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Real Estate Capital Scoreboard® – December, 2011

Chicago, Illinois, December 1, 2011 – The jittery stock market keeps real estate capital on the forefront of activities, as investors flee towards attractive debt and equity yields offered by brick-and-mortar versus low yielding corporate bonds and other less profitable investments. Even as markets fluctuate, interest rates remain steady with mortgage spreads continuing an overall downward draft with more CMBS and bridge lenders returning to the market.

Market highlights for the month are as follows:

• Project cash flow is the be-all-end-all any type of successful financing, although more new construction projects in select markets are now progressing.
• As interest rates decline, more lenders have been relaxing their reliance on debt coverage ratios as an underwriting standard.  They are underwriting to more traditional benchmark levels including 75% leverage and debt yield has now become one of the most important underwriting metrics, particularly with the CMBS industry, hovering in the low double-digit range for non-multifamily properties.
• While fixed-rate debt is attractive, watch for rising international bank rates as European banks unravel their banking problems.  Still extremely low, LIBOR has increased 20 basis points since summer, potentially creating more concerns about floating-rate debt.
• Non-Agency funding sources continue exploring alternative property types, over-and-above multifamily assets, as yields are driven to minimum levels within this asset class.  Retail and industrial properties are the largest beneficiaries, yet office and lodging are gaining popularity.
• Key benchmark treasury rates the five and 10-year notes, tightened to a range of about 100 basis points of each other, while overall spreads for mortgages are within 20 basis-point premium for the shorter-term maturities.  That said, commercial mortgage rates are still at historical lows and mortgage spreads over treasuries remain flat.
• In the next few months expect mortgage spreads to tighten even further, as much as 50 to 75 basis points, as lenders remain awash with funds and continue to elect lower pricing, rather than compromising on asset quality.  Within the past month, for example, CMBS pricing over swaps dropped 20 to 50 basis points. 

 

According to Jeanne Peck, the Real Estate Capital Institute’s Director, “The commercial property sector is bifurcated into haves and have-nots, with a substantial difference existing between credit and noncredit financing options.  The real estate markets are no different than the overall credit markets as far as trying to pinpoint successful businesses.”

Real Estate Capital Scoreboard® – November, 2011

Chicago, Illinois, November 1, 2011 – Uncertain economic conditions impinge on commercial property sales, particularly older office, retail and industrial properties in secondary locations.  Funding sources and investors alike are retreating from these asset classes as the lack of job growth office building sales, particularly for older properties in secondary locations. Lenders and investors alike, are retreating as fewer businesses consider new leasing. With a GDP growth of about 2%, not enough jobs are generated to allow landlords to raise rents based on commercial space demand.

Even though lingering problems face commercial property lending, funding sources are swollen with cash, as investors scramble to find some type of more attractive yields as compared with treasuries and corporate bonds.  A brief overview based upon active funding sources is as follows:

Agencies – The dominant multifamily funding sources for over a decade, the agencies compete on both price and leverage.  While securitized lending stays depressed, the agencies continue to migrate towards such funding as mortgage note buyers maintain faith in the future of apartment performance backed by implied governmental guarantees.  Also, the agencies are expanding prepackaged leverage offering of up to 90% in combination with mezzanine funding partners.

Banks – With many legacy issues settled, banks are again active in the short-term fixed and floating-rate funding space.  Since most new deals are of higher quality, banks hone in on sponsorship equity and guarantees for such properties; preferring to compete on pricing instead of leverage.  For the right situation, banks will the most competitive sources for loans with terms of 5 years or less, often dropping rate floors and providing more proceeds to strategic clients.  On a case-by-case basis, recourse can be reduced or even eliminated.

Life Companies – The most active funding sector for longer term permanent debt, the life companies aggressively compete for the highest-quality conventional property types.  This sector leads with competitive pricing instead of higher leverage or more risk.

CMBS – After a brutal retreat in August, CMBS lenders cautiously return to the market, but softening cash flow fundamentals restrict the scope of qualified borrowers and financeable properties. At the same time, the securitization industry is plagued with higher spreads of at least 75 basis points or more in contrast to balance-sheet lenders and loan syndication issues for larger funding in excess of $50 million.  Lastly, CMBS lenders only offer rate estimates rather than lock into specific pricing as available hedging mechanisms are too costly (due to volatility) for any type of rate protection prior to funding.  As such, securitized lenders will only compete for higher-risk loans bypassed by other traditional lenders.

The Real Estate Capital Institute’s Jeanne Peck warns, “Record-low interest rates aid realty cash flow performance, but economic uncertainty plagues any significant growth.”  She concludes, “Other than the multifamily and part of the healthcare properties sectors, the property markets will remain stagnant for most of 2012.”

Real Estate Capital Scoreboard® – October, 2011

Chicago, Illinois, October 1, 2011 – Lackluster economic growth domestically, real estate capital markets poke along at a measured pace.  After investors returned from the summer holidays a few weeks ago, the demand is insatiable for quality assets of all classes as funds flood the market given minimal yields in the corporate and government bond markets.  However, substantial pricing gaps and desirability between core properties and non-core assets, as well as primary and secondary markets.

On a property by property basis, real estate capital markets are summarized as follows:

Multifamily – multifamily capitalization rates are near historical lows starting in the low 4% range in major markets along the Coast. The high-end range for Class C properties in secondary markets is 400 basis-points-or-more, again illustrating the dramatic difference in core versus non-core assets. Extremely low mortgage rates help drive down cap rates for this sector, especially with agency support — often in the mid-3% range or more for Class A properties.

Industrial – Strong demand exists for credit deals with capitalization rates starting below 5% for the right tenant/lease profile. However, more typical properties trade in the 6% to 7.5% range. Expect a cautious growth in this sector based upon modest rental increases.  With strong credit, longer-term mortgage rates hover in the 4% to 5% range.

Office – the saving grace with this sector is the lack of new supply. Rents are at, or near, the bottom with virtually no room for discounting. Value add and opportunity plays dominate suburban office market transactions, while CBD core assets in major markets trade near the peak levels of 2007 as institutional investors seek shelter in high quality assets.

Retail – Tenants are finding excellent opportunities to move into second-generation space vacated by bankrupt retailers.  In most markets, a 4 to 5 year oversupply exists, although infill development opportunities may crop up. Developers are returning to more traditional retailing concepts including pharmacy and grocery-anchored centers, as online retailing makes more inroads into nonessential consumer spending. For the most part, lifestyle centers are the hardest hit categories. Pricing and financing mirrors other commercial property sectors, depending upon credit profile, etc.

Lodging – The lodging industry sales volume has nearly doubled from some of its historical lows. However, luxury and limited service projects, particularly in premier locations, still commands favorable capitalization rates as low as 6%; 8% or more is the norm for this sector for a vast majority of properties.

Jeanne Peck, Research Director of the Real Estate Capital Institute, notes that “since interest rates are ridiculously low, ownership focus is on preserving values through cost-cutting and other proactive management measures.”  She suggests, “the lending community is cautiously selective on financing new transactions, using lower leverage and more strict underwriting versus low interest rates as tools for getting deals committed and funded.”

Real Estate Capital Scoreboard® – September, 2011

Chicago, Illinois, September 2, 2011 – The nearly catastrophic stock market dive in the beginning of August triggered chaos in the CMBS world.  The market was severely tested as borrowers and lenders scrambled to close on committed loans.  Loans in process without rate locks were typically repriced 25 to 50 basis points.  Securitized lenders ceased quoting loans until the turmoil subsided and some new loans widened by a full percent (or more) for borrowers needing to close deals within the first part of the month.

The August pricing volatility varied as much as 200 basis points between balance-sheet lenders and the CMBS sources for similar loan opportunities – an unusually wide pricing differential.  Today life companies, agencies and banks hold steady on pricing and flee to quality instead.  However, as treasury yields continue to contract, lenders are carefully watching the markets for more pricing clarity. 

In many cases, rate floors are introduced to protect yields against too much downward movement in treasuries.  All in all, absolute mortgage rates for standard loans remain nearly unchanged throughout the month, albeit spreads over treasuries are wider.  Yet the flight to quality and risk segregation show dramatic pricing differentials above and beyond and any floors.  Competition for low leverage apartment deals in primary markets, for example, dives into 4% for ten-year deals, 3.75% for seven-year deals and below 3.5% for five-year deals — all rates are at generational record lows.

Within the mortgage world, numerous factors account for such drastic mortgage rate volatility, but none more than economic uncertainty, both nationally and globally.  The lack of faith in the economic recovery and domestic budget resolution forces investors onto the sidelines, bringing down treasury pricing to insignificant levels.  The Euro Zone monetary crisis forces even more investors to purchase treasuries.  In response, economists have been scaling back their forecasts for the second half of the year.  And now that investors are returning from summer holidays and confronting Hurricane Irene issues, more volatility is expected as various quality of real estate is sorted into the correct pricing levels within different regions of the county.

Ms. Jeanne Peck of The Real Estate Capital Institute indicates that, “The realty capital markets are on a very bumpy road filled with unexpected twists and turns, as well as deep potholes from troubled deals.”  She suggests removing any volatility that an investor can is key, “Drive slowly and watch closely for obstacles will be the most prudent actions for navigating through the remainder of the year.”

Real Estate Capital Scoreboard® – August, 2011

Chicago, Illinois, August 6, 2011 – As the stock market hit news lows in the first week of this month, bond investors hardly fear the Federal budget discussions and impending downgrades, helping keep mortgage rates low.  Instead, low treasury yields are driven by global financial market concerns and a double-dip recession.  In the past month, treasuries moved down to previous lower levels of the nearly a year ago, while floating rate pricing remains nearly unchanged.

More recent concerns revolve around the fragile CMBS markets as any savings in lower treasury costs are absorbed by higher swap spreads.  Spreads widened more than 100 basis points as note buyers are nervous about the market recovery and quality of securitized mortgage instruments.  Look for more volatility in this lending sector for the remainder of the year, as more mortgage bonds are issued based on stabilized pricing.

During the past year, income-property sales volume has increased by at least 25%, as investors step back into the buying arena.  Institutional demand for trophy assets (mostly from REITS) in major markets skews pricing dynamics even as market conditions improve.  Such investors will even consider paying above replacement cost in select “fortress” markets as extremely high prices drive new construction.  Greater profits await investors willing to consider non-downtown areas.  Capitalization rates dive below 5% for CBD assets and are about 200 to 300 basis points wider in outlying areas.  In search of more yield, private buyers now reign in secondary markets.

Multifamily rental increases go unabated with growth rates of 7% or more in select supply-constrained markets.  Population demographics with a larger younger workforce, rising rental rates, falling vacancies, limited supply and low mortgage costs are the ideal conditions for continued profitability in this property sector – especially in stronger employment markets.  However, nothing lasts forever.

Investors should take note of improving home ownership conditions, supply threats and other forces on the horizon.  Low cost mortgage debt is fueling new apartment construction and de-conversion of existing condominium inventory.  Furthermore, unsold home inventory is about three times the normal levels, creating an extremely attractive ownership scenario not seen in years.  Many housing markets are at rock-bottom prices and home ownership is now less costly than renting in numerous cities.  Lastly, banks are starting to loosen consumer credit and mortgage pricing based on historically low interest rates, adding even more reasons to consider ownership vs. renting.

The Real Estate Capital Institute’s Director, Jeanne Peck, professes that “We’re clearly at, or near, the bottom of the housing market and at the top of the rental market.”  She adds, “What goes up must come down, but the prospects are still very strong for owning core apartment assets.”

Real Estate Capital Scoreboard® – July, 2011

 

Chicago, Illinois, July 1, 2011 – The Fed quantitative easing policies, the Euro monetary crisis, rising concerns about inflation in China and the overflow of capital into commercial real estate are all tampering with low mortgage rates.

Treasuries are rising and the Federal Reserve has minimal room to continue monetary easing, despite fragile economic conditions.   Throughout the past week, treasury rates have risen in excess of 3.1%, the highest since the end of May.  Rates are already bouncing along the bottom of the curve and can only be expected to move upward.

Just as Treasuries rise, mortgage spreads also widened — by about 30 to 50 basis points; concerns loom over CMBS performance.  The Rating Agencies warn about the rapid reintroduction of pro forma cash flow projections as part of underwriting new loans.  To stay competitive, conduit lenders react by tightening underwriting and pushing back on leverage.  However, such lenders still offer cashouts and a wider spectrum of funding programs (e.g., combination permanent loan with mezz debt).

In the midst of such change, multifamily properties still capture the lowest rates.  Despite concerns about the future of agency lending, Freddie Mac and Fannie Mae are sought by investors and borrowers, alike.  Improving profitability, the government’s continued backing of the housing sector and no real short-term alternative solutions are reasons for guarded optimism for this funding sector to stay viable.

The lodging industry is the bright star in the commercial property sector and room rates rise and occupancy levels recover to pre-recession levels.  This sector is also supply-constrained as few investors dare to venture into new construction in the foreseeable future.  Lenders take note, selectively financing hospitality properties at pricing levels matching other more traditional commercial property types, although at leverage of 65% or below.

Ms. Jeanne Peck of The Real Estate Capital Institute, forecasts “very little room remains for absolute rates to drop further.”  Peck notes, “The main focus must be on improved cash flow performance through expense reductions and more aggressive income growth, where available.”

Real Estate Capital Scoreboard® – June, 2011

Chicago, Illinois, June 1, 2011 – The markets are heating up with the summer months. Once again, interest rates continue trending downward and spreads narrow as funding sources case prime quality investments. Investors are rethinking and retooling their funding programs based on the following:

Higher Leverage: To stay competitive, creative lenders are teaming up with Mezzanine debt players to provide a “one-stop” funding solution based on a higher leverage loan. The combined leverage often results in loans of up to 85% with blended interest rates in the 6% or higher range, a premium over conventional first mortgage debt.

Mezzanine/Preferred Equity: With yields tightening in the lower single-digit range, the preference for entertaining more equity rather than debt risk is appealing. Targets of 15% or more are still available within this funding format. However, the amount of higher-quality projects are bid up quickly, even in challenging markets as many investors are squeezed out of primary markets.

Alternative Property Types: Existing “value add” opportunities for favorite property types are sparse. Lodging, self-storage, data centers, flex industrial/office are gaining attention. Overall yields for such properties also are approaching the mid-teens for stabilized assets, while repositioning and value creation situations approach 20% or more.

New Construction: A small window exists for new construction, as lenders are reentering the marketplace with construction funds. Through most of 2012, new-construction will be limited, but investment pipeline is increasing for hard-to-find investments, particularly multifamily assets which are trading at pricing close to replacement costs. Since interest rates are extremely low, return on development cost are approaching a very narrow band, often within 100 basis points or less of the “exit“ capitalization rate.

Ms. Jeanne Peck, research director for The Real Estate Capital Institute, forecasts “very little room remains for absolute rates to drop further.” Peck thinks “The main focus must be on improved cash flow performance through expense reductions and more aggressive income growth, where available.”

Real Estate Capital Scoreboard® – May, 2011

Chicago, Illinois, May 4, 2011 – Real estate finance fundamentals are favorably gravitating towards borrowing as the triple play of lower treasury rates, compressing mortgage spreads and higher leverage levels fall into place.  During the past month, five and ten-year treasuries dropped by more than 15 basis points, while lenders slightly tighten spreads to remain competitive as more capital floods the markets.  Also, with values stabilizing for most types of income properties, funding sources are willing to offer additional proceeds.  Current highlights include:

Overall rates – With mortgages rates at historically low levels ranging in the 4% to 5.5% for longer term debt, borrowers prefer fixed-rate debt as pricing differential is barely significant vs. floating-rate formats.  That said, many lenders are removing floating-rate “floors” to remain competitive.

Performance – The markets have bottomed out as nearly all property sectors demonstrate improved profitability.  Apartments continue to outperform all other sectors as low home values and slow sale velocity challenge the residential market making renting more attractive to the otherwise home buyers.  In fact, for the first time in years, home ownership is less costly than renting in many markets.  Hospitality is on a rebound with business travel on the rise.  Office and industrial demand is up, although at cautious levels.  Lastly, retail rebounds as slowly rising consumer leads to better store sales and expansion plans for retailers.   Investors are noticing these trends as evidenced by bidding activities increasing substantially from last year and, in fact, approaching pre-recession levels for well leased properties.

Capital – Throughout this spring, substantial funds are available for funding most types of income-property real estate.  Funding sources are keenly aware of competition for quality properties with cash flows — pricing remains tight.  Conduit lenders are definitely back in the market offering higher leverage, while life companies compete on pricing and Agencies still dominate the multifamily arena.   As profitability returns and workouts are successfully addressed, banks are back seeking new business as well.  In general, lenders are more creative in looking at stabilizing assets, willing to bid earlier in the process to capture loans.  However, funding projects with ongoing leasing issues is still a challenge.

The Real Estate Capital Institute’s Jeanne Peck, suggests “expect more liberal underwriting standards as lenders scramble for a limited supply of quality loans.”   She also believes, “capital sources are certainly lowering yield expectations, but sooner or later, more risks will have to be taken as well; this may include higher leverage levels and lower debt coverage.”

Real Estate Capital Scoreboard® – April, 2011

Chicago, Illinois, April 1, 2011 – Modest economic growth steadily fuels the commercial realty markets with abundant debt and equity funds staying in step.  Inflation pressures are under control in the short-term, alleviating concerns of a double-dip recession.  However, maintaining modest growth proves challenging under current economic conditions as unemployment, weak housing conditions, cautious consumer spending, concerns about Europe and the Middle East and lack of liquidity for many business sectors still haunts entrepreneurial investment appetite. 

Regardless, realty capital markets are undoubtedly back to more normal levels as evidenced by the REIT and CMBS market rebound.  The number of capital providers and financing structures are far superior to those provided a few years ago based upon several factors:

Solid Values:   Conservative investors flock to the best quality, best located properties, accepting lower cap rates in lieu of volatility.  For instance, multifamily properties support 6.5% cap rates on a national average.  Interestingly, same-property dynamics show about a 400-basis-point range within the Class A-B-C quality spectrum.

Public market demand:  The strongest evidence of solid gains in the commercial real estate (“CRE”) sector rests with the public markets.  Appetite for income properties via REITs offers strong performance and tight pricing.  The underestimated rebound in the capital markets allows these companies to sell stock at very competitive rates; few attractive alternatives are offered in conventional stocks and bonds.  Many investors firmly believe that the commercial property sector has bottomed-out and is set for a steady recovery.

Prudent underwriting:  Rating agencies have increased subordination levels, translating to higher-rated tranches, which are more appealing to investors.  Furthermore, CMBS spreads dramatically tightened to more historical norms of about 250 basis points; B-Piece buyers are keeping new issues in-check.  Borrowers now have more varied options in addition to life companies and banks. 

Real equity:  Pricing concerns plague non-stabilized properties, especially in competition with under-performing maturing loans.  Extremely conservative loans backed by substantial equity are the only panacea for this sector.  That said, savvy investors purchasing such assets at reset prices on an “all cash” basis are expected to handsomely profit, if projects are well conceived and in strategic locations. 

Jeanne Peck of the Real Estate Capital Institute, forecasts “Spring capital markets are clearly in full swing as proof of REIT and CMBS dynamics.”  Adding, “CMBS [and other] investors are out in full force armed with lots of cash, but still maintain discipline as the memories are still fresh of the Great Recession.”

Real Estate Capital Scoreboard® – March, 2011

Chicago, Illinois, March 1, 2011 – As spring approaches economic recovery is delicate, but more encouraging signs are surfacing within specific realty product sectors and markets demonstrating job growth.  For example, many warehouse markets enjoy higher occupancies as global trade rebounds.  In addition, consumers are renewing spending, helping to ease oversupply concerns in the retail sector.  Of course, problems in the housing sector continue to translate to higher profits in most multifamily markets.

The Middle East tensions are favorably influencing lower mortgage interest rates.  During February declining treasury yields combined with compressing mortgage spreads helped interest rates stay in the 4.5%-to-6% range for many types of fixed-rate, longer-term loans.

Important trends changing the commercial property financing landscape include: 

• Economic Outlook:  The usual leader in economic recovery, the housing industry remains depressed.   Housing starts are nearly at a standstill.  Yet the economy is rebounding at a modest tempo with overall growth pegged at about three percent.  Such a pace is still below historical rebounds following severe recessions.  Nonetheless, the unemployment rate is expected to dip below nine percent – still a favorable statistic for overall income-realty markets.  Also on the inflation front, increases are minimal as economic recovery moves at a slow pace, benchmarked below two percent.  
• Low Rates:  In the short term, the Fed’s active monetary decisions are preserving rates at historically insignificant levels.  However, investors are nervous about longer-term consequences including global growth and fiscal spending. If overall mortgage rates remain in the mid-single-digit range, realty values will remain at healthier levels, otherwise higher rates will lead to more valuation pressures.  
• Demand for Quality:  During the past three quarters, further consolidation occurring as commercial realty markets bask in the abundant supply of attractively priced debt capital.  Although more equity is required [and readily available, universal investor demand is unabated for quality, income-producing properties.  Second-tier assets continue to suffer and a wide pricing differential exists between various quality classes.   
• Restrictive underwriting:  As Wall Street revives the CMBS platform, mortgage delinquency rates reach new highs, hovering just below ten percent.   New loan origination underwriting is now more restrictive due to lingering legacy issues.  As a result, life companies, and other lenders void of major legacy loans, are more competitive in this funding arena.  In addition, while pricing is relatively attractive, the net result across the board for newly originated loans includes more restrictive covenants, mandatory collection of reserves and escrows and loan covenants.  Investors demand adequate protections and want reduced risks in the event problems emerge.

The Real Estate Capital Institute’s Jeanne Peck, emphasizes, “Conditions are improving and optimism is in the air.  New construction should selectively rebound as demand is unabated for high-quality, urban infill properties.”

Real Estate Capital Markets State of the Union

San Diego, CA – February 9, 2011 – In a gathering of mortgage professionals this week at the Mortgage Banker’s CREF conference, the mood was a pleasant as a typical Southern California weather. The industry is clearly on a road to recovery of capital, although property fundamentals still lag in many instancess. Major discussion points of the conference include:

Attendance/Overall Mood: More than a 150% increase compared to the past two years, about 2,500 people. Definitely more CMBS lenders (20+ firms), mortgage bankers and, of course, life companies. Executive search professionals, larger developers/owners and mortgage REIT players also reemerged. Most attendees were surprised how quickly the capital markets have recovered, but are frankly concerned about the lack of quality product available for financing.

High points: “Abundant funds at competitive pricing for quality deals” was the positive theme of this conference. Overall, spread ranges of 150 to 225 bps over comparable term treasuries (and swaps) are the “sweet spots”, although many lenders lament that spreads will continue to tighten as competition intensifies and some expect spreads to be lower by 50 bps or more as the year progresses.

Low points: “Finding suitable product” would be a major concern. 2011 and 2012 will be record-years for CMBS refis, with many properties performing below par. In addition, banks are expected to unload substantial pools of legacy loans. Most lenders seek higher quality assets and are willing to stretch on pricing and leverage. They’re avoiding unstabilized properties and markets with anemic job growth. On the flipside, many yield-oriented funding sources expect a dearth of opportunities in restructured deals, discounted note purchases, etc.

Innovative Programs: Other than standard 65% to 75% LTV permanent loans, select lenders are now exploring the following: construction/perm combination debt; more open to secondary markets and entrepreneurial property types (e.g., lodging, fractured condos); partial fundings with earnouts based on future performance bumps; and, of course, more competitive pricing in light of heavier competition.

Real Estate Capital Scoreboard® – February, 2011

Chicago, Illinois, February 1, 2011 – Washington’s legislative impact on income-property real estate surfaces as the hot topic (e.g., Agencies fate, Frank-Dodd).  Yet the action timeline is still not clearly defined, or not in the immediate future.  Instead, the markets are still digging out of many problems supply/demand issues.  Meanwhile, the ownership burdens ease as capital has returned to full with a plethora of funding options resurfacing as noted below:

• Capital sources offer more flexibility, including reducing fees, prepayment penalties and other restrictions to keep existing performing loans as well as winning new business
• More bridge and subordinate debt lenders return to the funding arena. Senior debt lenders cautiously allow additional leverage, although subordinate debt is more carefully scrutinized including source and uses, escrows, default provisions and remedies, etc.  
• The competition for larger loans is pushing a number of lenders to go down in size
• Most permanent loan spreads over treasuries staying since last fall, as funding sources have scant investment alternatives with similar risk profiles.  The market prefers longer-term debt instruments.  As for overall pricing, 5.5% often surfaces as a floor on ten-year funds for more typical leverage deals; rate floor are rare for lower leverage, conservative loans,
• While mortgage spreads stay the course, Treasuries are another story.  Short-term obligations are at record-wide spreads, suggesting the markets are concerned about stagflation.  Such pricing indicates that many investors believe the Fed will be more timid about raising rates, despite inflation fears, deficit spending and other global fiscal policy concerns.
• Strong sponsorship with partially distressed portfolios voluntarily surrenders assets to lenders as if no strategic value play exists after all other reasonable options are exhausted.  Depending upon the circumstances, lenders cooperate with borrowers as long as all parties act in good faith.

 The Real Estate Capital Institute’s director, Jeanne Peck, suggests, “Recovering capital markets provide fuel for accelerating loan workouts.  In general, funding sources are maintaining underwriting discipline; only truly troubled and ill-conceived projects will fail.”

Real Estate Capital Scoreboard® – January, 2011

Chicago, Illinois, January 10, 2011 – Realty markets are rebounding, although at a slow and sporadic pace.  Each property sector shows varied investor demand, strictly driven by location, quality and cash flow dynamics as broadly outlined below:

Multifamily – As has been the case for most of this decade, investors clamor for Class A apartments in major markets.  Extremely aggressive pricing leads many to consider new construction in the major markets based on rapidly rising rental rates and tight supply.  In many cases, investor demand is overflowing into secondary markets, driving up pricing across the entire sector.  As long as the GSEs are active players in the financing arena, expect the apartment sector to maintain peak prices, often valued with below 6% cap rates.

Net Lease – Single-tenant, net lease properties in nearly all categories enjoy strong investor demand.  Overall pricing ranges from 6%  cap rates or more, depending upon credit and length of lease term.  This market segment is the most sensitive to interest rate volatility and should continue to show solid performance gains, depending upon cost of capital.

Industrial/Warehouse – Economic recovery helps this property sector maintain a strong foothold of investor demand.  Industrial properties tend to rebound faster than other commercial property sectors as overbuilding as “spec” development is closely linked to the overall economy, keeping capital in check with supply and demand.  Expect solid pricing in the “gateway” markets along the coasts and in the Midwest.  Cap rates will mirror net lease assets.

Retail – Retail properties are more location-driven than any other asset class.  While credit tenancy is important, sales performance of each location drives pricing as many retailers represent marginal credit.  Existing and new-construction infill properties are in strong investor demand with cap rates mirroring the highest quality properties in other property sectors.

Office – Office property values have been vacillating during the past year as office space dynamics greatly vary in different parts of the country and downtown vs. outlying locations.  “Core” CBD properties maintain strong pricing with cap rates hovering in the 6% to 7% range for newer, multitenant assets with long-term leases.  Conversely, many investors avoid the suburbs as oversupply and employment fundamentals lag. 

Other – Lodging, senior housing, recreational and other property types are also rebounding, but on an extremely selective basis.  These “business-type” properties vary widely in values and are heavily linked to sponsorship and performance.  As such, valuation metrics continue to emerge.

Jeanne Peck, director of the Real Estate Capital Institute, predicts, “The new year brings more optimism and hope as the worst seems to be behind us.”  Also stating, “While economic recovery is in motion, throwing caution in the wind is a reckless investment strategy.  Market volatility is very property-type and location-driven and proper due diligence is more important than ever”

Real Estate Capital Scoreboard® – December, 2010

Chicago, Illinois, December 2, 2010 – Real estate capital markets are improving, yet commercial mortgage delinquencies continue to rise for overleveraged properties still priced far above recovering values.   Statistics vary by property type, location, leverage and other underwriting metrics, but clear signs portend more loan performance issues for next year and beyond. 

November’s capital market performance ended with more rate increases as 5-year treasuries increased by over a half point and 10-year rates by over a quarter point.  Shorter-term rates remained relatively flat.  MBS spreads continue to widen as buyers of MBS remain on the sidelines and lender offerings increase as the year-end approaches.

On the positive side, the midterm elections, improving employment and a stock market rebound — all bode well for the commercial real estate sector including the following observations:

• Investor yield expectations still off target vs. seller liquidity and profit/loss parameters
• Sales momentum remains low, yet quality Core assets are very competitive due to scarcity
• Available distressed/foreclosed properties much lower than originally anticipated as most banks still write down loans, perform workout and “blend/extend” in preparation of monetizing their holdings.  However, 2011 and 2012 should offer more inventory for sale as banks aggressively move to clear their balance sheets with an improving economy.
• Single-tenant, credit properties enjoy dramatic price resurgence in direct correlation with improving corporate performance, similar to pre-recession levels.
• Banks are getting healthier but access to credit is still very tight

 

Observation:  Sponsorship net worth is an ongoing concern within the lending community, especially with the Agencies.  Lenders require at least 10% of the loan amount in Liquidity (cash, marketable securities).  In addition, 401k, IRA and unused credit lines typically do not qualify as part of the liquidity test.  Overall, net worth benchmarks include about from about 30% to 60% of the loan amount, depending upon the funding amount.

Jeanne Peck, Executive Director of the Real Estate Capital Institute, advises, “As we head into 2011, expect a lot more transaction volume as financial institutions want to realize more profits and finalize losses.”  Peck also suggests, “Values for non-core assets will continue to suffer as more assets are unloaded into the market.”

Real Estate Capital Scoreboard® – November, 2010

Chicago, Illinois, November 1, 2010 – Rates stay submerged at extremely low levels and the Fed moves to boost the economy.  In October, overall mortgage interest rates moved by about 10 basis points higher.

More signs of economic recovery in the commercial property markets as experts report flattening vacancy rates and greater cost savings from operations.  Other economic indicators influencing the real estate capital markets include:

• New construction of housing dipped to a historic bottom, per the US Census Bureau.  An ongoing trend of reduced homeownership — from near 70% to the historical norm of 60% — contributes to reduced housing starts levels not seen since World War II.   Such statistics bode well for multifamily properties.  But caution is in the air; the cost of home ownership is now more affordable than renting in many markets, indicating the residential markets are near the bottom. 
• Construction costs are lower by at least five to ten percent, particularly hard costs.   However, as more projects are announced, expect the cost savings will be short-lived.  Developers with economically-justified projects that are ready to be launched in the near future will be the winners in this game.
• Interest rates are expected to remain low for next 12 to 18 months.  Rates will increase with inflation, which won’t move until job creation occurs.  Thereafter, many investors feel rates will be noticeably higher within five years and that any asset financings obtained today will add substantial value. 
• Further pricing pressure on core assets as a weaker U.S. dollar brings more overseas investor appetite.  Foreign investors, already accustomed to lower returns, are more likely to bid on US core real estate when the dollar is weak.

 

 The Real Estate Capital Institute’s Advisory Board member, Randal Dawson suggests, “Projection for a stabilized economy is 2013 when most of the CMBS issues and real estate bank debt is expected to clear the system.”  Mr. Dawson also states, “By this time, the economic growth will further fuel more demand for commercial realty investments, both existing and new construction.”

Real Estate Capital Scoreboard® – October, 2010

Chicago, Illinois, October 3, 2010 – Benchmark indices declined about 30 basis points in September.  However, mortgage rates taking a steady course as funding sources demand yield despite the recent movement in Treasuries.  Alternative debt product options (e.g., bonds) offer more competition keeping pressure on yields and pricing at current levels.  In summary, overall mortgage rates comfortably trade within the mid-4% range for longer-term mortgage featuring full leverage.

Money for real estate investing is bountiful and lot’s of cash sits on the sidelines in search of the “right” deal, translating to the following trends:

• As market fundamentals continue slowly improving, banks and other financials institutions with excess real estate exposure are not selling assets very quickly, particularly properties with cash flow. 
• The hottest income-property markets with the fastest recovery prospects include the coastal core markets and major 24-hour urban markets with Washington DC, San Francisco, New York and Southern California at the leading edge.
• Often times in the final bidding process for new deals, a handful of final bidders appear; but the disparity in pricing is wide among such finalist, indicating the investors still have vary different expectations regarding market fundamentals.
• While prime-property pricing is being bid up for new acquisitions, lenders restrict refinancing to loan-to-cost limits as “cashout” of equity is a key concern.   Loan-to-cost restrictions hover at 75% or less, in most instances.
• The very best properties are trading close to replacement cost.  More funds are considering new construction options for both debt and equity, especially for multifamily deals.
• Lenders are still very conservatively underwriting most loans with lower leverage (e.g., 70% or less for commercial properties) providing the most common safety cushion for prudent sizing.  However since rates are so low and debt service coverage are high, many lenders are willing to “loosen” underwriting standards to include longer amortization schedules, more flexible prepayment provisions and other such tweaks.

 

Jeanne Peck, Executive Director of the Real Estate Capital Institute, notes that “The pent-up demand for higher quality real estate leaves a huge vacuum in the non-core property and market sectors.”  She adds, “Eventually, the older properties in tertiary markets may witness pricing appreciation and funding demand, as many investors are priced out of the core deals.”

Real Estate Capital Scoreboard® – September, 2010

Chicago, Illinois, September 9, 2010 – The summer season ended with Treasury yields declining, but returning to levels of the previous month.  Yet, more lenders returned to the market and the Agencies marched forward by offering even lower spreads by 20 basis points or more. 

Borrowers with high-quality, institutional projects are the winners within today’s debt markets.  However, a substantial disconnect exists for older projects in secondary markets as borrowers must accept higher pricing, less leverage and recourse.

Observations for the month include:

• Capitalization rates sliding downward in tandem with lower mortgage rates and increased availability of leverage – up to 75% for many institutional-grade office, retail, industrial and apartment properties.
• Overall capitalization rates for multi-tenant, commercial properties (e.g.,  office and industrial), are about 50 to 150 basis points lower than the beginning of the year – starting as low as 7.5%. On the other hand, credit-tenant commercial properties with longer-term leases can trade below 7%.
• Multifamily cap rates often are bid down below 7% for core-plus assets and can dip well below 6% for prime-quality properties in major markets.
• Investors bid up sub-performing properties and economic recovery looms on the horizon – particularly true for lodging properties.
• As has been the case for most of this quarter, rates are at their lowest levels since the 1960s.
• More banks and life companies re-enter funding landscape as balance sheets are being cleaned up.  Expect greater bidding on the “right” quality assets.

 

According to Jim Postweiler, Advisory Board Member of the Real Estate Capital Institute, “A substantial disconnect exists between available product and optimal debt pricing.”  He notes, “Funding sources are still selective, but will provide very attractive terms if conservative leverage is sought.”

Real Estate Capital Scoreboard – August, 2010

Chicago, Illinois, August 2, 2010 – Mid-year key economic indicators point to a more moderate recovery.  During July, benchmark treasuries moved within a quarter point range and settled lower by about 20 basis points for five-year notes, while ten-year notes moved down less than 10 basis points, respectively.  Mortgage spreads continued to barely tighten, netting slightly lower overall rates.

Throughout the first half of the year, lenders have been scouring the realty markets in search of performing projects with stabilized cash flow.  Yet limited opportunities may be found.  Simultaneously, scant funding options are available for projects without cash flow performance.   Few capital sources reach for deals on longer-term cash flow projects, unless substantial equity exists. 

With mortgage rates starting in the mid-4% range for longer term debt of seven years or greater, borrowers are migrating from floating-rate to fixed-rate debt.  As rates are at historical lows, focus on loan terms – other than pricing – include the following: 

• Loan-to-value sizing dominates underwriting funding limits, as debt service coverage ratios are relatively high due to low rates
• Subordination and non-disturbance agreements are more important to lenders as various players in the capital stack (e.g., mezzanine and preferred equity) take on new positions in situations where developer equity is reduced or eliminated
• Real estate tax and insurance collection conditions are more stringent, with lenders seeking tighter control in case of default
• Property insurance carriers must meet higher standards due to default within the industry
• Unauthorized transfers are no longer covered by most title policies, adding additional recourse carveouts

Skip Perry, Real Estate Capital Institute advisory board member notes that “lenders want quality loans, and are willing to sacrifice yield in return for safety of principal.”  He suggests, “conservatively underwritten income-property loans are precious commodities capturing premium pricing and terms.”

The Real Estate Capital Scoreboard® – July, 2010

Chicago, Illinois, July 7, 2010 –As stock markets slide downwards, treasury rates follow suit with five and ten-year yields rounding down about 30 basis points lower from June — below 2% and 3%, respectively.  Combined with dropping spreads, borrowers are now enjoying fixed rates in the 4% to 5% range for lower leveraged loans.  Floating-rate loans stay attractive, sometimes below 4%, as fears of inflation dissipate for the time-being.

 Oversupply of funds being mismatched against a much sought-after supply of higher-quality funding opportunities is the theme for much of 2010. However, this issue is evermore pronounced as lenders are under more pressure to fund such assets. Unlike the past two years, the real estate capital markets are more stable as fresh transactions established new value benchmarks helping to remove valuation uncertainty from the underwriting process.  Look to a flurry of aggressive lending at the end of the summer, when most capital sources realize production levels are inadequate.  

While still trying to maintain underwriting discipline, lenders seek creative funding solutions.  For the most part, lenders continue to impose floors to dampen yield erosion.  The yield dams, however, will break as more monies flood the market.   Expect longer amortization schedules (returning to 30 years), leverage approaching 75% or greater and funding flexibility such as partial fundings and forward-delivery loans.  However, debt service coverage will remain at about 125%, since rates are relatively low.

The Real Estate Capital Institute’s director, Jeanne Peck, expects “Qualified borrowers are fast gaining the upper hand in negotiating debt.  Low rates combined with more attractive leverage translate to fantastic cash flow opportunities.”  Adding, “However, the equity markets see such competitive financing as reasons to maintain solid pricing, as refinancing remains a very real option vs. liquidation.”

The Real Estate Capital Scoreboard® -June, 2010

Chicago, Illinois, June 7, 2010 –  More positive news on the realty capital front as recovery from the current downturn is recapitalized by funds which were raised prior to commercial mortgage product being more widely available.  Funding demand is readily available for freshly originated capital  underwritten to currently more stringent standards.  In particular, many non-investment grade credit funds desire new commercial mortgage exposure as secondary market spreads have rallied. 

How does revived realty capital market translate to property-level funding kinetics?  

• New Benchmarks – The Debt Yield (in-place NOI divided by total debt) has now emerged as a popular underwriting index.  This index provides a quick gauge of the debt payment cushion, similar to the debt coverage ratio.  For example, 9.5% to 10% was common yield in during the market peak (2007-2008); now the index falls within the 11-12% for most types of permanent loans. 
• Favorite Fives – The number five seems to be the most favorite digit for tweaking deals.  Funding sources use the number five in many different underwriting scenarios including: 5% more leverage (70% vs. 65% LTV), 5% less debt coverage (120% vs. 125%), 5 years more in amortization (25 years vs. 20 years) and 5% more occupancy in improving markets (90% vs. 85%).
• Floors – In select cases, lenders reduce [or even eliminate] floors and rate protection for floating rate loans on shorter-term debt (e.g., 5 years or less).  Rate protection can be waived for lower leverage loans, generally 50% or less.   Simultaneously, rate floors are dropping to 3.5% to 4%, as funding sources favor quality over more realty risk.
• Thinking Outside the Box – New Market Tax Credits, Private Placement Offerings (e.g., CIS-Sanctioned EB-5 Foreign Nationals Program), Recovery Act funds and other non-conventional funding vehicles are gaining attention, especially for new construction projects requiring substantial subsidies and equity capital.  Such funds can be used for more challenging assets including senior housing, retail and mixed-use as well as lodging properties.  Available on a select basis and in very focused areas, these programs are highly technical and therefore require substantial consulting expertise for processing. 

The Real Estate Capital Institute’s advisory board member Aaron Gruen suggests “Many economic indicators are improving or stabilizing indicating the worst of The Great Recession is slowly moving behind us.  However, while the capital markets are showing improvement and signs of increasing stability and recovery, asset-level performance improvement is spotty and inconsistent.  Heightened volatility and uncertainty continues to reign.”  He adds, “Targeted risk analysis is especially important today, given that uncertainty and ongoing shifts in demographics, consumer behavior and variability in economic and fiscal performance between and within regions that can be expected.”

The Real Estate Capital Scoreboard® – May, 2010

Chicago, Illinois, May 5, 2010 – Capital continues to flooding the markets and few attractive investment opportunities surface.  While many investors see improving conditions for funding, preserving cash flow remains tantamount.  Evolving realty capital market trends include: 

• Capital:  Both debt and equity are both back at levels well above 2009 lows.  Yields are rapidly compressing and good quality projects capture substantial interest with 30 to 50 bidders not being unusual.  Yet, unsecured funding for private developers still somewhat limited, while public funds have ample access.  Projects in second-tier markets, or without cash flow, remain dormant.
• Funding Sources:   Banks will save deals with negative basis, if borrower is a solid and responsive sponsor willing to commit some level of additional liquidity.  Otherwise, land and other non-cash flowing assets will be liquidated over the next few quarters.  Also, newly recapitalized banks [no legacy issues] are starting to advertise debt for income properties.  Meanwhile, life companies increase leverage to 70% or more and multiple CMBS players are back in action. 
• Fresh Faces:  Foreign buyers, including Canadian, Asian and European buyers are bargain-hunting for properties as well as financial institutions.
• Yields: Lowest rates hover in the mid-5% range for long term debt; 4.5% for short-term.  Core investments attract unleveraged returns in the higher-single range, while more entrepreneurial investors are trying for 15% returns, but finding very limited buys in a crowded buyer universe.  Buying mortgage notes emerges as a popular platform for distressed deals with higher yields, but many shy away from risks associated with potential title issues and prolonged court battles.
• New construction:  Need public backing for generating substantial equity.  Also, institutional and multifamily uses are justifiable – retail, office and industrial only on a very selective basis.  Ed[ucation], Fed and Med[ical] are the most attractive realty opportunities.  Also,  many believe it’s the right time to look for entitled urban land as infill remains hard to find.
• Protecting Cash Flow:  Tenants are very price sensitive and will sacrifice quality for substantial rent discounts.  In fact, in many markets commercial-property values declined to levels not seen in nearly two decades.

 Jeanne Peck, the Real Estate Capital Institute’s director, cites “Like Humpty Dumpy, investors sit on piles of cash.  These investors will either find profitable opportunities, or, cushion any financials falls by paying down debt on existing holdings.”

The Real Estate Capital Scoreboard® – April, 2010

Chicago, Illinois, April 1, 2010 – Realty capital markets continue on a slippery path of gradual recovery held up by the Fed’s desire to keep benchmark rates unchanged – a policy upheld since December, 2008.  Yet bond investors are nervous and driving up spreads as fed notes and bonds start to saturate debt markets and ultimately trending towards higher rates.  In the past month, treasury notes rate ranges climbed by 25 to 40 basis points, with shorter-term maturities showing the most movement. 

Ultimately, this trend leads to higher borrowing costs, but pressure to invest is driving down spreads over treasuries.  Bank cost-of-funds are still at record-low levels, but legacy deals and loan workouts take front stage.  Therefore, new construction and higher-leverage funding are still problematic for short-term fundings.

As for longer-term permanent loans, life companies, select CMBS lenders and pension funds are selectively returning to the realty capital markets, but in incremental steps.  Agency lenders remain firmly committed to multifamily lending about 85% market share.  Loan underwriting “tweaks” are now the norm as these lenders want to differentiate themselves in capturing funding opportunities from a limited pool of qualified projects.  Tweaks include:

• Typical bank deals are structured with very attractive spreads over LIBOR (e.g., 350 bps).  However, floors are formulated on the base calculation (LIBOR floor of 1.5%), effectively raising the rate to a base of 5%, for instance.  These floors are starting to be lowered as banks compete more.
• Mezzanine loans are now bundled with agency debt with leverage in excess of 80% becoming commonplace for higher-quality multifamily loans.
• Loans that are 100% or more above value are known as “pretend and extend” situations where lenders are losing hope of full principal recovery.  If more equity is contributed, bringing the leverage levels to 80 to 100%, financial institutions will usually cooperate with loan modification actions.
• Full leverage of as much as 75% of value is offered at premiums of 50 basis points or more in rate.  While the premium is still costly, this tweak signals lenders’ willingness to raise the leverage bar based on current values.

The Real Estate Capital Institute’s Advisory Board member, Gary Duff, notes “In a sign of renewed optimism, Wall Street reenters the markets in its more traditional role of funding large and highly structured transactions, as well as ventures with debt/equity components.”  Duff suggests “Normalcy is returning at levels comparable to the late 1990’s.”

The Real Estate Capital Scoreboard® – March, 2010

Chicago, Illinois, March 2, 2010 – A painfully slow rebound ignites mild excitement in select sectors of the income-property realty markets.  Sparks of hope kindle the industrial and housing sectors as most investors sense the bottom is near, or within the near horizon.  Choice retail properties also suggest a recovery as consumers cautiously return to stores.  Office and lodging assets are bombarded with oversupply linked to shrinking demand, corporate cost-cutting and rising operating costs.

Rising defaults plaque legacy mortgage portfolios and many lenders still choice to stay on the sidelines to workout their portfolios.  Banks are starting to liquidate non-performing assets.  The Agencies are tightening underwriting standards across the board using more conservative income and expenses, lower leverage, high debt service coverage.  Yet hope springs eternal.

Recovering from near-collapse within the past 18 months, the capital markets are ahead of overall real estate fundamentals.  The most important concern?  More money than funding opportunities.  Will the markets return to more liberal conditions?  Probably not very soon, but some positive signs surface: 

• Steady fiscal policy, repayment of government bailout monies, GDP growth, reduced job losses and recovering manufacturing contribute to growing optimism.
• Overall mortgage-rate ranges start just below 180 basis points, starting to approach historical norms.
• Tightening spreads between conventional funding sources and agencies – now about 25 to 75 basis points for select apartment fundings, for instance.
• Overall interest rates and benchmark indices holding steady despite improving economic conditions and fear of inflation as noted by a mild reaction to the Fed’s increase of the emergency lending rates late last month.
• Bidding is very brisk for prime multifamily and credit-deals.  Cap rates are clearly narrowing for “best in class” projects which should bode well for lesser-quality assets as investors move down the food chain.
• More lenders returning to the market including life companies, banks and even CMBS players.  The level of interest is conservatively more than double seen in the past year.
• Agencies and other select sources introducing mezzanine and more structured financing as part of the capital stack – the beginning signs of improving funding terms based on higher leverage.

 

Jeanne Peck, of The Real Estate Capital Institute’s Advisory Board, states “Denial is now being replaced with Decision.  Legacy funding sources and owners are starting to either restructure with fresh equity or liquidate.   2010 looks more like a year of action.”  She predicts, “We should have a very good feel of momentum by mid-year.”

Realty Capital Markets State of the Union

Las Vegas, NV – February 6, 2010 – According to industry leaders gathering in Las Vegas this week, debt capital is readily available for 2010.  Optimism is in the air and the mortgage lenders are starting to offer more generous terms and conditions. 

In summary, timing is excellent for select borrowers in securing debt based on the following conditions:  (1) Recovering economy, (2) Ample supply of capital and (3) Limited supply of financeable real estate assets. 

The following highlights summarize the 2010 state of the realty capital markets including an overall outlook and overall funding program offerings: 

Back to Basics:

•  As lenders workout of their legacy problems, new funding goals surface which are clearly more ambitious than 2009.
• Still underwriting of actual numbers w/o projections, yet inflation fears exist.
• Most lenders are Indifferent to spreads, but not competition.
• Valuing real estate properties in a declining market still a challenge.
• More allocation of funds available above target amounts if deal flow is of sufficient quality

Underwriting Dynamics: 

As has been the case last year, high-quality projects in major markets backed by excellent sponsorship and cash flow characteristics are most desired—especially based on low leverage of 65% of value. 

Location/Property Types:

• Major MSAs strongly preferred for optional pricing and leverage.  Otherwise a substantially most costly financing with lower leverage.
• Preferred property types ranked in order:  (1) Multifamily, (2) Credit-Tenant lease of all property types, (3) Industrial, (4) Retail, (5) Office – however medical office ranks equal to Industrial and (5) Lodging.

Pricing (Permanent Fixed-Rate Loan):

• Agency pricing for apartments starts in the low to mid-5% range for 5 year or greater term.
• Life company pricing starts mid-5% to 6% for 5 years or more term mostly targeted for commercial property pricing (agencies are more competitively priced)
• More entrepreneurial funds start at 7% or more targeting secondary markets, smaller fundings, older properties and lodging assets.
• Add a pricing premium of 25 to 50 basis points for loans below $5 million.
• Yield differential disappearing – typical ($5 to $50 million) vs. larger loans.
• Forward funds available up to a year based on 6 o 8 basis points premium per month.

 Leverage:

• Above 65% LTV on a select basis combined with lower spreads.
• Values based on the lower of: (a) purchase price, (b) appraised value or (c) lender imposed capitalization rate.

Real Estate Capital Market Leaders Cautiously Optimistic

Las Vegas, NV – February 4, 2010 – As lenders gathered here this week to discuss income-property financing programs, nervous optimism filled the air.   The overall forecast is mildly positive — particularly as compared to 2009.   Funding sources were battling liquidity in 2008; rebuilding balance sheets in 2009; and are now earning profits in 2010 which means mortgage investing is back in vogue again. 

However, lenders fear more uncertainty as the capital markets are imbalanced with relationship to income-property supply & demand fundamentals.  Based on key opinions of various lenders an economic outlook relating to realty capital markets is summarized as follows: 

• Modest job growths combined with controlled government spending discussions directly affect the current economic recovery, slowly trickling into the real estate capital markets.  A 10%+ unemployment rate is still problematic, though.
• Slowly recovering economy due to improved CMBS pricing, housing sales and employment statistics.
• Policymakers are also helping by holding interest rates low at levels favorable for real estate markets.
• Industry leaders are reporting a pickup in capital activity including hiring staff, allocating more funds for advertising/marketing and bidding on more transactions.
• Commercial-property problems loom including hanging vacancy (especially office and retail), less space needs, increased operating costs.
• As lenders workout of their legacy problems, new funding goals surface which are clearly more ambitious than 2009. 
• Life companies under less pressure than banks to liquidate assets, if recovery is on the horizon – longer-term balance sheet hold.
• Still a “buyers market” bias due to flat or declining pricing and lower demand, a worrisome scenario for sizing property values.

In summary, industry experts agree that these and other factors will assure that mortgage capital will be readily available in the foreseeable future.  The realty capital markets should continue on a path of greater liquidity.  Yet the biggest trick will be finding suitable real estate investments as the property markets are recovering slower than the capital markets.

The Real Estate Capital Scoreboard® – February, 2010

Modest job growth combined with controlled government spending discussions directly affect the current economic recovery, which is slowly trickling into the real estate capital markets. Policymakers are also helping by holding interest rates low at levels favorable for real estate markets. Funding activity is scant, but signs of new hope are emerging. During the month, some lenders slightly dropped mortgage spreads by at 10 to 25 basis points. Short-term loans remain relatively unchanged, while permanent loans now start at about 5.5% for multifamily assets and 6% for commercial properties.

As lenders workout of their legacy problems, new funding goals surface which are moderately more ambitious than 2009. As has been the case last year, high-quality projects in major markets backed by excellent sponsorship and cash flow characteristics are most desired — especially based on low leverage of 65% of value. Since rates remain low and funds are scarce, lenders resort to more creative solutions to capture such limited opportunities, including offering mezz debt and applying net worth covenants.

A renewed interest is arising in mezzanine programs, particularly for multifamily fundings. On a selective basis, funding sources can dip below the standard 125%-debt-service-coverage threshold for loans already on the lender’s balance sheet. Payment formats based on self-liquidating amortization schedules of 5 to 10 years and a maximum leverage is 80%.

Net worth covenants are required on a selective basis to help protect lenders against problems associated with sponsorship vs. the actual asset. For instance, the sponsorship should maintain a minimum net worth equal to the loan amount of which 10% or more is liquid. Noncompliance results in a loan default which is curable by principal paydown or additional credit support (e.g. letter of credit). This structure is more difficult to enforce for partnerships with different principals, as well as larger institutional-grade transactions.

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The Real Estate Capital Scoreboard® – January 2010

 

Chicago, Illinois, January 11, 2010 – The start of a new decade adds fresh hopes and fears in the realty capital markets.  The Fed’s persistence in supporting lower rates is helping to avert more financial suffering from increased cost of capital.  Investors are encouraged to gravitate from low-yielding governmental debt.  Dual-personality investing prevails as many of these same investors seek relief on legacy assets, while trolling for fresh new assets based on more attractively reset prices. 

How are capital markets positioned for this new decade and what are the key trends starting off the year? 

• Oversubscribed Monies:    More funds exist than placement opportunities.  Buyers expect lower prices and sellers don’t want to realize heavy losses unless under duress.  During the past year public funds (mainly REITs) raised more than twenty-five billion dollars of equity for income properties funds.
• Redefined Pricing Expectations:  Sellers are reluctant to unload legacy assets at deep discounts, contrary to market logic given today’s stagnant economy.  Investors targeting performing assets for traditional property types remain disappointed in trying to acquire seemingly distressed, value-add and Core-plus deals.  Overall returns of 20% or more targeting shorter holding periods are sparse in major markets.  Such investors will need to expand risk horizons and lower return expectations to include longer holding periods, more diverse property types and non-gateway markets. 
• Replacement Cost Metrics:   Investors willing to forgo immediate returns rise as winning bidders.  Mostly private and overseas funds, these players understand values based on replacement costs, as well as currency plays.  Overall returns are ignored, instead focusing on extremely low costs per unit, assuring limited probabilities of competition from new construction over the long term.
• Rising Liquidity:   Last year numerous major investors reported plunging transaction volume levels of as much as 90%.  As 2009, will be remembered for limited activities in the capital markets, this year should see more deals as financial institutions liquidate sub-performing assets.  However a dearth of activity is not expected; rather a modest pace at first.
• Looming Loan Maturities:  As much as a half-trillion dollar of debt will mature this year with limited prospects of refinancing other than the current funding sources, in most cases.  Furthermore, 2011-12 maturities are at similar levels.  Many believe further government intervention will continue as few economically justifiable “rescue capital” solutions surface.

 

The Institute’s Advisory Board Member, John Oharenko believes, “We’re bouncing along the market bottom as values continue to slide, but a less dramatic levels.”  He suggests, “Some of the greatest investment opportunities lie ahead, especially for those buyers willing to sacrifice current return and relying upon overall market momentum to improve during the next three to five years.”

# # #

The Real Estate Capital Scoreboard® – December 2009

Chicago, Illinois, December 1, 2009 – Substantially discounted senior loan levels combined with eroding property values force legacy funding sources into difficult decisions in managing technical defaults, monetary defaults and loan maturities.   The stage is clearly set for workouts and recapitalizations well into next year, while new lenders are seeking high-yield opportunities with fresh capital for workouts/restructures, partner buy-outs, loan purchases and property acquisitions.

Multifamily and senior housing properties continue attracting low-priced/high-leverage funds via the Triple F’s (FNMA, Freddie and FHA).  Otherwise, commercial properties attract capital with mixed results. 

For instance, partially leased, Class-B office ventures are considered only if located in Class-A locations.  Discounted-cash-flow underwriting for such fundings include trended economic vacancy is trended towards historical norms, often below actual figures as investors brace for more economic storms.

In today’s tight credit market, important metrics for any financing ventures include:

• Quality Sponsorship:  Sponsor analysis is tantamount.   Lender must have complete information about a borrower’s portfolio performance and maturity schedule.  Full understanding required of assets, liquidity, liabilities including all contingent liabilities.  All information must be up-to-date, especially valuations and economic performance.
• Reset Valuations:  Commercial real estate prices have dramatically declined by more than 30% from a year ago and well over 40% as compared to peak levels of 2007.  The most shocking is the steep plunge in prices for multifamily assets, historically considered the most immune sector in the industry.  Furthermore, even the most resilient markets in the country (e.g., Northern California) report fundamental weakness in demand.
• Changing Credits:  Although numerous credit tenants are contracting, newly forming tenants emerge including governmental agencies, academic institutions, specialty retailers, etc.
• Additional Leverage:  Mezzanine loans and preferred equity selectively offered for building up the capital stack.  Consideration of additional collateral and partnership interests for leverage enhancement.

In summary, overall market sentiment focuses on avoiding liquefying legacy projects unless absolutely mandatory.

Mark Hayton, an Advisory Board Member of the Real Estate Capital Institute notes, “Credit-tenant commercial properties remain financeable, although strict underwriting standards are necessary.”

Fairly Negotiating Real Estate Placement Fee Splits

INTRODUCTION

Within the real estate capital industry, deciding equitable fee sharing arrangements is often one of the more debated issues between various professionals involved in structuring a specific transaction.  Not to be confused with overall fee structuring, this discussion is completely separate from the actual negotiations with the property owner (e.g., exclusive vs non-exclusive and pricing).  Otherwise known as “fee distribution”, “splits” or “co-brokerage” agreements, fee sharing arrangements cover all types of real estate capital activities including consulting, sales, financings, partial-equity and joint venture assignments.

Fee sharing discussions don’t apply to certain situations, including smaller fees and individual assignments.  Although no fee is too insignificant, for smaller fee assignments that are typically $25,000 or less, fee sharing arrangements are more casual as the depth and scope of such assignments seldom require multiple disciplines.  These fee sharing arrangements are usually more standardized.  Also, capital transactions limited to single individuals and organizations may be irrelevant or subject to internal compensation policies.

Fee sharing discussions are usually structured based upon rules of thumb.  Brokers, investment analysts, administrative personnel, closing professionals and others within an organization — as well as outside parties involved in a transaction — will each have individually-biased views on fee distributions. Such discussions typically lead to heated debates on “fairness”, “reasonable”, “standard”, “market rate”, “customary” and “typical” as defined by each party.   Of course, everyone normally believes that their position is “right.”

THE FAIRNESS DOCTRINE

Rather than debating about right or wrong, or what is considered fair, fee sharing discussions need to center around facts and circumstances.  To avoid conflicts, each party should agree beforehand about the “fairness” of the fee sharing allocations based on determining responsibilities and dedicated resources.  

Needless to say, defining “fairness” in fee sharing arrangements is both an art and science.   The science identifies specific variables in the fee split equation; the art applies the importance of the variables using weighted averages.  For instance, how much importance does experience and market knowledge factor into calculating an individual’s contribution to the transaction?

More often than not, fee sharing agreements are blended with management policies, experience and instinct — normally resulting in “fair” distributions. In most instances whereby fee split allocations are not deemed fair by all parties, conflicts will develop. Therefore, the goal of fee sharing arrangements, like any other business ventures, is based on an equitable “win-win” outcome.

For all parties to view the process as completely fair and unbiased, experience and instinct should be supported by applying clearly defined criteria measuring personnel contributions to the entire real estate capital placement process.  Control and Placement are the two such components forming the basis of measuring time and resource allocations in this process.

CONTROL AND PLACEMENT – THE FOUNDATION OF FEE SHARING DISCUSSIONS

Fee sharing based on fairness guidelines are rooted in Control and Placement.  These two components equally form the balancing point of fee distribution. Control focuses on capturing a real estate capital placement opportunity such as a project sale, mortgage origination or joint venture.   Placement forms the counterweight for successfully completing a funding assignment.  Said another way, Control represents the capturing the opportunity and Placement converts the opportunity into a successful transaction.

Understanding Control and Placement is relatively simple. However, identifying the various components and subcomponents can become a daunting task.  And more often than not, Control and Placement will be interrelated as elements within each of these components mesh together to make the process successful in totality rather than piecemeal.

Control and Placement discussions assume all parties involved in fee sharing discussions are professionally qualified and licensed.  For example, an individual with accounting and real estate analysis software training should be responsible for project cash flow analysis.  Before any sharing arrangements occur, parties must be properly licensed to conduct business and collect fees in the various States where projects exist.  Typical licensing requirements include sales brokerage, appraisal and loan origination.  Otherwise, any agreements are not legally enforceable, regardless of professional qualifications and Control/Placement responsibilities.

In addition to the qualifications and licensing requirements, three other factors to consider in formulating Control and Placement responsibilities to additional professionals while insuring that the client’s best interests are served include:

• Outsourcing services to professionals with specialized expertise for document reviews, physical inspections and demographic reports
• Portfolio vs. single-asset assignments
• Project timelines – how quickly does the assignment need to be completed

 

While few professionals actually break down fee arrangements using such components, more disciplined approaches to these decisions rely upon identifying various subcomponents and applying formulas for calculating contribution/compensation levels apportioned to all parties involved in the transaction. The CAP Fee Sharing Model is one such tool used for identifying and quantifying contributions with the goal of computing fee split allocations to all parties involved in the transaction.

FEE SHARING CALCULATIONS

Realty professionals will certainly have different definitions of how to identify and weight Control and Placement, or other variations of these components.  As a result, The Real Estate Capital Institute interviewed a wide spectrum of industry leaders in the debt and equity capital markets including investment sales specialists, consultants, mortgage bankers and other brokers for the purpose of creating a fee distribution model that reasonably and accurately reflects Control and Placement measurements, resulting in the CAP Fee Sharing Model.

The CAP Fee Sharing Model demystifies the process of systematically computing equitable fee splits.  As mentioned earlier, this model centers on Control and Placement for quantifying fee sharing arrangements.  The goal of this model is to generate interactive fee sharing calculations based on “Win- Win” objectives for all parties.  The calculations require applying weighted-averages to important tasks within the process.

The Model divides Control and Placement on a 50/50 basis, further subdividing these components into subcomponents along with assigning weighted averages.  Control/Placement is a straightforward computation since both components carry equal weight.  Measuring subcomponents is a more challenging task as their respective values are more subjectively analyzed.  Regardless, the modeling formulates a basis for further discussion of the value of services provided by the various parties in the capital placement process. 

The Control variable is subdivided into three components: Referral/Generating Leads, Handling Client Communications and Procurement of Exclusive Agreement — accounting for half of the total fees.  Placement, the other half of the fee split calculation, includes Underwriting, Marketing and Closing subcategories.  Each of these major components and their respective subcomponents are further outlined below, including definitions and weighted average values in relationship to the entire fee.

CONTROL

Control is defined as the ability to secure a transaction for capital placement including sale, refinancing, joint venture, etc. The control results collected efforts in negotiating the agreement (mortgage banking application, exclusive sale agreement).  Control is not necessarily limited to a single individual or organization and often involves multiple groups of professionals, depending upon the scope of the capital placement assignment. 

The key subcategories of Control include: Generating Leads, Handling Client Communication and Procuring an Exclusive. These Control subcomponents are presented in sequence of a typical transaction beginning with identifying the project through obtaining an exclusive.

Referral/Generating Lead (10% of Total Fee):  Generating leads and mining for new client relationships is the initial step necessary in initiating a transaction. Cold-calling is the most common method of finding leads. Attending various real estate seminars and conventions, actively participating in professional organizations and other more effective methods of meeting clients also produce effective results. Regular follow-up based on additional meetings, phone calls, e-mailing campaigns provide continuous links of communication. In some cases this process may take days, months or even years. This activity has a value of about 10% of the entire transaction, and is typically known as a “referral fee” if no other action is taken by the broker involved in the process.

Handling Client Communications (10% of Total Fee):  Naturally speaking, client communications on an ongoing level take the referral process to the next level.  More frequent communications help to establish stronger links with the client, requiring more time and energy, as well as information gathering and analysis work to secure project control. As with the referral process, client communications can be an ongoing situation spanning a long time period. Handling communications is typically interwoven with the referral process and accounts for a total of at least 20% of the fee. 

Procuring the Exclusive (5% of Total Fee): Procuring the exclusive is the final step in successfully establishing project control.  Securing the exclusive, whether a loan application or a listing agreement, indicates that the referral process and client communications have culminated to a fruitful conclusion. Most professionals will agree that tying up an exclusive clearly indicates that half of the fee has been earned. Without this last step, the parties involved in securing the fee are working under more challenging conditions as other non-exclusive brokers may also be competing for the transaction.

PLACEMENT

Upon securing Control, Placement completes the process of successfully marrying capital with a project. Placement subcomponents include Underwriting, Marketing and last but not least, Closing — all discussed as follows:

Underwriting (20% of Total Fee):  As part of securing control and processing the transaction, underwriting bridges the gap between securing and funding the transaction. The key ingredients for underwriting — which accounts for 20% of the fee — include analysis, review of various documents and preparing a complete and detailed offering memorandum for sale, refinancing or other realty capital structure. Each of these components is described as follows:

• Document Reviews: Review of documentation involves reading and understanding key variables in a specific real estate capital transaction including leases, rent rolls, historical performance, physical property information and overall market dynamics such as supply and demand, vacancy, comparable property performance. 
• Financial Analysis:  Simple ratio tests, discounted cash flow analysis and other capital budgeting techniques are used for translating documents into financial ratios for further discussion.
• Offering Memorandum: The last component of underwriting is tying together all of the salient facts of the transaction including document highlights, location and property dynamics, financial analysis and sponsorship information 

 

Marketing (20% of Total Fee):  Marketing is the third component in sequential order, also representing a weighted average of 20% of the total fee. After the project has been secured for Placement and the information has been processed into a detailed offering memorandum, the marketing process begins. The goal of the marketing process is to deliver the optimal capital placement source for the project based upon contacting qualified capital sources, negotiating and filtering offers and conducting tours.

• Contacting Prospects: Contacting prospects is an ongoing process as the marketing team needs to identify the appropriate real estate capital sources including buyers, lenders and joint venture partners. The process is more extensive than simply cold calling as these prospects must be prescreened as to performance and reliability. More often than not, prospect relationships span a number of years and transactions. Furthermore, contacting prospects may also be challenging depending upon market conditions (prosperous economy vs. recession) and property types such as senior living deals and more complex mixed-use developments, for instance.
• Negotiating Offers:  The second step of the marketing process, negotiating offers, is equally as critical as finding the qualified prospects. Market knowledge and negotiating expertise always play key roles in determining the direction and scope.
• Tours and Inspections:  Finally, property tours in various other inspections can mean the difference between success and failure. Overall knowledge of the property, locational dynamics, immediate area, ingress and egress issues as well as overall market conditions, all lead to successful property tours.

Closing (10% of Total Fee):  Without a doubt, the closing must be handled with the same amount of importance as all other elements of the fee placement process. Too many things can go wrong if all parties assume that the transaction is on track by simply passing the closing process to the attorneys, title company and others. However, the transaction team should not provide legal advice unless properly staffed and authorized by the client to do so.  Instead, the responsibility lies in following through on any paperwork flow relating to the key business terms of the transaction based on the following:

 

• Document Review:  As to the business points of the transaction, the documents should be reviewed with the client to be sure that the negotiated items are identified.  Once again, any legal, tax, title or other technical document review issues should be left with experts such as accounts, lawyers and other third-party vendors.

 

• Processing Documents:   Processing the documents includes communications with attorneys, surveyors, municipal officials and other parties involved in documenting the transaction.  However, to the extent that documents need to be collected and assembled for further processing and review, the transaction team’s role will be defined as necessary, depending upon expertise and circumstances.

 

OBSERVATIONS

 

A host of other factors need to be considered when discussing fee sharing arrangements among real estate professionals including teamwork, sliding scales and  of course, qualifications.

Teamwork:  In today’s marketplace, most success real estate capital placements involve integrated teamwork, often in the same office.  In addition, highly specialized disciplines such as hotel consultants and healthcare professionals are involved in packaging and marketing special-purpose assets.  Even more expertise is required when working with single-purpose financing sources such as FHA/HUD and when equipment leasing is included with the property.

Sliding Scales:  Upon completing an initial transaction, various parties may decide to change roles and become more, or less involved. Subsequent transactions involving the same client may have lower fees splits with parties that have already initiated a transaction, but only want to share in the referral process. Other parties would therefore have more responsibilities, and take larger percentages of the fees.

Qualifications:  The skill set and experience are tantamount variables for sizing fee splits.

PROS AND CONS 

The advantages of using the Chicago Fee Distribution Model are as follows:

• Established baseline formula as a tool for further discussions.
• Systematic weighted-average point system providing benchmarks for measuring variables involved in determining equitable fee sharing arrangements.
• “Fine tuning” of key variables present indices for further discussion and weighted averages may be altered depending upon specific circumstances.
• Weighted average is for each variable helps define importance of various levels of resources, including labor allocation.
• Objective and independent methodology available to supplement existing fee arrangement policies within an organization.

 

Limitations include:

• Very difficult to address and weight intangibles such as professional experience, corporate loyalty, and other factors not included in the model.
• Variable and weighted-averages are subject to wide variety of interpretations.
• Weighted-average points are applied subjectively.
• Not all variables may be included.

Measurements are only as good as inputs.

EXAMPLES

Traditional 50/50 Arrangement: The classical example of a fee sharing arrangement assumes two parties, the listing agent and the buyer’s representative, share fees on a 50/50 basis. In this example, the listing agent has Control and the buyer’s agent executes the Placement. Fee Placement modeling is hardly needed as the roles are clearly defined.

Intra-office Arrangement: Medium and larger real estate organizations offering full services such as appraisal, consulting, brokerage and management normally have fee sharing policies. Even so, disputes surface various professionals view their roles differently in fee sharing. For instance, an appraiser who has a long-standing relationship with a property owner can get control of an exclusive listing and performs a substantial amount of investment analysis. Under such a scenario the appraiser would most likely not have a broker’s license, as well as play a very limited role in marketing and processing the closing. 

These circumstances justify a fee split of as much as 40% of the total fee calculated as follows:

• Control 20% – composed of 10% referral and generating lead plus 10% handling client communications and no credit for procuring exclusive as the 30% should be paid to the broker with the license responsible for securing listing and communicating with potential buyers.
• Placement 20% – full credit for underwriting including document review, financial and packaging. Again, the remaining 30% of the total fees relating to marketing and closing are not included in the appraiser’s list of responsibilities.

 

Structured Transaction Arrangement:  The more difficult and technical the realty capital placement assignment, the more scrutiny is required to determine equitable fee sharing arrangements. In the case of highly structured transactions such as joint ventures, land sale leasebacks, mezzanine loans, preferred equity deals and other hybrid debt/equity vehicles, multiple disciplines merge to complete the transaction.

The most common arrangement may include a combination of fee splits along with payments to outside vendors.   These outside vendors — including lawyers, accounting firms and financial consultants – will handle highly technical details relating to the marketing and structuring efforts of such transactions.  Fee sharing arrangements will often include flat-fee, hourly billing or other non-commission type payments.

In summary, structured-transaction fee sharing arrangements are difficult to illustrate.  Yet more often than not, highly sophisticated property owners work with equally sophisticated capital funding sources, demanding highly-professional, multi-level services.

 

 

CONCLUSIONS

The Real Estate Capital Placement Fee Split Model presents a clear and concise that of discussing the sharing of fees and distribution of responsibilities. In and of itself, this process is not a substitute for clear communications between all parties, a rather a guideline of how fees should be shared along with responsibilities.

The most important element within this process is open and honest dialogue. Also, should circumstances change, including allocation of time and resources, all parties need to be flexible on fee sharing modifications.

The Prepayment Fee – The Fine Line between Mortgage Maturities

 

Prepayment penalties can be a substantial latent cost for borrowers, as well as attractive profit protection for lenders.  Borrowers require flexibility, while lenders seek yield preservation.   

Prepayment language is more important today, as the yield curve favors long-term debt with better pricing and terms than shorter maturities.  All things being equal other than term, the major difference between notes rests within the prepayment calculations. 

Nearly all short-term loans of five years or less have liberal prepayment penalties, and in some cases, none.  Long-term debt is often burdened by the prepayment penalties that can cost as much as 10% of the loan balance, depending on the formula used.

Some overall rules about prepayment penalties are as follows:

1)         Usually locked out from prepayment during first half of the term

2)         Negotiable if coupon rate is substantially below current market rate

3)         Minimum penalty typically at one percent

4)         Yield-maintenance formula works best for borrowers expecting lower rates later in the term

5)         Declining Balance formula provides calculated certainty in loan payoffs

6)         Defeasance formula requires costly processing and multiple approvals – more applicable for locked cash flow loans (e.g., long-term, net lease properties)

7)         Types of funding sources have a direct correlation on prepayment formulas (e.g., balance sheet lender has more flexibility than lender intending to sell the note)

The Real Estate Capital Scoreboard® – November 2009

 Chicago, Illinois, November 2, 2009 – The recovering stock market is gradually translating to more favorable conditions in the realty capital markets. While the capital markets are relatively dormant as lenders seek to shore up the balance sheets, select life companies, banks and private funding sources continue conservatively funding transactions.

Furthermore, Mortgage REITs have reentered the market, seeking higher leverage loans, but at larger rate premiums. Greater competition from this sector will continue pressuring other lenders to offer better pricing.

Regardless of pricing, project quality and sponsorship remain tantamount as lenders stay defensive.  As such, current pricing trends include the following:

• During the past month, benchmark treasury yields moved nearly a quarter percent higher, yet rates remained steady as many lenders continue using rate floors for permanent loans. 
• Floating rate debt remained unchanged as prime bank customers pay floating-rate pricing starting at about 4.5%.

• While new transactions are still rare, refinancings and restructuring of loans remains in the forefront of real estate capital markets. Appraisers and investors are using band-of-investment calculations for sizing values and loans absent of any relevant market comparable data.  Given current debt pricing, capitalization rates under such models typical start at 7% for multifamily properties and 8.5% for commercial assets. Multifamily agency pricing favors securitized loans vs. balance sheet debt as the agencies CMBS markets slowly recover.
• Opportunity investors armed with significant equity capital aggressively hunt for bargain price distressed assets with pricing of 20% or more on an overall return basis using five-years or less time horizon.
• Commercial and industrial tenants with specialized space needs and multifamily projects using FHA funds, such as 221(d)(4), are the only sources of new construction demand.  Return-on-cost yields start at 8% for “definable” credit-worthy tenants, otherwise double-digit figures are more representative of current development risk pricing.

 

Aaron Gruen, an Advisory Board Member of the Real Estate Capital Institute notes, “The Great Recession has permanently altered consumer, investment, and governmental behavior.Both public and private sector interests which influence land use and economic development need to reset their models and practices to work out projects and plans affected by the Great Recession and to respond to the opportunities the economic recovery will present.”

The Real Estate Capital Scoreboard® – October 2009

Chicago, Illinois, October 1, 2009 – The Fed announced that the recession is starting to fade away. The real estate capital markets remain in the doldrums, with more news of increasing delinquencies and foreclosures, looming loan maturities with limited refinancing prospects, declining occupancies, tenant bankruptcies, oversupply and contracting space demand well into the foreseeable future. 

Yet fresh transactions are trickling into the markets, filling value data points. As financial markets are recovering and lenders shore up their balance sheets, deals are repriced, sometimes at levels of 20% to 40% lower than the peak era of 2006-07.  This fall’s positive signs shining on the capital markets include the following:

• Substantial amounts of capital funds are flowing into the public markets, mainly into mortgage and equity REITs.  However, finding qualified investments at “distressed” pricing remains the biggest challenge.
• Life companies trickling back into the mortgage market, as overall bond pricing has improved.  As a result, pricing is tightening by at least 25 basis points.  However, many life companies still feel minimal pressure to originate new loans, continuing to adhere to minimum loan floor rates.
• For high-quality assets with conservative leverage, no “cash out” rules are relaxed as funding sources vie for the premium properties.
• As equity positions vanish in newer legacy ventures, mezzanine and other subordinate lenders busily work to maximize their ownership positions, hoping to protect their investments as markets gradually recover.  In many instances, some of the same lenders converting into ownership positions as also raising additional funds for buying other properties to profit from the currently distressed environment. 

Randal Dawson, a member of the Real Estate Capital Institute’s research notes, “Valuation driven by lower-leverage debt pricing and higher equity yields offers the most effective methodology for understanding values in today’s illiquid markets.”   Adding, “Equity yields continue climbing, as commercial property values show more signs of stress.”

The Real Estate Capital Scoreboard® – September 2009

Chicago, Illinois, September 1, 2009 – Declining property values prices reset investment yield boundaries for all types of income-producing properties. No asset classes are immune – ranging the entire spectrum from institutional-quality, credit net lease deals to distress hotel ventures.  With limited exceptions, new construction developments grind to a halt as investors rethink risk/reward because of ever-eroding market fundamentals.

The “Defi Refi,” takes front stage among lenders with legacy loans, whereby debt terms are defensively renegotiated.  All parties try to avoid foreclosures as long as the collateral is reasonably maintained at occupancy levels within the given submarket.  Defi Refi loan sizing is further outlined as follows:

• Other than senior housing in select markets, few properties see any rental growth; protecting existing cash flow remains a top priority in contrast to any increases.
• Pro forma projections are reviewed downward, as owners expect stable or declining rents/occupancies.  For instance, multifamily properties with rental decreases of 3% or more are underwritten and trended downward vs. trailing operating history figures.
• Markets are strained with a special emphasis providing some form of debt relief in key markets (e.g., Florida, the Inland Empire, Phoenix, Austin, Las Vegas, Atlanta, the Upper Midwest).
• Voluntary conversion of debt to partial equity is offered as an additional solution to eroding debt balances, increasing 2% or more on vacancy rates for apartments.
• Roll-in of the prepayment penalty deemed to be a cash-out – defined as an optional cost to “better” their financing – hard line by FNMA – small penalty (e.g., 2%) not a big issue if a couple of 2% on LTV but NOT 75% to 80% jump, for instance.
• Standard provisions include lengthening amortization schedules and loan term, offering interest-only payments, reducing (or removing) non-monetary default provisions such as debt service coverage and loan-to-value covenants and partial forgiveness of debt.

 

The Real Estate Capital Institute’s Advisory Board Member, Harold “Skip” Perry, laments, “The volume of foreclosures and restructuring leads me to believe the end is not in sight for at least one to perhaps two years.”   Skip suggests, “Defensive investment tactics are the norm rather than the exception until more trades occur and properties are marked-to-market based on current conditions.”

The Real Estate Capital Scoreboard® – August 2009

Chicago, Illinois, August 3, 2009 – Mid-summer market madness clouds the real estate capital industry, yet bursts of hope glimmer as more properties are sold and investors are beginning to see a bottom.  As short term rates remain near the bottom, with LIBOR sinking to a record low, plenty of funds are available.  However, funds are sidelined in anticipation of even more favorable pricing in the coming months as distress deals are predicted to flood the market within the next two years.  Other market highlights include the following:

• Pricing readjustments of 20% to 30% below 2007-08 levels emerge as new benchmarks. With rare exception, pro forma valuation is replaced with direct capitalization of actual income. In fact, most investors are revamping net operating income figures with downward income expectations, while expenses are expected to rise — particularly property taxes and utilities.
• The yield curves for secondary-market and older properties are substantially steeper as investors focus on prime-location assets at relatively attractive price levels. Such assets are sized based on overall yields often in excess of 15% or more.
• Mortgage pricing substantially favors multifamily assets as debt is still available at 6% or less for higher leveraged the assets via the Agencies.  Conversely, commercial properties are financed at levels of 60% of value or less with strict cash-out requirements and other provisions (e.g., recourse) previously thought too onerous as lenders cherry-pick deals. 
• With distressed debt deals offering very appealing rates and principal reduction, astute investors redouble efforts in this investment arena.  “Loan to own” opportunities appeal to such buyers, especially those with development and management expertise. Banks and other distressed financial institutions provide an ongoing pipeline of deals.
•  “Hidden” prepayments plaque many acquisition deals with existing, assumable debt as lenders force pay down – along with corresponding penalties – in those cases where the purchase prices create unusually high leverage due to the denominator effect.  Less evident, although just as critical, the same issue applies for lenders requiring pay downs from borrowers, even if no new recapitalization occurs as balance-sheet cleansing continues.

 

Gary Duff, an Advisory Board Member of the Real Estate Capital Institute, remarks that “More market clarity is expected in the fall when investors return from the summer holidays.  For now, most institutions consider asset management as their top priority.”  He suggests, “Many legacy owners are more concerned about losing income stream rather than capturing new opportunity plays.”

The Real Estate Capital Scoreboard® – July 2009

Chicago, Illinois, July 1, 2009 – While the Fed decides to keep interest rates steady, the capital markets reset property values and debt underwriting metrics to levels not seen in nearly a decade.  Meanwhile, lenders focus on recasting legacy deals with preferred borrowing relationships.  As expected, new funding opportunities are extremely limited based on highly conservative leverage of 60% or less for commercial properties with capitalization rates in the high single-digit range.

On other hand, apartment financing funds remain readily available via the Agencies at attractive spreads and leverage.  However, more submarkets are reviewed for possible downgrades as vacancies continue to rise throughout various parts of the country.

While the market activities are generally slow, especially in the mid-summer months, clear signs of readjusting capital markets are evident as noted by the following dynamics:

• As capitalization rates approached 10% for many type of “Core +” investments, pricing on a per unit basis look “right” according to many investors, yet uncertainty remains with respect to rent growth and tenant retention.  The big fear being reduced cash-flow pro forma projections, now known as “re-forma.”
• Landlord underwriting is now an important part of the tenant process to ensure performance on space build-out, payment of commissions and reliable future operations.  Landlords without the ability to demonstrate capital resources are at a competitive disadvantage.
• “Zombie” properties, defined as overvalued performing assets which will be difficult to refinance within the immediate and medium-term timeline, haunt lenders and borrowers alike as to exit strategy reversions.
• Net operating income calculations based on adding capital reserves create more debate between buyers and lenders; lender funding availability and underwriting guidelines overrule any such discussions.
• Active bidders include private funds in various formats such as REITs, opportunistic syndicates and wealthy individuals – few public players hunting today.
• Largest transactions are limited to about $75 million per lender, and few deals are “clubbed” as lenders are remain focused on internal portfolio issues.

 

An advisory board member of the Real Estate Capital Institute, Jim Postweiler, notes that “Smaller properties below $25 million enjoy the most amount of acquisition activity.  Larger projects still create issues for attracting optimum leverage and sufficient funding sources.” Postweiler adds, “Foreign investors, mainly from Europe, are reemerging as buyers for prime investments in major CBD markets.”

The Real Estate Capital Scoreboard® – June 2009

Chicago, Illinois, June 1, 2009 – Late spring realty capital markets are starting to show more signs of life, although caution is the word. The agencies continue to provide liquidity to the multifamily markets, while banks and life companies cherry-pick commercial property loans.

Focal market dynamics include the following:

• Building activity is winding down to trickle levels, particularly in office and commercial construction which includes multi-tenant retail space.  The economic downturn and tight credit conditions dampen any prospects for non-residential construction, at least for the next couple of years as oversupply imbalances prevail.  Moreover, lower prices for commercial real estate as acquisitions are much more viable than development. 
• Bank stress tests are succeeding in mildly boosting confidence by persuading investors that no more major negative news is on the horizon. In fact, many banks scored higher than expected.
• Credit remains tight as a lack of confidence plagues bond ratings. Investors still feel that the Rating Agencies are miscalculating risk with more defaults on the horizon.
• By historical standards, real estate debt pricing is still very widely priced in comparison to treasuries.   Highest-grade corporate bonds are trading as low as 100 to 200 basis points and average investment-grade corporate debt is priced in the 450 basis point range.  Meanwhile, the most favorable pricing for multifamily properties is below 300 basis points; commercial properties start at 450 basis points reflecting the perceived tenancy risk for that type.
• As treasury yields spiked upward most of the month, some lenders are holding down, or reducing spreads by 20 to 30 bps, to maintain reasonable levels of loan production for the highest-quality properties.
• More assets are repriced and lenders are unloading impaired legacy assets at discounts of 30% or more. More assets are expected to enter the market during the remainder of the year as valuation and mark-to-market issues are synchronized.

 

According to Jeanne Peck, an advisory board member of the Real Estate Capital Institute, “sellers without a dire need to for immediate liquidity are taking a ‘wait and see’ position.  Today’s indecision could lead to tomorrow’s panic to sell against upcoming CMBS and bank loan maturities without refinancing options.”

What's wrong with a real estate correction?

About a year ago, the real estate capital markets turned topsy-turvy.  Investors, lenders and real estate professionals alike panicked.  Debt and equity funds nearly evaporated based on false risk/reward expectations.  Nearly all capital markets reached “pricing nirvana,” leaving no room for error as prices peaked to unchartered levels.  Typical income-property loans often were priced within a percent of treasuries — well beyond any historical underwriting guidelines measuring debt coverage margins, leverage and valuations. 

Today, the opposite is true.  Over-reactive fear governs expectations.   The aftermath of the mortgage-backed securities re-pricing and fresh concerns about financial institutions’ real estate portfolios force investors to the sidelines.  Mortgage markets remain dislocated and more problems appear on the horizon.

Are real estate markets in a continuing downward spiral?  Not exactly, if history is any guide. 

Markets are reaching “correct” levels as measured by the past decade.   Many will argue the past five years’ realty capital market conditions were abnormal.  Investors scrabbled from the “tech wreck” in search of new profit frontiers; Wall Street greeted them offering lucrative yields blessed by the rating agencies.  The model worked as long as values continued climbing. 

The rating agencies claimed the new role as risk arbitrators of real estate capital – an untested valuation model for monitoring rapidly expanding mortgage securities market.  Wall Street became Main Street for policing realty supply-and-demand risk fundamentals as well as the traditional role of providing capital.  The judge and the jury.

By the end of 2006, overall commercial property pricing skyrocketed to unsustainable levels as values increased by as much as 40 to 50%, while rent levels remained flat — or even declined.  Investors justified such economics by accepting lower profit thresholds often based on optimistic cash flow projections.

In contrast, more “correct” market conditions existed during the late 1990s.  Project yields were more evenly matched to interest rate costs.  During this era and for most of the Twentieth Century, investment returns normally required positive leverage based on current cash flows, resulting in positive leverage. 

In conclusion, the correction will continue with prices trending downward until investors start capturing more sensible yields in to project and cash flow fundamentals.  The speculative premium needs to be removed from pricing expectations.  This re-pricing is a healthy side effect of excessive capital market behavior.  Measurable, risk-adjusted cash flow will dominate investor’s return expectations — back to basics!

The Real Estate Capital Scoreboard® – May 2009

Chicago, Illinois, May 1, 2009 – Within the past month, rates have continually climbed for longer-term treasuries, nudging upward by more than a quarter point. In the meantime, the most active lenders in the marketplace — the Agencies (Freddie Mac, Fannie Mae and FHA/HUD) — correspondingly dropped mortgage spreads.

As a result, overall interest rates remain relatively competitive for multifamily properties, starting in the mid-five-percent range for ten-year debt.  Leverage levels of 75% of value are still available for this asset class.

In contrast, other income properties, including office, retail and industrial assets are underwritten to extremely stingy standards. Few lenders are actively seeking new origination funding opportunities as workouts and corporate viability issues overshadow mortgage lending goals. Commercial loans are generally funded at levels of 65% or less with overall interest rates starting in the higher-6% range and climbing into the mid-8% range.

Full leverage funding opportunities still exist for credit-anchored projects in all income-property categories, as long as BBB or better rated credit ratings are available with reasonable remaining lease terms.

Bright spots in the capital funding marketplace are also beginning to appear. More life companies, banks, pension funds and other sources not plagued with legacy deals are reemerging.  Initially, the pricing requirements are steep and leverage remains conservative, but some loosening is expected as these players start competing for transactions.

As far as specific benchmarks for any funding opportunities within today’s market, the following items are nearly universal minimum requirements:

• Lower Values:  Property values continued declining as more investors realize operating losses and lenders foreclose on distressed assets.
• Limited Growth:  Few, if any, markets are underwritten with any type of income growth. On the contrary, most lenders are forecasting flat, or declining income conditions with expenses rising.
• Higher coverage:  125% debt service coverage ratio for nearly all properties is a minimum threshold.
• Greater Equity:  For refinancings, borrowers must show at least 20% or more of “real” equity as cashouts are frowned upon.
• More Reserves:  Effective property age concerns are forcing borrowers to set up larger reserves for maintaining and retaining competitiveness.

 

Barry Moss, a Real Estate Capital Institute Advisory Board member, notes “Lenders, borrowers, investors, tenants, developers and nearly everyone in the real estate industry is in a defensive mode.”  He suggests, “As TARP/TALP funds trickle into the financial system and lenders mark down legacy assets to current metrics and sell those assets, more badly-needed liquidity will return to the industry and transaction activity will increase.”

The Real Estate Capital Scoreboard® – April 2009

Chicago, Illinois, April 1, 2009 – Commercial and residential income-property values and mortgage underwriting continues readjusting to more conservative levels not seen in more than a decade.  While most buyers and sellers are tangled in a pricing stalemate, funding sources define debt and equity metrics based on refinancing and renegotiating terms.  However, such metrics substantially vary from the sizing dynamics that many investors have grown accustom to. 

Current underwriting realities mainly include stringent resizing of existing cash flows, higher capitalization rates and lower new-construction costs — all summarized as follows:

Cash Flows Readjustments:

• Best case is assumes annualized with a careful review of recent trailing three months occupancy and collections.
• “Re Forma” vs. Pro Forma – whereby funding sources expect outright lower income in anticipation of more challenging economic conditions.  Numerous lenders expect income levels to drop from 3% to 6% during the year.
• Expense increases – Higher vacancies translate to carrying more common area expenses.  Furthermore, few investors expect meaningful lower taxes and operating costs.

Higher Capitalization Rates:

• 8% is the now new valuation benchmark for most commercial properties; Single-tenant, credit deals secured by longer-term leases hover in the 7% range.
• Below 7% reserved for prime residential and trophy properties or properties with substantial contractual upside.
• Full service lodging starts at 9% to low single-digit range as RevPAR and operating cash flow have been substantially reduced since 2008.
• Smaller projects based on 1031X trades may be priced as much as 50 bps lower than typical capitalization rates, as demand remains brisk.
• Substantial widening for C-Properties by at least 150 basis points or more — moving into the double-digit range.  Price reductions of 30% or more are common as compared to Credit and Class-A/B assets, as this segment of the market remains very illiquid.

 

New Construction Realities:

• Despite public infrastructure spending, construction costs are lower as construction spending has decreased and competition has increased.  Commercial building construction costs have fallen by more than 10% during the past year.
• Return-on-Cost yields are in the double-digit range.  As investors focus on purchasing projects well below replacement costs and higher-leveraged debt is scarce, development yields must be priced 200 basis points or more above cost of debt.

 

According to Aaron Gruen, a member of the Real Estate Capital Institute Advisory Board, “While declining rents, rising capitalization rates, and challenging economic and financial conditions make for black moods for real estate investors and developers, this is a good time to prepare for the return of prosperity.” He adds, “From a longer term perspective, prices are more likely to be bargains, constructions costs are low, and loans are likely to be prudently made and taken.”

The Real Estate Capital Scoreboard® – March 2009

Chicago, Illinois, March 2, 2009 – As the first quarter winds down, the real estate capital markets are filled with caution and anxiety as lenders crave for market stability.  Realty capital markets remain challenged with the following issues in the forefront of discussion:

• Valuation Concerns:  Many investors believe that cap rates will return to higher single-digits — in norm with historical levels.  Institutional-grade assets are valued starting at 7% for multifamily properties and 8% for commercial properties.  Furthermore, lenders require substantial supporting data (recent comps) to justify lower cap rates.  Secondary markets and older properties pricings start at 100 basis points or more with much wider variance.
• Capital Availability/Allocation:  Most financial institutions are playing a defensive role, rather than pursuing aggressive growth and funding strategies.  Shoring-up balance sheets and shedding unwanted loans and other realty assets remain key priorities.  Select sources state that they would like to return to the market by the second quarter and mid-year.  Lenders are allocating substantial portions of funds for refinance and rollover, rather than new loan origination.
• Relative-Value Pricing:  Attractively priced CMBS debt (Triple-A quality) offers the best investment opportunities for investors preferring to capture the most favorable yields, rather than new origination funds.  Such yields are in the lower-double-digit range.  As such, mortgage rates are still favorably priced for borrowers — within the range of 6.5% to 8.5% for conventional properties based on 10-year terms. 
• Delinquencies:  For the most part, loan delinquencies and defaults are at controllable levels.  Retail properties pose the most challenges, as numerous merchants are in either bankruptcy or requesting substantial rent discounts.  Co-tenancy issues also raising concerns for further occupancy reductions. 
• Tighter Funding Standards: Most lenders are strictly enforcing shorter amortization schedules and wider debt coverage ratios (e.g., 1.25X and 25-year maximum) to restrict proceeds, rather than relying on loan-to-values restrictions as a primary underwriting variable.  That said, 55% to 65% is the norm for most institutional-quality, non-multifamily loans.  REITs, pension funds and private equity capital players requiring less leverage enjoy excellent rates and terms.  Leverage-oriented investors are forced to stay with bank lines, hoping for more favorable funding conditions.
• Maturity Risk:  Agencies and many life companies favor longer-term loans in excess of five years as refinance rollover risks are of concern.  Meanwhile, banks mitigate such risks by relying upon recourse and substantial funding deposits, often in excess of 10% of the loan amount.
• Large Loan Vacuum: $50 million + loan funding sources are limited to about a half dozen major life companies.  Otherwise, lenders must syndicate such loans.  Loans under $10 million still offer numerous options including banks, life companies and private capital. 
• “Floor” Rates Prevail:   While lenders are still quoting fixed-rate loans based on treasury spreads, most loans feature floor-rate minimums.   Naturally, floating-rate loans are still quoted floating over Libor, Prime, etc – floors are also imposed on such funding structures.

 

Randal Dawson, a member of the Real Estate Capital Institute Advisory Board declares, “2009 looks to be a year of refinancing and with limited acquisition activity.” Dawson suggests, “Distressed deals will be the norm for most new acquisitions and investors will be overwhelmed with renegotiating overleveraged debt.”