which will grant any potential buyer flexibility, so that debt will not represent an impediment to any future equity deal.”

Property owners, however, are acting a bit differently. “Many users of capital are not sellers and are locking in long-term interest rates to capitalize on the ready availability of historically low-price debt,” Toft said. “With debt rates significantly below equity rates, borrowing currently is attractive because of the readily available effects of positive leverage on equity returns. Even though some lenders may be adjusting their property valuations downward due to their perceptions of rising cap rates — thus reducing potential debt proceeds — debt capital still remains plentiful. As long as sources of capital have ready supplies at acceptable prices, users of capital will at least have options.”

“Debt-capital providers have become even more conservative as conditions in the corporate credit market have deteriorated with the weakening economy.”
— Youguo Liang Prudential Real Estate Investors

On the equity side, it's fluctuation time. “Many equity players are hesitant to commit in the current market, given the uncertainty surrounding property values,” Jaekel said. “Rental rates are the key determinant for values, and there's been a significant slowdown in leasing activity in the first quarter. If tenants begin to regain their confidence and sign new leases, equity dollars will return. If not, equity will remain on the sidelines,” according to Jaekel.

So far though, the worries haven't been enough to keep the equity floodgates from flowing. “We've seen approximately $2 billion raised over the past six months,” said Jacques Brand, managing director and head of real estate investment banking at Deutsche Banc Alex. Brown, New York. “Overall, the performance has been fairly strong. Retail investors are seeking yield and the non-dedicated equity investors are rotating out of other sectors, such as telecom and technology.”

Brand cites lodging as the best performer in the REIT sector because of the strong cash flows and attractive valuations from a historical perspective.

Healthy merger and acquisition activity — to the tune of some $250 billion over the past three years — also has been in evidence. “The equity markets like consolidation,” Brand said. “We're seeing about one deal per month. The driving factors behind this trend are the desire to increase scale, access to new geographies, ability to acquire high-quality properties and add talented management teams.”

Brand says he's now advising many public companies to go private because they are either too small to go it alone or cannot attract significant institutional investor interest.

Jonathan Kempner, president of Washington, D.C.-based Mortgage Bankers Association of America (MBA), said that investors appear to be giving attention to fixed-income securities, driven by a combination of desire for lower volatility and returns based on dividends or interest payments.

“The result has been a general rebalancing from equity to debt, particularly higher-yielding, real estate-supported debt securities, and a reallocation among the equity sectors toward income-producing stocks,” Kempner said. “The resulting influx of funds should benefit real estate at least through the remainder of 2001.”

Mark Gibson, executive managing director at Houston-based Holliday Fenoglio Fowler, said the significant change in 2001 is where investors' equity is being invested.

“Not only do we expect the momentum markets [New York, Washington, D.C., Boston, San Francisco, etc.] to receive significantly more investment dollars this year, we believe more investors will be searching for consistent cash-on-cash returns, rather than higher returns on opportunistic transactions. In other words, expect a greater emphasis on current returns rather than increases in residual value,” Gibson said.

Last year, Holliday Fenolgio racked up $11 billion in total sales transactions.

Outside influences

Given this landscape, it certainly doesn't appear that investors have shut down their pipelines to any extent. In fact, capital flows into commercial real estate in 2000 eclipsed the previous year by 33.2%, according to national transaction data compiled by the Chicago-based CCIM Institute and Landauer Realty in their joint CCIM/Landauer Investment Trends Quarterly (ITQ) report.

According to the ITQ, investors capped off 2000 with an unprecedented level of spending from September through December. Every region of the country exceeded previous long-term dollar volume averages, and the $27.1 million mean price for all transactions established a new high-water mark since the ITQ was established six years ago.

“As the nation suddenly became more focused on risk, two things happened [in the fourth quarter],” said CCIM Institute President Darbin T. Skeans. “First, real estate was seen as a safer harbor in a period of financial market turmoil. Second, within the real estate sector, investors diversified as a risk-hedging strategy.”

Given this activity, Prudential's Liang cautions long-term investors on the need to understand the increasing influence of non-real estate issues on the availability of capital to the industry, and hence on the pricing of real estate assets. “As the real estate capital markets have become more integrated into the broader capital markets, events that have directly little to do with real estate per se, like the long-term capital crisis and the current economic slowdown — though to a lesser degree — will affect the availability of capital to the sector,” Liang said.

Top capital providers so far

Two major players consistently have provided capital to the commercial real estate arena over the past decade — banks and CMBS. But that appears to be changing, said Cohen Financial's Jaekel. “Interestingly, in early 2001, banks did not increase their commitment. Why not? Banks primarily are short-term floating-rate players, but the market demanded long-term, fixed-rate product due to the yield curve inversion. Therefore, CMBS and life insurance companies would be considered the most active lenders so far this year,” Jaekel said.

“On the debt side, the traditional yield curve was inverted during the first quarter, with 10-Year Treasuries below short-term interest rates. This inversion led to an increase in long-term, fixed-rate financing.”
— Thomas Jaekel Cohen Financial

Jacques Gordon, international director of investment strategy for Chicago-based Jones Lang LaSalle (JLL), cites pension funds and 1031 buyers as the main capital suppliers. “Both have capital to invest and both are highly motivated to close deals,” he said. “For pension funds, real estate was their best-performing asset class last year and they want more of it. Tax-motivated buyers are rolling huge gains made on properties bought between 1991 and 1997. They are highly motivated to close deals and avoid capital gains taxes.”

For its part, the MBA has been compiling its own financing market profile. “Preliminary numbers indicate that commercial banks and thrifts continue to be the largest providers of debt capital for commercial real estate,” Kempner said. The next largest sources of debt financing are CMBS structures and life companies and pension funds, with life companies and pension funds also investing heavily in the investment-grade portions of CMBS.

According to Kempner, Fannie Mae and Freddie Mac were active in the multifamily market, driven by their need to meet HUD low- and moderate-income housing goals. The recent heavy volume of single-family refinancings is probably putting significant pressure on the ability of the two firms to meet their required housing goals, thus making it likely that they will remain active buyers of qualifying multifamily property loans through the end of the year.

As the life companies and pension funds become more directly involved in the business, partnering is another major development that may become more of a trend than a one-off event, particularly as times get tougher for developers in a supply-constricted world. Witness Atlanta-based Post Properties and its recent partnering with the New York State Retirement Fund to own two Atlanta apartment projects worth about $67 million. The company says it will do similar equity deals in the months to come.

Pension funds, though never willing to gamble too heavily on the commercial real estate gambit, have opened their coffers in a bigger way of late. For example, the California Public Employees' Retirement System (CalPERS) has increased its total real estate investment allocation to 8% in 2001 from 6% in 2000. The System also has significant partnerships with real estate firms such as Houston-based Hines and Washington, D.C.-based Carlyle Group.

REITs come bouncing back

Big REIT deals marked the start of 2001, with major marriages in nearly every property segment. First, Chicago-based Equity Office Properties Trust snapped up Menlo Park, Calif.-based Spieker Properties for $4.48 billion plus debt. More recently, Englewood, Colo.-based Archstone Communities Trust purchased Arlington, Va.-based Charles E. Smith Residential Realty in stock for $2.2 billion, and Irving, Texas-based Felcor Lodging Trust bought Washington, D.C.-based MeriStar Hospitality Corp. for $1.1 billion.

“Many users of capital are not sellers and are locking in long-term interest rates to capitalize on the ready availability of historically low-price debt.”
— Gaylord L. Toft Transwestern Commercial Services

Why the consolidation trends? Maybe it has something to do with the future, which Ross Smotrich, managing director at New York-based Bear, Stearns says is a win-win game for REITs.

“On the one hand, if the economy continues to slow or stay soft, REITs should benefit from good, stable cashflows and modest growth in earnings per share,” he said. “As the economy starts to improve, on the other hand, we think real estate fundamentals also will benefit. If the economy does improve, it seems that rents, occupancies and loss-to-lease also will improve. If occupancies go — in whatever market you want to pick — from 98% to 99% down to 94% to 95%, by definition that's not as robust, but it's clearly not the end of the world.”

Without a doubt, REITs had a banner 2000. The Morgan Stanley REIT Index was up 26.8% for the year as a whole, ending with an especially strong 7% total return in December. They've also ticked up so far in 2001. In the first quarter, average REIT earnings rose 7.5% over the same period in 2000, according to the National Association of Real Estate Investment Trusts (NAREIT). “Among equity REITs, the strongest performance was seen amongst the office, mixed industrial/office and specialty sectors, with those REITs reporting double-digit FFO growth per share growth, on average,” said Michael Grupe, NAREIT senior vice president and director or research.

Two recent studies also highlighted the REIT success story. Boston-based AEW Capital Management LP's Spring/Summer REIT Report says REITs will continue to outperform most sectors of the broader equity market over the next 12 to 18 months. The report says that although a great deal has changed in both the economy and the capital markets in a relatively short period, real estate continues to persevere despite softening markets, falling transaction volumes and waning capital.

Michael J. Acton, vice president of AEW Capital Markets and principal author of the report, notes that as the U.S. equities market moved into “bear market” territory during the first quarter of 2001, REITs continued to outperform other investment alternatives. Even though returns have drifted, REITs continue to benefit the investors' broader portfolios.

“Yields are high, correlations and volatility are low and the sector remains under-priced,” Acton said. “REITs are doing what they are supposed to do, which is provide a 10% to 12% return over a reasonably long holding period. We've long held the position that an investment in REITs is an investment in real estate, and the data shows that REITs can bring many of the benefits of commercial real estate investment to theportfolio.”

Released in April 2001, REITs: A Safe Haven in Volatile Financial Markets, by Kenneth Rosen of Berkeley, Calif.-based Lend Lease Rosen, makes the case for more institutional investment in REIT stocks compared with more traditional investments. “Recent volatility in the stock market highlights the need for investors to reexamine the benefits of portfolio diversification,” he said. “The [REIT] market offers investors an attractive option in this regard.”

According to the MBA's Kempner, two factors have contributed to the hot REIT market. “First, the massive declines in the tech and telecommunication sector stocks have sent investors looking for lower-volatility safe havens. Second, the fact that the current economic slowdown has not been accompanied by real estate declines — and real estate investments continue to perform well despite the slowdown — has served as evidence that REITs are no longer the same strongly pro-cyclical instruments we saw in the past. The headlines for this downturn are about laid-off high-tech workers in California, not empty office buildings in Atlanta and Dallas,” Kempner said.

“The equity markets like consolidation. The driving factors behind this trend are the desire to increase scale, access to new geographies, ability to acquire high-quality properties and add talented management teams.”
— Jacques Brand Deutsche Banc Alex. Brown

In the bigger picture, Kempner maintains that long term, “we may be seeing a permanent shift toward real estate-based securities, both debt and equity. Many investors and investment managers have received an expensive lesson in the benefits of well-diversified portfolios. What we may be seeing is not a transitory shift toward REITs and CMBS, but a more permanent reallocation toward real estate that should carry through for a number of years, particularly as now-chastened baby boomers facing retirement reallocate toward income-producing securities.”

On the heels of the consolidation trend, REITs themselves are now tapping into Wall Street for new stock issues for the first time in nearly three years.

CMBS stages a comeback

The CMBS market has ridden one of the wildest roller coasters around, but after a slightly weaker 2000, the sector is poised for a significant comeback.

According to Commercial Mortgage Alert, CMBS issuance reached its zenith at $78.4 billion in 1998, followed by a drop to $67.8 billion in 1999 and $60.9 billion in 2000.

Based on the $16.8 billion of global issuance for the first quarter of 2001, New York-based Moody's Investors Service is predicting a strong year for CMBS, supported by favorable interest rates. First-quarter results were up more than $3.4 billion over last year, Moody's reports in its most recent quarterly review and outlook for the sector.

The rating agency also cautions that recent accounting rule changes could affect deal volumes in the U.S. market and that continued cooling of U.S. retail spending could put the credit quality of many deals under pressure.

“The CMBS industry seems to have been caught flat footed by FASB 140 [a Financial Accounting Standards Board rule that went into effect April 1], which is a significant concern because it could impact CMBS structures and issuance levels,” said Tad Philipp, managing director for Moody's North America. FASB 140 calls into question the flexibility given special servicers in dealing with defaulted loans should this special treatment preclude sales accounting treatment for originators transferring loans into a trust, which strikes at the heart of securitizations.

“We may be seeing a permanent shift toward real estate-based securities, both debt and equity. Many investors and investment managers have received an expensive lesson in the benefits of well-diversified portfolios.”
— Jonathan Kempner Mortgage Bankers Association of America

There is also mounting concern about increasing loan delinquencies. According to a new study by New York-based Standard & Poor's, delinquencies within the CMBS market continued to accelerate in the first quarter of 2001, tripling the average quarterly increases experienced in 1999 and 2000. There is concern that this increase will result in more unresolved loans, and that recovery values could be impaired during a period of economic softening.

Despite their relatively good performance over the past year, Standard & Poor's expects more retail loans to require special servicing as retailer problems rear their heads in the form of delinquent loans.

The delinquency rate advanced to 0.955% as of March 2001. The total amount delinquent was $1.137 billion on a base of $114.3 billion of rated conduit CMBS transactions.

Still, according to Brand of Deutsche Banc Alex. Brown, the unexpectedly low interest rate environment, beginning with the big November through December 2000 rally in the 10-year Treasury rate, has had two positive effects.

“First, supply through the first four months of 2001 has come in significantly above expectations,” Brand said. “Most of this was in the form of fixed-rate conduit loans, which came in almost 50% above beginning-of-the-year forecasts. Second, while the interest rate environment of the first quarter strongly favored fixed-rate origination over floating-rate, we expect that the 60-basis-point back-up in the 10-year rate since mid-March will reduce the spurt in fixed-rate production in favor of floating-rate financing. On the whole, we expect 2001 issuance to be about 10% ahead of 2000 - or approximately $55 billion.”

Property type pros & cons

So which properties are on more radar screens these days? According to the CCIM/Landauer Investment Trends Quarterly, office and industrial led the investment charge in fourth-quarter 2000 with an 11% increase and 4% increase, respectively, over the previous quarter. The Pacific states and Mid-Atlantic region led the nation, accounting for nearly 50% of investment dollars; however, the Mountain states registered record volume and the Southeast region ended the year with a flurry, up 27% over third-quarter 2000 results.

According to Jones Lang LaSalle's Gordon, downtowns are in vogue again. “Central Business District real estate is back in fashion and lenders are willing to do more in downtowns than they have done in a long time. Luxury rental housing in cities and suburbs is a strong sector from both an equity and a debt perspective. Competition to finance Class-A product is fierce,” Gordon said.

Going forward, nearly everyone has apartments near the top of their popularity lists. “If I were to pick one property type that was most-favored it would have to be multifamily,” said John Gough, managing director at San Franciso-based LoopLender, the online mortgage origination arm of LoopNet. “Multifamily transactions have become a staple for conduit securitizations, insurance companies and for regional banks alike. Of the 46 loans closed by LoopLender over the last 12 months, 58% have been secured by multifamily property.”

But at least one top lender sees warning signs ahead. “We have increasing concern with vacancies and rental levels in all product lines, with some products feeling the impact of recession in certain markets a lot more than others,” said Howard Levine, president and CEO of ARCSCommercial Mortgage, Calabasas Hills, Calif. “Definitely there are concerns about technology and dot-com blowups and how a recession will impact real estate. And it is in fact impacting it.”

ARCS has ranked as the No. 1 Fannie Mae DUS lender for the past five years. In just the first four months of 2001, the company closed a whopping $1 billion of new business.

Levine says that certain products will feel the impact of this environment more than others. Specifically, he cites hotels as feeling it now “with occupancies down pretty much across the board in virtually every market. Corporations are cutting back on travel, and we're observing that in the tightest markets like New York and weaker markets like San Jose.”

Significant construction also is occurring in those markets which have few barriers to entry, available land and low-cost construction, including the Southeast and in markets dominated by technology companies.

Ben Johnson is an Atlanta-based writer.

Despite their own economic problems, overseas markets are importing newfinancing techniques and embracingforeign investors.

Foreign markets gain financing advantage

After years of trying to transplant the American-born concept of commercial mortgage securitization abroad, the idea is finally catching on — especially in the United Kingdom, Canada and Japan.

The popularity of overseas securitizations is gaining enough momentum for New York-based Ernst & Young to note in its annual CMBS update: “The big news for 2000 was the growing CMBS market in countries around the world. And this is good news. We don't expect volume to mushroom any time soon — each market has its own issues to iron out — but it is exciting to watch as the capital markets contribute to liquefying the real estate market on a global basis.”

One of the largest and most successful securitizations is that by Canary Wharf Group plc. The company announced in May that it will securitize the income from three of its largest office buildings — two 700-foot-high towers for Citigroup and Credit Suisse First Boston, and another 13-story, 512,000 sq. ft. building that has been leased by Morgan Stanley, for occupancy in August 2003.

The company has more than 6.8 million sq. ft. of office space under construction in 12 buildings at Canary Wharf in the Docklands area on the west side of London.

The securitization is expected to raise nearly $1.2 billion, of which about $450 million will be given back to the firm's original investors and the rest used to pay down a construction loan.

Canary Wharf is the U.K.'s second-largest publicly traded property firm. Recently its leasing program has been on a roll. Last December, it signed McGraw-Hill Cos. to a 322,000 sq. ft. lease in a 12-story building for December 2002 occupancy. In January, it signed Credit Suisse First Boston to another 515,000 sq. ft. in a new building under construction. In February, it snagged Lehman Brothers for more than 1 million sq. ft. at a new development site.

An even larger deal is said to be in the works, a $2.15 billion refinancing by British Land, the U.K.'s largest publicly traded company.

“We remain bullish on Europe, which will outperform the U.S. real estate markets this year,” says Jacques Gordon, international director of investment strategy for Chicago-based Jones Lang LaSalle.

As if to underscore the popularity of foreign properties these days, Lend Lease Global Properties SICAF, a Luxembourg-based global real estate opportunity investment fund, just raised about $600 million from 16 institutional investors. The fund expects a total capitalization of about $2 billion, including leverage, once its investing period is completed over the next 14 months.

Since its launch in April 1999, the fund has invested approximately $350 million in the United Kingdom, Portugal, Hong Kong, Korea and Germany. The fund's focus continues to be on Europe and Asia.

New York-based AIG Global Investments has launched its own $1 billion opportunistic fund for European-directed investments. But unusually, it is straying away from “mature” Western European markets, instead favoring office markets in Athens, Greece; Estonia; Italy and Germany. Retail markets are favored in Polish inner cities and in Italy; and residential markets are favored in Germany.
— Ben Johnson

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