Reinventing Finance

Summer 2010
Clockwise from top: Amy Clement, David Grissom, Gerard Sansosti, Simon Ziff, Simon Ziff, Marie Conroy

While 2010 may not turn out to be a banner year for capital flows to commercial real estate, investors of all stripes do have a growing hunger for yield, which has led to an increasing willingness to wade back into the market. Still missing from the overall picture, though: a much-anticipated boom of dispositions/acquisitions of problem loans and distressed properties. Still out of favor, too, are property portfolio sales and financing for large developments.

Lenders are cautiously optimistic this year, said Gerard Sansosti, executive managing director in the Pittsburgh office of Holliday Fenoglio Fowler. "There’s more money in the system and they’re feeling better about what they have. They’ve identified their problems and want to lend more money." At the same time, he cautioned, terms are so stringent that "there’s not enough product." The trend could go in one or two directions, noted Sansosti — either lenders will "stick to their guns and compete on pricing" (with an attendant tightening of spreads) or they will begin to "change the box," with more risk in the financing structure, valuation and LTV. Sansosti believes that "we will go up the LTV curve."

Sansosti offered a snapshot of how financing is being done now: Geographically, life insurance companies want "the four main food groups" in primary counties in primary markets, though they are still cautious about office. CMBS and mortgage REITs want the best product and the best sponsor in markets where the life insurance companies won’t go: to the secondary and tertiary markets. Construction loans are very difficult and banks are extremely conservative. In addition to looking for substantial preleasing, they are seeking additional relationships from borrowers, such as business accounts. Regarding valuation, lenders are looking at a debt yield of 10 to 12. They are less concerned about what values or replacement costs are – cash flows are primary. Underwriting is based on cash flow, assuming the lender is comfortable that the cash flow will remain stable.

Simon Ziff, president of Ackman- Ziff Real Estate Group, noted that there are "haves" and "have nots" in terms of financing desirability and they are divided more by geography than by property type. The "haves" initially included Class A properties in New York and Washington, D.C., he said, "but the bandwidth expanded to B+ properties in New York and Washington and A properties in Chicago, Los Angeles and Boston," adding that "then it will be B buildings in secondary cities."

Currently, Ackman-Ziff is doing between $500 to $700 million in office financing, mostly in the Northeast. It is also assisting in selling some distressed assets, financing shopping centers, hotels and apartment complexes. From Ziff’s perspective, the new wrinkle in financing is that A and B notes are almost all being placed separately, where for years it had been generally all one note.

Holliday Fenoglio Fowler is seeing more listings for investment sales, a good sign since "investment sales have to pick up to drive the debt side," Sansosti reported. "People are becoming more aggressive on the equity side." He added that funds, thwarted by the lack of distressed availability, have bought B notes of the Developers Diversified, Flagler (see Inside Finance column) and Inland CMBS.

Marie Conroy, principal of the Reznick Group, PC, a national accounting, tax and business advisory firm, said that "in the next three to six months, we will see a demand for more integrity in underwriting," she said. That means more of a focus on borrowers with an established track record, versus those who jumped into the business during the heady days earlier in the decade. Conroy is not seeing any new types of debt instruments being created, although she has seen transformations in the mezzanine loan world.

Her advice for those looking to refinance: start early and plan not only with lenders but also with your advisers, in particular your tax advisers. When people do that, she said, "I think they’re pleasantly surprised that things are not as bad as they thought."

In the tax world, restructuring debt often means a significant modification. For tax purposes, the definition of significant modification means that a new debt instrument takes the place of the old; it is a cancellation of indebtedness. Conroy said that "we work with a lot of clients as they plan to restructure debt to minimize the occurrence of a significant modification and the income they have to recognize." For example, in cases of "reacquired" debt, the cancellation of indebtedness can be spread over five years rather than one year, if a timely election is made. Also, the strategic use of net operating losses can minimize what you have to recognize in the current year.

Is the Trouble Just Starting?

Ernst & Young’s 2010 Market Outlook: Trends in the Real Estate Private Equity Industry report stated that "the sentiment for opportunistic investing in 2011 seems brighter and is being projected by many as the start of a great vintage of asset acquisitions." But at the same time, the firm pointed out that "there are more than 8,000 banks in the U.S., most with sizeable exposure to real estate," with 51 percent of the commercial real estate debt by year-end 2009 concentrated in the 107 largest banks and 47 percent spread broadly over the 5,060 U.S. banks with total assets between $100 million and $10 billion. There has been what it called a slow but steady stream of bank failures in the U.S. since 2008.

"Distress is coming, it’s a question of when," Gerard Sansosti said.

Amy Clement, who heads the owner representative services group at Childress Klein Properties in Charlotte, said that 18 months into the recession, the firm is now beginning to see clients address their commercial real estate problems. In contrast to previous recessions that were "mild, shallow and quick," she said, "this is the opposite. It’s a very different world we’re living in. There’s been an absolute lack of liquidity in the market."

Childress Klein has been helping a number of clients with problems ranging from developing re-use strategies for projects (mostly in the retail sector) suffering from tenant delinquencies and defaults, to large land transactions where master plans have not come to fruition. The company is also seeing challenges of community and regional banks on construction loans gone sour.

The question remains, if neither banks nor owners whose loans are underwater continue to have no incentive to sell, will the debt overhang prevent new lending?

"It’s a quite substantial issue: until institutions work through the challenges in their own portfolios they won’t be able to invest," she said. Clement believes that banks and other financial institutions will have a longer memory, coming out of this recession, than the industry has shown in the past. Moreover, she said, "There will be opportunities. There’s a lot of capital on the sidelines."

Among the non-traditional equity investors, she noted, the trend is to invest directly in an operator or a property, not in a pool. Medical office properties will continue to attract capital, because "People feel there will be continued demand. You need the bricks and mortar. You can’t outsource medical care or do it on the Web."

Despite the emergence of new CMBS vehicles (see Inside Finance column), industry observers do not see strikingly new types of financing or new players in the market. Gerard Sansosti noted that the recent-vintage mortgage REITs "have been out there, but the money has been priced too high to put it out. They’re still the higher leverage players: with 75 to 85 percent LTV amounts, but they want eight percent plus a half-point or point." That financing would suit "someone who has to transact," he said.

But as Alliance Commercial Partners, LLC shows, even companies focused on value-add acquisition opportunities don’t necessarily turn to funds or CMBS vehicles. Alliance’s most recent acquisition was a nearly 250,000-square-foot, 82 percent occupied Class A office building in Greenwood Village, Colo. that had been built in 1984 and renovated in 2000. (It also included a 5.45 acre undeveloped parcel of land that is entitled for development.)

David Grissom, director of capital markets for Alliance, said that insurance companies are the best sources of non-recourse debt.

"There are a lot more in the market that was on the sidelines last year," he said. "Pricing has dropped significantly from the end of the year to now. Debt from debt funds is more expensive. I know there are banks getting back to the market, for non-recourse, though we haven’t gotten quotes yet."

Like other industry pros, Grissom said that there have been few acquisition opportunities. "I thought things would have broken loose by now," he said. "But no one has the incentive to sell. Lenders are working with borrowers and the lenders that have taken properties back haven’t been willing to take the pricing to sell them."

Differing Expectations

Lenders are not quick to dispose of problem loans, either. In its "Is History Repeating Itself" report, Ernst & Young outlined the results of a recent survey about U.S. distressed real estate loans, based on responses of investment funds, private equity, institutional investors and developers. Among the findings:

Pricing continues to be the biggest barrier to increased transactions, but the gap may be closing.

Over 80 percent were looking to acquire portfolios of $100 million or less.

More than half of those surveyed said they had purchased or attempted to purchase problem loans, but only 17.5 percent actually had.

Investors were beginning to lower their expectations: 16 percent were looking for more than 20 percent; the rest were almost equally divided between expectations of 10-15 and 15-20 percent returns.

What is property worth? Determining value is not just a philosophical exercise. It is a continually moving target, with shifts in cap rates and cash flows and made more complicated by the recession’s paltry number of comps.

Jeffrey Rogers, president and COO of Integra Realty Resources, a large valuation company in the United States, commented "This is what we look for now: how healthy is the rent roll? How strong is the tenant? What’s the tenant’s credit? How long will the tenant be in? What are the rates? Are they at market? The tenant will renegotiate; we may mark the lease to market. We also look at the durability of cash flow, with staggered leases."

If a project was begun in 2007 and is coming online now, he said, "assumptions must be redone — 75 percent occupancy in six months? That’s not going to happen. You have to take a deeper dive into the pool of tenant quality."

Integra had 40,000 assignments in 2009 and expects to do more in 2010. Clients are banks, debt funds, pension funds and developers. The firm also provides litigation support and works for "special servicers and the Morgan Stanleys of the world," Rogers explained.

Looking ahead, Rogers said, "If you’re in a 24-hour city, for the most part you’re going to be OK. Cities will be the first to survive. They’ve had a net positive gain in population over the last 12 months. Suburbia and tertiary markets will have problems."

Will the FDIC, in selling non-performing and performing loans as well as construction loans, land and development projects through pools of asset sales from failed banks, help to establish pricing and create more clarity and confidence for lenders and investors? Industry observers are skeptical.

The structured transactions program, unlike the RTC, which sold assets outright, enables buyers to acquire a partial interest in a pool; the FDIC creates the LLC to which the pool of loans is conveyed; becomes a partner entitled to cash flow from loans and offers financing, to boot. Leverage alternatives to date have been at 4:1 or 6:1. The structured transactions program is announced and marketed through financial advisors selected by the FDIC.

The FDIC recently announced a winning bidder of $490 million in loans: a sale of an equity interest in a limited liability company (LLC) created to hold certain assets transferred from 19 failed bank receiverships. The purchaser of the interest in the Multibank Structured Transaction Single Family Residential 2010-1 is Roundpoint Mortgage Servicing Corporation.

The sale was conducted through a competitive auction held in February. The winning bid was submitted on a 50 percent leveraged ownership interest basis. The FDIC will hold the remaining 50 percent equity interest in its receivership capacity.

Marie Conroy of the Reznick Group noted that any clients who are interested in FDIC sales recognize that there will be a long process involved and that it will take a few months to get a deal done. "It’s not instantaneous," she said.

Gerard Sansosti of Holliday Fenoglio Fowler said that the FDIC is not an emblem of pricing of debt portfolios. "They’re in the business of moving it off the books," he said. "The cents on the dollar figure tends to look worse than it is."