ULI’s Real Estate Finance and Investment 2013 conference in San Francisco featured seven plenary and concurrent sessions as well as plenty of time for conversation among participants. Program topics included the following: the current market for real estate equity and debt; prospects for development; institutional investor perspectives; mezzanine capital; repositioning assets and value-added investing; investing in single-family residential; and managing investment risk.

There were few surprises; much of what participants heard and said reflected themes we have been echoing since the beginning of 2012: “It’s the economy, stupid” and jobs drive the economy; there’s a wall of money aggressively looking for current yield; the eurozone’s economy is a mess and likely to stay that way for a long while; leverage is available in size and at frighteningly little cost; and investors are migrating to niche strategies and secondary and tertiary markets in search of deals; Fannie Mae and Freddie Mac remain a mess; and pro forma underwriting has been seen raising its ugly head (infrequently) again, to name just a few. 

The following is a summary of some of the key takeaways from the various sessions:

  • A wide array of investors are active in the U.S. real estate investment space including: offshore investors (Germans, Japanese, Chinese, Dutch, etc.); institutional investors (pension funds, endowment funds, sovereign wealth funds, etc.); high-net-worth individuals and family offices; open-end and closed-end funds; and, of course, real estate investment trusts (REITs).
  • Panelists defined numerous investment strategies at work today ranging from a focus on core assets and liquidity (i.e., on the quality, quantity, and durability of cash flow) to recapitalizing individual and portfolios of troubled properties.
  • Investors are continuing to move up the risk curve and assume “measured” underwriting risk in exchange for higher yields, entertaining investments in both secondary as well as tertiary markets, niche property classes, and increased leasing risk.
  • Capitalization rate compression is being evidenced in the secondary and tertiary markets as investors compete to get money invested; this was rated a short-term phenomenon, soon to be replaced by quality management as the way to increase income and value.
  • The largest investors are increasingly investing through separate accounts and “sidecar” funds to maintain increased investment and management control.
  • Sustainability is drawing increasing interest among investors as well as tenants, with the latter being driven by employee interest.
  • Sustainable strategies are a must for new development.
  • Panelists uniformly agreed that there would be increasing amounts of debt capital available in 2015 from all sources (commercial banks, insurers, and securitized lenders) except the government-sponsored entities (GSE), whose fate and appetite and future remain in flux.
  • Insurance companies cannot source enough deals to meet their appetites as securitized lenders become increasing more competitive.
  • Commercial banks cannot source sufficient deals, either; panelists saw the potential for weakening deal structures combined with increased leverage as banks compete to lend.
  • Commercial mortgage–backed securities (CMBS) were noted as improving overall, with “CMBS 2.0 sort of better than CMBS 1.0” as issuers continue to face legislative issues such as retention requirements and refinancing risk as the classes of 2007 and 2012 roll over.
  • The GSEs are expected to contract gradually, with much of their activity replaced by private capital sources.
  • While new sources of debt capital such as pension funds, mortgage REITs, etc., should find the sector attractive, none appears sufficiently interested to commit to building the required architecture.
  • “The party hasn’t started yet” as the economy and real estate fundamentals do not support speculative new construction.
  • The only sector readily financeable in today’s marketplace is multifamily.
  • Mezzanine investments remain “bespoke” transactions, individually structured to meet the needs of the current owner and the property.
  • Mezzanine capital investment rates of return today range from 9 percent to 15 percent, give or take. 
  • Repositioning and value-added investment is defined as “getting down to business and doing something about the property” rather than waiting for cap rate compression to rescue you.
  • As in mezzanine transactions, each value-added transaction is individually crafted to meet the needs of the property and/or the current owner; required yields are in the 15 percent area.
  • In regard to the single-family, residential real-estate-owned to rental sector, panelists agreed that this was a business sector with scalable staying power and potential returns in the 15 percent range; they also recognized the importance of enterprise management.
  • Risk should be divided into two segments: partner risk and product risk.
  • Risk should be analyzed in the context of loss of return versus loss of capital.
  • In regard to assessing and managing risk, panelists said they focused on applying stress tests to property-level cash flows, noting that debt-service-coverage ratios were more important than leverage (loan-to-value ratios) tests in measuring risk.
  • Debt yield should be analyzed on both a current basis as well as on a time-of-projected-exit basis; “we’re trying to measure ability to withstand stress.”
  • Pro forma underwriting is “passé.”

Monday’s Numbers

The Trepp survey for the period ending May 31, 2013, showed spreads coming in a little with all-in costs remaining in the sub-4 percent range for top-tier assets and in the mid–4 percent area for less “pristine” assets and borrowers.

Asking Spreads over U.S. Treasury Bonds in Basis Points
(Ten-Year Commercial and Multifamily Mortgage Loans
with 50% to 59% Loan-to-Value Ratios)

12/31/09

12/31/10

12/31/11

12/31/12

5/31/13

Month earlier

Office

342

214

210

210

171

178

Retail

326

207

207

192

165

172

Multifamily

318

188

202

182

151

164

Industrial

333

201

205

191

154

168

Average spread

330

203

205

194

160

171

10-Year Treasury

3.83%

3.29%

1.88%

1.64%

2.16%

1.70%

The Cushman & Wakefield Equity, Debt, and Structured Finance Group’s monthly survey of commercial real estate mortgage spreads for the period ending May 2, 2013, showed spreads for ten-year, fixed-rate mortgages secured by Class A property coming in as much as 15 basis points during the past month, with spreads for Class B property narrowing a similar amount. 

10-Year Fixed-Rate Commercial Real Estate Mortgages (as of May 2, 2013)

Property

Maximum
 loan-to-value

Class A

Class B

Multifamily (agency)

75–80%

T +165

T +180

Multifamily (nonagency)

70–75%

T +175

T +180

Anchored retail

70–75%

T +170

T +210

Strip center

65–70%

T +190

T +230

Distribution/warehouse

65–70%

T +185

T +215

R&D/flex/industrial

65–70%

T +185

T +235

Office

65–75%

T +175

T +205

Full-service hotel

55–65%

T +235

T +280

Debt-service-coverage ratio assumed to be greater than 1.35 to 1.

Year-to-Date Public Equity Capital Markets

DJIA (1): +16.36%
S&P 500 (2): +115.23%
NASDAQ (3): +14.89%
Russell 2000 (4): 116.28%
Morgan Stanley U.S. REIT (5): +7.18%

 (1) Dow Jones Industrial Average; (2) Standard & Poor’s 500 Stock Index; (3) NASD Composite Index;
(4) Small Capitalization segment of U.S. equity universe; (5) Morgan Stanley REIT Index.

U.S. Treasury Yields

12/31/11

12/31/12

6/7/13

3-Month

0.01%

0.08%

0.05%

6-Month

0.06%

0.12%

0.08%

2-Year

0.24%

0.27%

0.30%

5-Year

0.83%

0.76%

1.02%

7-Year

1.35%

1.25%

1.52%

10-Year

1.88%

1.86%

2.10%

                                   

Key Rates (in Percentages)

 

Current

One year prior

Federal funds rate

0.09

0.16

Federal Reserve target rate

0.25

0.25

Prime rate

3.25

3.25

U.S. unemployment rate

7.60

8.70

1-Month LIBOR

0.19

0.24

3-Month LIBOR

0.28

0.47