Last year was momentous for the real estate debt and equity markets as both exhibited signs that investors are slowly beginning to return. This year should be no less interesting.
Though slow in overall transaction volume, 2009 in the institutional real estate debt and equity markets can be categorized as a year in which the market reached for footing, yet remained fearful of the looming debt maturities and deteriorating fundamentals that could prolong valuation declines. The mindset of the equity investor last year and undoubtedly into the first part of this year has been that of a flight to quality, with a clear divide struck between high-quality core and value-added real estate. This reality is embodied in the high degree of investor interest in institutional-quality, core apartment transactions.
Apartment brokers have noted that attractive investments have received a number of offers from credible buyers at capitalization rates for some specific assets that have actually decreased during the recent quarters. The most liquid apartment assets today possess easy access to employment, highway infrastructure, and mass transit; can demonstrate consistently high occupancy; and possess very low execution risk. Unlike most other product types, the apartment market has undoubted seen increased liquidity through the availability of debt from Fannie Mae and Freddie Mac.
The same can be seen from investor appetite for other property types as well, but the availability of these investments in 2009 was very limited, and the situation in early 2010 appears to be no different. Investors have a significant interest in grocery-anchored properties with the dominant local grocer and relatively stable in-line tenancy that can demonstrate a strong sales history. However, the availability of this product for purchase has been low because these properties likely are performing well during the downturn and owners are unwilling to part with them. Institutional office and industrial investors are searching for high-quality real estate, though the availability of this property type is also constrained and actual transactions are limited.
Conversely, institutional investor demand for value-added product was extremely limited in 2009, a situation that should continue into this year. The primary reason for this lack of interest is the general concern about underwriting execution risk. Institutional buyers are finding it extremely difficult to underwrite and value assets in a market with declining fundamentals. The notion of a value-added transaction today is to identify distressed borrowers on core assets and attempt to recapitalize the assets, allowing the new equity to obtain value-added returns for core risk. The challenge with this strategy is that lenders so far have been willing to accommodate borrowers in working through the difficulty, especially on assets generating positive cash flow, thus limiting some degree of distress.
The value-added product offered for sale today is generally being considered by smaller, private investors, or owner/users in the case of office and industrial properties. These buyers are seeking product in primary markets with which they have intimate familiarity, and they generally buy on a dollar-per-square-foot basis. In the case of recent value-added office transactions, capitalization rates are quite low due generally to depressed building occupancy, but buyers are legitimizing the acquisition because of an extraordinarily low dollar-per-square-foot price. These buyers believe they are more familiar with the local market and prospective tenancy. A number of these are all-cash buyers and are not reliant on debt, which allows them to be more aggressive on price.
Though the disruption of credit markets was a leading cause of the recent economic downturn, as 2009 progressed these markets also showed some of the strongest signs of recovery as growing investor appetite for risk combined with government policy actions to improve liquidity and overall market confidence. The market for legacy commercial mortgage–backed securities (CMBS) was a direct beneficiary of many of these government initiatives, and even though extreme volatility was present for most of the year, an impressive improvement of senior security prices provided hope for a new level of market stabilization.
The private debt market, while slower to respond than public securities, also seems finally to be showing some signs of thaw. A return to a more normal environment by private lenders, which constitute the majority of capital providers, is a key to restoring overall real estate liquidity as large maturities and the possibility of further valuation declines still loom over the sector.
While the improvement in senior CMBS can be partially attributed to investors viewing specific securities as fundamentally cheap, the strong recovery in prices was also led by introduction of the term asset–backed loan facility (TALF) and the public/private investment program (PPIP). These government programs were aimed at restoring liquidity to the public debt markets by providing financing for senior CMBS buyers and allowing for the possibility of higher expected total returns.
While these programs have provided a positive influence on the senior parts of the capital structure, those securities lower in the credit spectrum that are more affected by real estate fundamentals have continued to lag due to rising loan delinquencies and actual loan defaults.
Another encouraging sign for public real estate securities was the revitalization of the new-issuance CMBS market, with three transactions brought to market in the fourth quarter of 2009. Though these transactions were not the traditional multiborrower conduit deals, the positive response from investors showed there is still demand for commercial real estate debt that is viewed as having a more realistic underwriting approach. While it should not be expected to reach the same volumes seen from 2005 to 2007, the measured return of the CMBS market should provide an additional source of financing in 2010.
With the need for most lending institutions to recapitalize internal balance sheets in addition to large existing commercial real estate exposures, the private debt markets witnessed a prominent change in underwriting standards. Though the apartment sector had the additional liquidity of Fannie Mae and Freddie Mac, most borrowers for other property sectors had to face the realization of a new lending environment that now includes amortization, coverage on in-place cash flows, and proceeds determined by all-in debt yields (net operating income divided by loan balance). Because most borrowers were initially unwilling to accept these new terms or unable to provide a level of debt paydown to secure financing, lenders and borrowers were mired in a standoff that will be carried into this year.
Moving into the end of last year, certain lender terms did become more competitive as flat interest rates of 8.0 percent or higher started to trend lower for high-quality assets as attractive alternatives for lenders became less prevalent. Though 80 percent loan-to-value, interest-only financings are not expected to be available again anytime in the near term, this year should see a return of many traditional lenders with new allocations to the sector, albeit at new underwriting standards.
While the expected supply of private debt capital is not likely to be sufficient to dramatically reduce loan defaults for undercapitalized properties, new acquisitions at new property prices should be able to obtain a more traditional level of financing at historically attractive rates.
Last year was momentous for the real estate debt and equity markets as both markets exhibited signs that investors are slowly beginning to return. This year should be no less interesting as investors remain vigilant regarding current real estate fundamentals, ever-closer debt maturities, the market’s response to the gradual pullback of governmental stimulus, and the availability of credit. Perhaps most important, sellers will need to materialize in 2010 for a market to truly develop.
