Best Capital Sources In An Altered Market

REQUIRED READING: Industry news headlines often provide valuable, high-level information on future trends, but there is also great value in looking to one's day-to-day routine to identify what is around the corner.

Doom and gloom is still at large on the panel circuit, but its intensity is lower. For instance, the noise level in our office bullpen of commercial loan originators and staff rose dramatically through the end of summer 2009 – contrasting with the lack of chatter earlier in the year.

What is driving this increase in noise level? Many investors and commercial real estate firms eager to refinance existing debt and provide themselves with extra runway through the downturn have faced a dearth of debt and equity options, given the frozen credit markets and general economic malaise.

Lending standards have tightened significantly in the past 18 months, across all property types, geographies and levels of property quality. Less capital was allocated to real estate, and significantly less attention was paid to loan origination, as the focus shifted to asset management and dealing with current portfolio issues.

The situation is now changing, and financing options are appearing to resurface for both refinancing and acquisition activity. The current challenge is to identify the key financing sources in the market and the profile of projects that will fit in each capital source's strike zone.

So, who is lending right now? First, life companies are active in the market, financing stabilized, institutional-quality projects with solid cashflow, consistent with historic lending guidelines. These firms will also look at single-tenant properties with credit-tenant leases.

This capital provides leverage in the 50%-60% loan-to-value (LTV) range for typical deals, and higher leverage based on credit tenancy. Pricing has tightened slightly since the beginning of 2009, with deals now pricing in the 6%-plus range. These sources provide cover for long-term amortizing debt that is coming due, or for deals in which a well-capitalized sponsor is willing to bring significant equity to the deal.

In short, although dollars from life companies are available, the higher leverage levels underwritten in the past are currently not available.

Today's lending parameters
Looking to financing options that provide leverage to a wider universe of properties, first-trust deed lenders are beginning to make more noise for deals that are considered slightly below life companies' criteria. This money works best when a sponsor is seeking maximum leverage to refinance existing debt (usually short-term).

These loans tend to provide a term of five years, with pricing of 7% to 10% and perhaps leverage slightly higher than life companies offer. These capital sources are seeing enough deals today that they can focus on cashflowing properties but allow for smaller deals or deals outside of specific prime geographic areas to be financed. In qualifying loan proceeds, these lenders are underwriting properties to market rates and average occupancy levels consistent with the specific region.

Recently, there was an assignment to arrange maximum leverage financing for the acquisition of a portfolio of stabilized major-metro-area grocery-anchored shopping centers that was being sold at a competitive cap rate on current income.

The expectation was that there would be a program offering a first trust deed of 70% leverage. Lenders wound up underwriting to elevated debt yields, and they eventually came up against a wall of 55% to 60% leverage on purchase price, given that the property type was retail, which was being viewed as a primary reflection of dipping consumer confidence nationally.

Pricing was in the 8.5% to 10% range, and tenant rollover was being marked to market. Mezzanine debt brought with it 75% total leverage, but pricing was quoted in the mid-teens, and the structure included a back-end participation for the mezzanine lender, reducing the return to equity to below acceptable levels.

Although the deal had sufficient cashflow to support a blended low-teens interest rate at 85% leverage, lenders wanted to see more sponsor cash in the deal. That push is a recurring theme when buyers are acquiring properties at a discount to historic pricing, but still expect historic leverage levels to apply.

Another pool of lenders with available capital in the market are mortgage real estate investment trusts (REITs), which provide first-trust deed funds to borrowers. Several of these mortgage REITs have recently raised capital via the public markets with the mandate to make first-trust deed loans against a debt yield of 12% to 13%, depending on the property type, with high single-digit pricing.

These sources are seen as motivated to deploy capital, as their structure mandates that they pay dividends to investors on the total capital raised, regardless of how much has been lent out.

GSE options

One consistent pocket of liquidity is provided by government-sponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac and the Department of Housing and Urban Development, which continue to be active in the multifamily sector, supporting lending programs at competitive rates for this property type.

The GSEs are lending at up to 75% leverage levels at rates in the high 5% to 6% range. Programs cover apartment buildings and portfolios. Multifamily property is a stable performer among the main property types, and the government support for these debt programs is reflected in how it is an efficient debt market today.

But financing limitations apply here as well. For instance, there are two current transactions in which groups are acquiring stabilized, large multifamily assets at competitive cap rates and would like to immediately place long-term financing on the property based on historic cashflow and cap rates.

Loan proceeds are severely impeded by the cost basis in each of the properties, as a conventional loan would exceed their cost basis in the property and lenders would not want to provide cash out on newly acquired properties.

Another source of capital in the market today is provided by private money (non-bank) lenders. Previously, there was a great deal of capital chasing deals for properties with value-add components and those underwritten using accelerated pro-forma rents. Borrowers were able to finance these projects with more conventional lenders, with many current examples of highly leveraged projects that have fallen victim to market timing.

Today, borrowers find themselves in time-sensitive situations and are turning to private-money lenders to refinance existing loans or access leverage on acquisitions at depressed prices. Rates range from 10% to 17%, with proceeds based on the lender's perceived exit value of the property.

The private-money market has the potential to fit well for buyers that are acquiring notes on condo projects that they are underwriting as apartments. Often, the discount available when the buyer is buying distressed notes is secured due to ability of the buyer to show certainty of execution. In some cases, buyers are closing all cash and then immediately leveraging between 50% and 80% of their purchase price.

Another emerging use of the private-money market is to fund discounted purchase offers by borrowers that see the opportunity to buy back their own debt at a discount. Similar to the case of buying discounted notes, certainty of execution is a large factor in soliciting a discount.

In order to capitalize on what was predicted to be a flood of available properties at depressed prices, new capital was formed over the past 18 months, with the expectation that these opportunities would come into the market in late 2008 and 2009.

These opportunity funds had the expectation of reaching a 20% or higher return and equity multiples of 1.7x to 2.5x on all types of distressed transactions. The expectation was that there would be a flow of product that would provide sophisticated buyers able to move quickly and capture high returns in a short period of time.

This, however, has not been the case to date. Even on development projects that were never built out and have little hope of full recovery in the near future, lenders, in the majority of cases, have not sold these loans, given corporate-level capital issues. In addition, recent policy enables lenders to hold these troubled assets for a longer period of time. Equity investors have also had a hard time plugging a pro-forma exit cap rate on developments.

Opportunity funds represent a large pool of liquidity that is re-tooling to the current environment. Our assessment is that there is a spotty opportunistic atmosphere, and there will be relatively few trades in this space to come for some time.

The market's future
Overall, how are lenders dealing with the new market conditions? As in the past, lenders are trying to differentiate themselves, based on deal size, geography or property type.

With capital sources coming back into the market, more deals have greater potential to be funded, even though there are tightened underwriting standards. There has been a significant uptick since the beginning of 2009 in activity in the marketplace, with many lenders active and looking to deploy capital.

Regional banks are also returning to lending, albeit at much more conservative terms, looking closely at sponsorship, market and property nuances and constraining proceeds to address unforeseen future risks.

Capital sources are beginning to get more comfortable with valuations, in spite of what has happened to valuations over the last 12 months. There are specialized lenders in the market for particular property types, but the challenge is finding the niche of deals for specific capital sources.

Looking forward, there are three main factors that will drive capital sources to re-enter in the market. First, we must have continued progress toward stabilization of economic fundamentals in the U.S. Second, there must be recognition of a floor on rents and a floor on values. The market is waiting for an uptick in transactional volume to support new values in each market.

Third, government policy, which has a dominating effect on the future of capital markets, must be favorable. A healthy commercial mortgage-backed securities market greatly benefits liquidity in commercial real estate. If securitization originators are forced to maintain risk-based capital requirements in line with 10% of the credit risk associated with the loans they originate, their activities (and subsequent liquidity) would be severely curtailed.

In addition, because the GSEs have provided a present reference point to what efficient capital markets have looked like in the past, a modification of the government's support for these programs would disrupt the one seemingly stable property type today.

Lastly, loan modifications in certain situations allow borrowers enough leeway to maintain control of their properties amid a weakened tenant base and conservative lending environment. In cases that have a clear path to lenders eventually claiming full recovery, a loan modification (e.g., interest-only payments or decreased reserve requirements for a defined period of time) can help maintain the fragile stability in sub-markets and also motivate borrowers to maintain the quality of their properties.  Â

Commercial real estate lending is transforming from a commoditized product to a business driven by strong sponsorship, a stable business plan and property management. As this fact begins to sink in, investors will start to become more active. Though some would argue that we have seen a paradigm shift in the commercial real estate industry, others remain optimistic that a healthy, active market will return, albeit in a different form.

There still remains much to be seen, but capital is available. Investors and owners just have to know where to look.

Max Friedman is a senior analyst at George Smith Partners, a Los Angeles-based national real estate investment banking firm. He can be contacted at (310) 557-8336, ext. 128, or


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