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REDEFINING ‘BUSINESS
AS USUAL’
A KeyBank executive discusses real estate capital market
trends in the western U.S.
Gregory Rickard
With venture capital and publicly traded securities on shaky
ground in recent years, investment bankers have flocked in droves
to the commercial real estate arena. When these new capital
sources moved to take advantage of attractive borrowing rates
and reduced costs of capital, competition for investment properties
increased virtually across the board. But the current environment
has also produced new and sometimes unexpected changes in the
ways that lenders and borrowers conduct business, and the effects
of these trends will take years to unfold.
New Players
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Rickard |
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Where there once existed a well-known subset of investors interested
in commercial real estate transactions, a wide range of players
is now finding safe haven for their capital and sharing financial
risk through increased interests in this sector. But these new
investors should be aware that although commercial real estate
is living up to its reputation as a stable investment choice,
the current state of real estate capital markets has moved away
from equilibrium. Furthermore, investors should be aware that
real estate investments require careful timing and selection,
and they are intensive to underwrite and expensive to acquire
and manage.
Currently, while market conditions remain soft for certain property
types, such as office, sales prices remain relatively steady
and higher than might otherwise be expected. This seems to go
against traditional market fundamentals, where the outlook for
reduced tenant demand would lead to lower property values. However,
in this type of environment, it becomes difficult to rationalize
value without considering the relative availability of investment
properties to the availability of inexpensive investment capital.
In short, sellers are able to command higher prices for their
properties, due to reduced borrowing costs in this low interest
rate environment.
Sophisticated Transaction Structures
The onslaught of capital channeled through the investment banking
world has connected with more traditional real estate investors
and has resulted in sophisticated financial solutions becoming
standard options for funding a real estate transaction. This
has led to increasingly complex transaction structures involving
both investment equity and project debt, in which acceptable
returns on investment can be generated from previously marginal
opportunities.
Mortgage banking products have also become more complex, creative
and competitive thanks to this new environment. Loans are intensely
shopped in a highly competitive environment, where a few basis
points in pricing can be a deal-breaker. As sophisticated solutions
become the norm, borrowers are also becoming more educated on
the options available. As an example, KeyBank, acting as a Fannie
Mae DUS (Designated Underwriter and Servicer) lender, has underwritten
several loans aggregating more than $70 million for Fannie Mae’s
DMBS (Discounted Mortgage-backed Securities) program for a privately
owned developer of multifamily properties in Southern California.
The DMBS facility provided the developer with exceptionally
low borrowing costs of less than 2.1 percent, all-inclusive.
To make the transaction viable, the assets had to meet rigorous
underwriting standards, moderate leverage and a minimum dollar
threshold. This provided the company access to a sophisticated
financing structure typically available only to institutional-sized
developers.
Attractive Borrowing Rates Enhance ROI
Exceptionally low senior debt borrowing rates in recent years
have facilitated positive leverage, when the cost of debt is
less than the capitalization rate of the asset being financed.
This enhances the leveraged return on investment and, at the
same time, facilitates a higher loan advance rate. However,
lenders have recognized that current market conditions facilitate
higher leverage because of higher valuations, and have kept
matters in check by focusing on cash flow underwriting and debt
coverage ratios. After all, it is cash flow that covers the
monthly mortgage rather than liquidation value.
This positive leverage situation has likely contributed downward
pressure on capitalization rates as arbitrage opportunities
are exploited and the market becomes more efficient by pricing
in such arbitrage into asset values. In other words, buyers
will continue to use arbitrage in the market by pushing cap
rates down to the level equal to their cost of capital, and
a financing benefit will remain until such parity is reached.
These fundamentals will ebb and flow with the changing interest
rate environment, which has brought good fortune to many real
estate investors in recent years through predictable short-term
interest rates. The disciplined borrower will be sensitive to
match borrowing strategy (floating vs. fixed rate and loan term)
to asset strategy (short-term sale vs. long-term hold) or risk
being on the wrong end of the rate and leverage hammers when
the market shifts. It can happen quickly, and it will be too
late once rates start moving.
Lack of Equilibrium
Equity and mezzanine money providers have proliferated in the
last few years. The growth of market players has been primarily
through large institutions. The resulting onslaught of investment
capital, coupled with inexpensive senior debt and a deal-deprived
environment, has created intense competition among capital providers
as well as property buyers. In this scenario, the true winners
have been property sellers. This environment has facilitated
financially engineered returns on investment that would not
otherwise be achievable in a capital market operating closer
to equilibrium.
One way to explain this state of the market is that the influx
of capital has chased capitalization rates down, and at the
same time, compressed yields. The market is arbitrating any
remaining incremental profit out of each deal through financial
engineering, and the fulcrum to this see-saw is the cost of
capital. It is noteworthy that the group most insulated from
these unstable property markets is developers. Because they
create value through entitlements and asset creation —
rather than arbitrating pricing and yield inefficiencies —
they are best positioned to ride out market shifts.
The hangover of highly tiered capital structures involving multiple
third-party capital providers is a highly complex workout situation
should a deal go wrong. To avoid the pain later, the capital
providers and property owners should figure out up front where
the chairs will rest when the music stops. Borrowers should
keep in mind that longer timeframes are now required to assemble
and execute capital components, and exit strategies from complex
transactions tend to be more complicated. For example, a typical
commercial mortgage closing averages 60 to 75 days to complete.
When a more sophisticated solution, such as an inter-creditor
agreement, is put into place, finalizing the transaction can
take up to 30 to 45 days longer, although the results can be
well worth the time.
Tapping Into the Capital Stream
The proliferation of capital has been facilitated by a broadened
array of sophisticated financial services that have gone mainstream,
where even the local boutique developer or private investor
has easy access to sophisticated real estate financial services.
This has happened because capital sources such as institutional
investors and investment banks have chased the client base downstream
in search of higher returns and stronger deal flow. For example,
investors that would once make a single investment in a multifamily
property with over 200 units are now attracted to multiple investments
in properties in the 50-unit range. While the investors lose
the economies of scale, there are more opportunities in the
smaller deal range now that so much capital is chasing the larger
deals. By taking advantage of the smaller deals, these investors
realize the higher returns that are possible in this market.
For lenders, this trend means that it is becoming tough to justify
one-off deals when competitive forces are compressing yields
on capital. It is now crucial for lenders to establish long-term
relationships with development partners and real estate investors
who will bring repeat business over time.
Currently, low cap rates and decreased return on investment
expectations reflect today’s short-term interest rates.
That makes sense for real estate investors planning to hold
assets for 1 to 3 years, which many are. Market behavior strongly
suggests properties are being held on a speculative basis. The
relevant benchmark is long-term rates, which are more in line
with typical investor hold periods. Currently, long-term rates
would suggest that certain property classes, such as multifamily,
are overpriced.
Re-inventing Commercial Real Estate Investment
Banking
The increased sophistication of transactions is affecting not
just individual deals, but also the way financial services are
delivered. The real estate investment banking and commercial
banking communities are moving toward one-stop, full-service
delivery of investment, commercial banking and mortgage banking
services. Business models applied by capital sources that can
best meet their customers’ full range of needs will ultimately
prevail — and savvy banks and other capital sources are
assessing their service delivery methods. In the next 5 years,
the lending world will undergo an evolution, as institutions
reinvent themselves to remain competitive and profitable.
These trends are some of the many effects of the multitude of
influences acting on the world of commercial real estate finance
in today’s unpredictable business environment. Only time
will tell what the lasting effects of these trends will be.
However, it is safe to say that as the market fluctuates and
eventually returns to a state of equilibrium, the ways that
capital changes hands will have evolved into a new and more
complex set of norms, and ‘business as usual’ will
have been redefined.
Gregory Rickard is senior vice president and district manager
for KeyBank Real Estate Capital in Los Angeles.
©2004 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints of
this article contact Barbara
Sherer at (630) 554-6054.
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