I attended two of the myriad ULI Member Industry Roundtables—“Real Estate Capital and Policy Trends” and “Sourcing Debt and Equity”—held on May 19 at the Spring Council Forum in Phoenix, Arizona.
Key takeaways from the individual tracks were as follows:
Real Estate Capital Market Trends in 2011:
- While the panelists agreed that we have entered the recovery phase, there was no consensus as to exactly where we are in it; this is also known as the “not knowing what inning we are in” syndrome.
- Coming off the capital markets roller coaster of the past decade, 2010 saw quarter-over-quarter sequential improvement in transaction activity.
- Values appear to have stabilized, having fallen approximately 44 percent peak-to-trough; increases in value will have been market- and sector–specific, with broad generalities about both markets and sectors generally wrong.
- Record price levels are being recorded by trophy assets in first-tier markets; there is little activity everywhere else, although panelists expect this to change over the balance of the year.
- While distressed assets are starting to trade, only 40 percent have been resolved to date as the process remains cumbersome at best and banks need to allocate income and equity carefully among losses.
- Capitalization rates are firming across the board; it will remain most evident in transactions in the first-tier markets.
- Real estate continues to attract capital due to its absolute relative investment value as compared to alternatives.
- Current spreads between capitalization rates and debt yields provide positive leverage to investors.
- Investment capital is available from a wide array of investors including the following: domestic and global equity funds; domestic and non-U.S. individual and institutional investors; real estate investment trusts (REITs); sovereign wealth funds; and nontraded REITs.
- Institutional real estate funds have gone from queues to redeem to queues to invest.
- REITs have completed their deleveraging and are circling the acquisition market, waiting for opportunities to present themselves; the public equity and debt markets remain accessible and user-friendly.
- Debt is becoming increasingly available; first-quarter 2011 commercial mortgage–backed securities (CMBS) issuance equaled 2010’s total issuance.
- The refinancing required for the near term combined with the “looming wall of debt maturing and requiring refinancing in the 2015-to-2017 period” remains problematic both today as well as in the future.
- Equity capital is available, but is it “smart and deep, or dumb”?
- Life insurance companies are seeing an increasing number of deals and are expected to complete $45 billion to $50 billion in loans in 2011 while still remaining selective in the deals they will do.
- Freddie Mac and Fannie Mae are facing increasing competition from private sources of debt capital such as insurance companies.
- Commercial banks are increasing their presence in the debt market . . . slowly and cautiously.
- Debt for multifamily development is available in the 75 percent (plus or minus) loan-to-cost area; floating-rate debt is allowing banks to take advantage of the arbitrage available over their cost of deposits.
- Institutional investors are consolidating their investments among fewer sponsors.
- For opportunistic and distressed investors, “15 percent has become the new 20 percent” as sponsors “dumb down” expectations.
- When institutional investors will start to reallocate investment capital from core to value-added and from first-tier cities to other markets remains a mystery.
Real Estate Investing in a Fast-Changing Policy Environment:
- “It’s like a ‘corn maze’ ”; at times, it’s hard to know which way policy and legislation will go.
- Fannie and Freddie: complete reorganization after the 2012 election seems the most likely course of action.
- Ninety-five percent of Fannie and Freddie delinquencies come from single-family loans; multifamily, with only 5 percent delinquent, is highly profitable to both agencies.
- More commercial banks and life insurance companies are expected to move into the multifamily lending space, drawn by the ability to receive wider spreads, initially estimated at 25 to 50 basis points.
- Covered bond legislation is likely to be passed by the House of Representatives this year but then languish in the Senate. Covered bonds are secured by both a specific pool of assets as well as the credit of the issuing entity. Covered bonds have been successfully used by European financing institutions for over 200 years; why not here?
- Risk retention in some form or another will be implemented in the near future as the comment period is winding down. A wide array of structures are under consideration; the only thing that seems sure at the moment is that someone will be left holding 5 percent of the principal amount of a to-be-defined something and that the cost of borrowing via the CMBS/conduit route will become more expensive.
- Of greater concern is a proposal that will require underwriters to defer their profit on the “Premium Strip” until the entire offering has been retired (repaid). This has the potential to be a showstopper and will therefore be “reworked” to mitigate industry concerns in some way. Having to wait as long as ten years to book a profit should be a showstopper.
- Other subjects discussed included the following: Basel III and Solvency II, which will impact the capital ratios of commercial banks and insurance companies, respectively, and the prohibitions under the Volker Rule (which should have little impact on the real estate space).
Conduits and CMBS Lending: What Role, What Impact?
- Underwriters are focusing on debt yield rather than debt-service-coverage ratios as it is believed that debt yield is a better measure of ability to pay current debt service as well the property’s prospects for refinancing in the future; 9 to 10.5 percent is the current debt yield metric.
- Mezzanine debt is becoming more readily available; underwriting standards include: 1.05/1.10 to 1 debt-service coverage and 85 percent overall loan-to-value; interest-only structures are becoming more prevalent.
- “Pro-forma underwriting is a thing of the past; if utilized today, only for very, very short time periods.”
- “We can finance a 737 jet and a regional jet; single-engine planes are very difficult”; financing for “A” properties in “B” markets is available.
- “Can you finance a borrower convicted of a ‘small’ felony?”; question is how has the borrower performed financially and how has the borrower behaved relative to his or her legal responsibilities under the mortgage, and “I guess, how small a felony?”
- “We’re being cautious; there’s no deal I would jump in front of a truck to finance.”
- With 25 conduits in the market, are underwriters, to compete and win deals, “getting out over their skis again?” Maybe a little, but only a little.
- The “welcome sign” is up for Class B property.
- No one at the moment seems overly concerned with the high concentration of retail properties in current offerings.
- Borrowers are facing a two-tier market: Tier I—insurance companies with lower loan-to-value ratios focused on more pristine properties; Tier II—CMBS with higher loan-to-value ratios and properties a little “dinged, but not damaged.”
- Volume for 2011 is projected in the $35 billion to $40 billion range.
- Brokers with specialized knowledge and experience in the mortgage markets can be very helpful in getting deals done.
- Starting to see floating-rate, interest-only bridge loans for “transition” properties.
- Lessons learned from the past crises? Too early to know; panel was hopeful.
- Pricing today: ten-year term—all-in, mid-5 percents.
- Mezzanine: two- to three-year term—9 percent to 11 percent all-in.
- In terms of representations and warranties, looking for more than just a “warm body”; amount at risk has to be “important” to the borrower and represent a meaningful amount of net worth.
- Risk retention will help to align the interests of the various parties; that being said, it will reduce liquidity among issuers and B-piece borrowers and increase cost to borrowers.
Raising Equity Capital in 2011:
- Nontraded REITs are raising significant amounts of capital from individual investors who are seeking higher-yielding investments; this has allowed the sector to be among the largest purchasers of both operating as well as net-leased, single-tenant properties.
- Nontraded REITs are beginning to expand their investment horizons to include the following: institutional “no-load”-type structures: joint ventures with operating partners; build-to-suit structures; “recapitalizations” of owners/developers and properties; and value-added properties.
- Nontraded REITs are also structuring offerings to include a liquidity component.
- Core investors (in all shapes and sizes) are beginning to “move up” the risk spectrum in search of current return; this entails both markets as well as properties.
- Investors are becoming “inventive,” willing to focus on B-pieces, mezzanine equity, and debt—“anything” to “get their yield up.”
- Obviously, there is plenty of liquidity (and therefore competition) in the market.
- As was said at an earlier session, there is now a line to get money invested in income-producing real estate.
