As with the equity market, the real estate debt market is slowly coming back to life, led by the revitalization of commercial mortgage–backed securities.
Historically, the three most important aspects of real estate were location, location, location. When one is looking to raise capital, however, this motto should be replaced by job growth, job growth, job growth. Both private and institutional investors are focused on deploying capital in markets that are poised for job growth and in deals that provide current cash flow. In tow, banks have cautiously stepped back into the market with tightened underwriting standards and zero appetite for risk. There are certain steps that investors can take to better position themselves in 2011 as they attempt to navigate a changed capital market with new players and different investment strategies.
The landscape of the joint venture equity market has changed dramatically since the financial crisis took hold of the market in 2008. As a result, sponsors should reevaluate how their business plans and goals align with those of their equity partners and curtail their expectations in regard to promote structures. Since reentering the market in the fourth quarter of 2009, institutional equity investors have taken a flight to quality and focused on deploying capital in major asset classes within markets that are poised for job growth, or in gateway cities along the East Coast and West Coast. To date, these firms have been hesitant to take development risk because they have been able to achieve their returns by investing in existing assets that have been trading at discounts to cost. For the most part, institutional equity is finding attractive opportunities to either recapitalize or acquire distressed assets that have lease-up or market risk. However, as fundamentals for certain asset classes and markets have begun to stabilize, we are finding institutional investors beginning to invest in development opportunities and see that trend continuing in 2011.
With a number of U.S.-based institutional equity sources sidelined with legacy issues, foreign equity has been actively making direct investments in trophy and core properties as well as entity-level investments with best-in-class sponsors throughout the downturn. This capital, fueled by the weak dollar and the repricing of assets in the U.S. market, is focused on gateway cities and long-term holding periods. According to data provided by New York City–based Real Capital Analytics, foreign capital as a percentage of total U.S. transaction volume grew from 13 percent in 2008 to 16 percent for year-to-date 2010. In addition, high-net-worth and family office equity are becoming more active in the market, investing in more stabilized assets that provide cash-on-cash returns in excess of what they can achieve in the stock and bond markets. This equity has been targeting longer-term holds in multifamily and single-tenant properties leased to credit tenants.
Today, all three of these groups are actively looking to form partnerships with local operating partners but under new structures that include higher coinvestments hurdle rates, and curtailed acquisition, asset management, and development fees. Real estate investors and developers seeking to raise third-party equity need to cast a wider net when searching for potential equity partners and expand their relationships to include at least two to three different sources. This will mitigate risk and ensure that a new deal will fit within the investment parameters of at least one of their partners.
As with the equity market, the real estate debt market is slowly coming back to life, led by the revitalization of commercial mortgage–backed securities (CMBS). Through November 2010 there have been ten issuances of CMBS debt totaling $9.5 billion, both conduit and single borrower. This is up from $1.36 billion of issuance in 2009, but still well shy of the $273 billion issued in 2007. As CMBS activity continues to ramp up in 2011, both liquidity and the number of active CMBS lenders in the market will increase. However, today’s market for bank debt remains quite challenging. The limited number of active bank lenders, conservative underwriting, and the seemingly zero tolerance for risk have elongated the approval and closing process for virtually all banks. Sponsors should be aware of these challenges before entering into purchase agreements and should take the following precautions to ensure that their deals get financed.
As suggested with equity, sponsors should expand their banking relationships to include at least two to three lenders, if not more. Many banks are still not lending on commercial real estate, and if they are, their parameters have likely changed dramatically. Sponsors should reevaluate their existing banking relationships to see if they still fit with their lending needs. Even if they do, it is still wise to have at least two or three backups in this market; this is especially true for developers who are in need of construction financing.
In general, banks are proceeding with caution and are able to be more selective in choosing the deals they will lend against. In today’s lending environment, the deals that are getting bank financing have the most straightforward business plans and can have only one risk variable associated with them, whether it be sponsorship, lease-up, or construction risk. A good way for a sponsor to improve the chance of qualifying for financing is to mitigate the deal variables before approaching a lender.
Once the lender is approached, a sponsor should need 60 to 90 days to arrange the financing—especially when dealing with banks. Lenders in today’s market have an extremely low tolerance for risk. That, coupled with the low level of competition in the market, has pushed the average closing time frame out to between 60 and 90 days. Consequently, being patient with the lender and understanding the lender’s needs will help get financing done in this market.
Last, expect to use more equity. The days of 80 to 90 percent leverage from banks are over for the time being. According to Real Capital Analytics, through May 2010, the average loan-to-value ratio for loans originated by regional and national banks was just shy of 70 percent. The combination of low competition in the debt market, increased pressure from regulatory examiners, and banks’ aversion to risk have lowered the amount of proceeds available for most deals in today’s market. In addition, banks are being very selective not only about the properties they lend on but also the sponsors with whom they work. It is important for borrowers to have a track record of success and a balance sheet when seeking to obtain bank financing. If these are not readily available, sponsors should find a partner that can bring both to the table.
Looking forward to 2011, we anticipate more lending in commercial real estate by banks as balance sheets improve and nonperforming assets are shed, enabling them to focus on lending versus value preservation.
