FEATURE ARTICLE, JUNE 2005

FAST-PACED FINANCE IN THE WILD WEST
Low cost of debt and other factors have led to a flurry of investment activity in the West’s real estate markets.
Bryce Blanchard

Blanchard
The West’s real estate investment market has taken an incredible ride during the last few years. Historically, low debt costs and increased appetite from investors for tangible, cash-flowing investment vehicles have spurred unparalleled commercial property activity. As interest rates trend higher, the question is what will happen to real estate values?

In the last 5 years, whether through private ownership or through investment in publicly traded REITs, real property has been the place to be. However, anytime an asset class has abnormally high returns over a substantial period of time, the red flag of long-term investment principles raises its ever-present head. Can continued acceptable returns in real estate remain achievable in the face of inflationary debt pressures?

2004 featured a 50-percent increase in the number of deals nationally over 2003. Sellers have found themselves in an enticing environment featuring exit sale prices that lock in tremendous profits. These selling prices often beat projected expectations despite selling in the midst of weak leasing market fundamentals (excluding the retail sector). Buyers, meanwhile, have been looking for stabilized yields with cash flow certainty and relative principal security. Inexpensive debt has further fueled activity and overshadowed what has appeared on the surface to be extremely low cap rates. The low initial cap rates are offset by attractive internal rates of returns (IRRs) based upon positive leverage and the prospect of increasing rental rates with improved general economic conditions.

The last few years of spectacular performance cannot be expected to continue indefinitely. The price of real estate is connected to the relative returns and risks of other asset classes. The clearest relationship with which to draw conclusions is the correlation between cap rates and 10-year Treasury yields. Historically, this spread averages around 300 basis points (3 percent). National indicators show that the current spread is actually slightly above the historical average despite the compression in cap rates over the last few years. So what is going to happen if long-term debt (as measured by the 10-year Treasury) increases significantly?

While some prognosticators believe that the Federal Reserve’s commitment to raise interest rates in a measured fashion will not cause much upward pressure on the 10-year Treasury, others disagree. For real estate owners, it is critical not to miss the window of opportunity associated with today’s seller’s market, especially if debt costs trend up and the historical spread associated with the risks of real estate ownership holds true (3 percent).

Western commercial real estate markets show positive signs including increases in absorption and lots of new construction. As the economic environment changes, investors should be able to continue generating quality returns with careful asset planning and sound market advice. It is critical, however, that owners who anticipate selling in the next few years weigh the merits of putting projects on the market today before interest rates and their correlated cap rates erase potential gains.

Bryce Blanchard is an investment broker with NAI Utah Commercial Real Estate in Salt Lake City.

Top Ten Misconceptions About Lending in the West

Sherlock
10) The Western Market is California: While the Golden State remains the favorite in the West amongst all types of capital providers, lenders are keenly interested in deploying capital to experienced developers and investors active in Las Vegas, Phoenix, Seattle, Portland and emerging markets like Tucson and Albuquerque.

9) Money is Available for Every Condo Conversion: There has been a great deal of capital invested into the condo market, both for conversions and development. But lenders are seeking deals with a map in place, a converter with a track record, a submarket that hasn’t been oversaturated with product, a property that has some differentiators and a business plan that demonstrates velocity will be achieved.

8) There Aren’t Any Value-Added Deals to Capitalize: We live in a seller’s market where the upside opportunity is often getting squeezed out of acquisitions today. Still, the experienced investor with the right finance strategy can create strong returns with a strategic and well-thought-out plan juggling market demand, finance structure and positioning strategy against high acquisition values and rising construction costs.

7) Don’t Worry About Costs, Prices Are Going Up: Lenders are cognizant that many budgets went out of balance over the past year, and it doesn’t matter what caused steel and concrete prices to escalate. Return on cost and the spread differential with projected cap rates still matter to the capital providers.

6) It’s the 1980s All Over Again: Yes, it is a good time to be seeking capital. And there is more capital allocated to real estate than ever before, more lenders seeking deals and more structured loan options available…so lenders have to be competitive as they chase deals. But the maturing public market for real estate capital has resulted in more sophistication, more discipline and greater transparency in reporting than ever before.

5) No Cash Flow, No Problem: Sure, market rental rates can be achieved faster by filling vacant space rather than waiting for leases to turnover, but an occupied building with predictable cash flow will always make more sense to a lender. In this compressed cap rate environment, everyone is looking for a value-added upside, but lenders are looking for cash flow (with the exception of the experienced developers with a solid lease-up strategy in place).

4) Local Market Expertise is Passé: With the amount of money chasing deals, investors have expanded their geographic horizons to find suitable investments. While it is true that most deals can be shopped to as many as 20 to 25 viable lenders and that there is more money than deals in the market, capital providers still want borrowers that have the knowledge and ability to exploit opportunities in the local marketplace.

3) Use Your Usual Capital Structure — It’s the Easy Way: Availability of capital isn’t the challenge today, and stiff competition between lenders has brought new ways to stack capital into the marketplace. Developers that invest the time and effort in examining creative capital structures are discovering that there are ways to either enhance their profits or minimize their risks compared to how they structured their deals a few years ago.

2) Use Your Usual Lender — It’s the Safe Way: Relationships with capital providers are still very valuable, but some lenders are experiencing too much concentration risk in product types like condominiums and may not be there when you need them most. Furthermore, it’s prudent for active developers to have multiple options within each tranche of the capital stack — it’s the best way to ensure superior execution, market competitive pricing and ensure the best combination of risk and reward.

1) There’s Never Been a Better Time to be a Borrower: Well, maybe there has been a better time, it’s just that there are very few people who can recall “the perfect storm” of plentiful capital, low rates and strong demographic trends coming together like they have today. Of course, there are many developers and investors who can remember a time better than today to be a buyer…if only it wasn’t so hard to find deals!

Thomas Sherlock is a shareholder and executive vice president of Buchanan Street Partners, overseeing the management of the company’s debt and structured finance line of service, new client/business development, and enhancement of the firm’s capital market relationships.

 



©2005 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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