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FEATURE ARTICLE, JUNE 2004
REAL ESTATE CAPITAL MARKETS UPDATE
Western real estate players keep eyes on interest rates
in a dynamic market.
George Smith
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Smith
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Was April 2004 a bump in the interest rate road? Second quarter
2004 started with Alan Greenspan’s positive economic
outlook. The chairman of the Federal Reserve expressed no
further concern about the risk of deflation, a theme that
ran through much of 2003 and early 2004. Fed watchers concluded
that the Fed has a definite upward bias on interest rates
but generally agree that a rate hike will not occur until
September or October and possibly not until after the November
election. A clearer economic outlook, based on sustained growth,
is needed before there is further reaction to March’s
strong performance figures. If a rate increase is an eventuality
rather than a potential, the issue then is how much rates
will move and whether or not the market has already factored
in most of the fluctuation.
With 1-month Libor at 1.1 percent, there is a significant
spread between the short- and long-term indices. More borrowers
are debating the virtues of floating-rate loans with flexible
pre-payment provisions versus longer term fixed-rate loans
that have less flexibility and pre-payment options requiring
defeasance or yield maintenance provisions.
The consensus of economic forecasters is the following: (1)
Inflation is projected to rise moderately but remain between
2.5 and 3 percent; (2) The economy will create approximately
175,000 new jobs monthly during the next year, which means
no change in the unemployment rate; (3) Payroll increases
will not spur any significant additional economic activity;
(4) Growth forecasts are 4.5 percent for the first half of
2004 and 4 percent for the second; (5) the Fed funds rate
will end the year in the 1.5 to 1.75 percent range, which
is still low by historical standards.
Mortgage Rates Will Continue to Enjoy Tight
Pricing Spreads
Mortgage rates are a combination of the corresponding treasury
rates and the risk-based pricing spreads, which are predicated
on the lender’s analysis of individual property characteristics.
Currently, these spreads are tighter than at any time since
Wall Street began securitizing income property mortgages 10
years ago. While 10-year treasuries have risen, 10-year mortgage
rates are lower than they were in 2000 when treasuries were
between 5 and 5.5 percent. Lenders have more money to lend
than there are quality loans available. It is an unprecedented
borrower’s market. Portfolio lenders, including banks,
savings and loan associations, and insurance companies, are
healthy with strong capital ratios and historically low delinquency
and default rates. Bond buyers have fueled the CMBS market
by tightening the spreads for investment-grade real estate
bonds that are trading at or inside similarly rated corporate
bonds. This is expected to continue.
Multifamily
Apartments have become the favored lender property category.
There is more competition providing tighter pricing in this
commercial real estate sector. Fannie Mae and Freddie Mac
offer AAA bonds to fund mortgages resulting in fierce competition
among all lenders. Some CMBS lenders will price multifamily
rates at break-even because they want apartment loans to represent
30 percent of their mortgage pools. Eighty percent loan-to-value
(LTV) loans are commonplace, and some lenders are extending
to 85 percent. With floating-rate loans as low as 2.5 to 3
percent and fixed-rate loans in the low 5 percent range, borrowers
are weighing the trade off between the two as it relates to
their economic forecasts. Every point saved per year is equivalent
to 14 basis points over a 10-year term.
Not all multifamily markets are created equal. Southern California
has an acute housing shortage with no signs of abatement and
the prospect of steady rental increases. There are a number
of other major metropolitan areas where growth is strong and
land or water are becoming limiting factors. Land is scarce
in many western markets where apartment builders must compete
with condominium builders who are willing to pay higher prices
that can be passed on to the homebuyers. As a result, new
luxury apartments are being built that provide condo-quality
amenities and finishes.
Apartment cap rates have dropped in lock-step with the decline
in fixed-rate mortgages. Cap rates in Southern California
are 6 percent or less, with 5 percent figures becoming the
new benchmark in many prime markets that have definable barriers
to entry.
Value-added redevelopment has become a major opportunity for
many multifamily developers. They are upgrading and repositioning
30- to 40-year-old properties built in the 1960s and ‘70s.
The upgrades include new recreational facilities, Internet
connectivity, exterior and landscaping upgrades, and unit
finishes, including appliances, contemporary lighting, flooring,
granite counter tops, crown molding, bathroom fixtures, etc.
A strategically repositioned property competes favorably with
new units but at lower rents in comparable locations. Financing
is readily available at leverage levels of 97.5 percent of
cost when combining construction loans with mezzanine debt
or preferred equity investments.
Construction costs have seen dramatic escalations in a number
of the major building trades. While lower interest rates have
reduced the cost of construction, it does not make up for
the increased cost of land and labor. Builders who were operating
with 9 to 10 percent un-leveraged returns are now at 7 to
8 percent. However, with the corresponding drop in cap rates,
profits have remained stable.
The price of single-family detached housing has moved out
of the reach of many buyers. For others, affordable homes
mean untenable commute times. This has made condominium ownership
an attractive alternative and sparked a trend to urbanization
and downtown re-development. Condominium prices in Southern
California have moved toward $400 to $500 per square foot
for four- to six-story buildings while the luxury condominiums
on Wilshire Boulevard in Los Angeles have escalated to $700
to $800 per square foot. Construction financing is readily
available at typically 80 percent of cost and at 65 percent
of the projected sales price.
Retail
Retail is the second-best performing property sector. With
the exception of markets where Wal-Mart has affected the local
supermarket chains, the market/drug-anchored centers remain
the favored product because people have to do things like
eat, purchase staples and buy pharmaceuticals. In the larger
metropolitan areas with their land assemblage problems and
dense population characteristics, the open-air specialty/entertainment
centers have gone head-to-head with the traditional enclosed
mall. Finally, high-growth areas like Southern California
are seeing unanchored strip centers in dense population areas
running at near 100 percent occupancies with the dominant
tenant profile being entrepreneurial immigrants.
1031 exchange buyers have driven down cap rates and are out-bidding
institutional and REIT investors for product in the $5 million
to $30 million range. Pricing spreads are between 110 and
130 basis points over the 10-year treasuries for loans at
75 to 80 percent of value, 1.20 debt coverage ratios and 30-year
amortization schedules. Rates are in the mid-5-percent range
and closer to 5 percent if LTVs are 60 percent or less.
Office
Office financing remains the softest in West Coast markets
with low double-digit vacancy rates and flat to softening
rents. Essentially, the only office product currently under
construction is for either owner/users or heavily pre-leased/build-to-suit
product. Since office is a desired mortgage product, lenders
are carefully underwriting them by factoring in lease-rollover
risk and submarket vacancies in addition to actual building
vacancies and rental rate trends. A solid alternative is the
financing of high-vacancy Class B and C office buildings in
core locations that lend themselves favorably to adaptive
re-use as urban mid- and high-rise condominiums. Residential
development has less environmental and traffic impact, lower
parking requirements and higher property tax revenues —
all favorable factors for rezoning.
Financing Availability
Fixed rates will be somewhat volatile as swap spreads, which
are a measure of risk between short- and long-term rates,
increase in volatility. In the latter part of April, swap
spreads widened by 12 basis points for 10-year loans. In the
near term, continued upward pressure on fixed rates is expected
but it is not likely that rates will exceed 6 to 6.25 percent.
Floating rates are not expected to move until higher rates
are paid to investors to attract short-term capital or the
Fed raises the discount rate.
Many investors, particularly the insurance companies and pension
funds, have actuarial rates they must achieve. To do this
they are diversifying portions of their portfolios by investing
with advisors in opportunity funds — a warmer and cozier
2004 version of the vulture funds of the early ‘90s.
These funds take more investment risk by co-investing with
developers. They typically provide 90 percent of the equity
component in the capital structure. Housing funds have been
achieving IRRs in the 25 percent or higher range. For other
types of value-added and new construction investments, returns
are projected in the 15 to 20 percent range.
Summary
This year is expected to be more volatile than either 2002
or 2003. It will be an unpredictable year for the capital
markets. It is an election year with the country at war and
record budget and balance-of-trade deficits. The CPI is rising,
fueled by increases in the commodity markets, but at acceptable
levels. The economy is growing and unemployment is expected
to be stable. The Fed may no longer need to keep its foot
on the brakes. Rates are expected to rise moderately but still
well below levels of the last 35 years. There are no bargains
and distressed real estate is hard to find. New development
is difficult and time consuming and requires better execution
of multiple disciplines to be profitable. It will continue
to be a borrower’s market but not a market conducive
to postponing decisions when available capital meets the borrower’s
needs.
George Smith is the founder and chairman of George Smith
Partners in Los Angeles.
| Reverse Construction
Exchanges
Daniel McCabe
How often have you experienced this? You want to sell
your old property and locate the ideal new property. Unfortunately,
the perfect property has not been found. When this situation
occurs, there is an alternative: you can build the new
property in a 1031 tax-deferred exchange. The structure
that allows for this is commonly known as a reverse construction
exchange.
In a reverse construction exchange, the qualified intermediary
purchases the land, usually through a separate organization,
which they set up, called an exchange accommodation titleholder
(EAT). They can then construct the building with money
borrowed from either the client, or the client and the
lender. The client and lender are both protected by notes
and deeds of trust or mortgages on the property for the
dollars they have advanced. In addition, the EAT will
issue to the client an exclusive option to purchase the
property once it is completed.
The client or its construction company enters into a contract
and a construction management agreement with the EAT so
that they are making the construction decisions with regard
to the project.
Most construction projects cannot be completed within
the 180-day limitation set forth by Section 1031. Therefore,
it is standard and customary to use what is known as a
classic reverse exchange and for the client to begin the
construction (or at least the planning and permit process)
prior to selling the old property.
The distinct advantage in this situation is timing. In
many cases, clients need a new project completed to meet
a specific business need but cannot shut down the old
operation until the new one is up and ready to run. The
reverse construction exchange addresses this concern precisely.
The client may lease the building from the EAT once it
is completed, usually for the amount necessary to cover
the debt and ongoing building expenses. The client can
then completely outfit the new building with any equipment
or specialty manufacturing that is necessary. Then the
client can move into the new building and return to the
old building to do the cosmetic adjustments necessary
to maximize the sale value and put it on the market. Once
the old property closes, Section 1031 requires that the
client must identify a replacement property. This will
be the property it built through the EAT and is currently
leasing. The client can then close on it. If the client
has loaned money to the EAT, the EAT then pays off its
debt to the client and/or the client’s lender. The
client will be in possession of its ideal property —
one that fulfills its needs and desires — and will
have been able to maximize the dollars from the old property
to accomplish the goals of its 1031 strategy.
Dan McCabe is president of Investment Exchange
Group in Denver.
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©2004 France Publications, Inc. Duplication
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from France Publications, Inc. For information on reprints
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