Abundance of Capital Continues to Reward Stabilized Properties, Gateway Markets

Winter 2012

On the same day that Federal Reserve Chairman Ben Bernanke announced a third round of quantitative easing (QE3), economist Sam Chandan noted at the 2012 ICSC/NAIOP Real Estate Capital MarketPlace Conference in New York City, that the goal of monetary policy has been to push investors, of all types, seeking better yields, toward other forms of investment and away from Treasuries.

Chandan said that some overpricing can be seen, such as in the multi-family sector, and that core properties in gateway markets are continuing to attract major capital because “when underlying fundamentals are uncertain, liquidity counts even more.” Price momentum takes on a life of its own, with the sheer density of lenders exerting pressure. Chandon further remarked, “Today’s interest rates and monetary policy are not ‘the new normal.’ We are planting the seeds of future defaults in the loans we are now making.”

Speaking about the economy and the future of commercial real estate, Chandan observed that rather than real estate fundamentals or quality of property, “The biggest factor in deterioration of loan quality is the competitiveness of lenders — that same environment will not prevail for the exit strategy. Fundamentals, the economy and labor markets matter more in secondary and tertiary markets, where risk-averse lenders believe that cash flow will not rise sufficiently over time to cover rising interest rates,” he noted.

Unlike two or three years ago, when access to credit was a constraint to job creation, now there are other reasons, including political uncertainties, taxes, healthcare costs and concerns about Europe. Chandan commented that the recession’s crash in housing values brought about an unintended consequence as well; the single-family housing market had been an engine of job creation among small business, through home equity lines of credit.

Although the backdrop for the conference was an anemic recovery and continuing uncertainty about Europe and Asia, the economists, developers, fund managers, lenders, advisors and equity investors speaking throughout the day agreed on several points:

  • There has never been a better time to be a borrower, because there is such an abundance of both debt and equity capital. (Of course, it helps to be looking for financing for stabilized assets in major markets.) Lenders are “clicking on all cylinders,” in the words of Michael Tepedino, senior managing director of HFF, L.P.
  • Underwriting is still conservative, focusing closely on current cash flow, lease rollovers and the competitive landscape. Debt yield is a key metric for lenders.
  • While loan-to-value (LTV) ratios have inched up, there is still a great need (and many sources available) for mezzanine, B-note and preferred equity financing. Panelists stressed that they were not in the “loan-to-own” business.
  • Financing prospects are less bright for Class B suburban office properties and unanchored retail centers (the term “junkyard dogs,” used to describe such properties, quickly became a conference favorite).
    Additional conference highlights follow:

The Debt Panel

Marc McAndrew, executive vice president and head of real estate banking for PNC Real Estate, reported that PNC expects its volume to reach $10 billion in 2012. “Our hit rate is down significantly; we have to look at a lot more stuff,” he said.

Much of the panel focused on retail real estate. McAndrew noted, “There is not much of a home for ‘junkyard dogs’ at PNC, and there has never been as big a chasm between the haves and have-nots in retail on the equity and debt sides. Lifestyle centers, fortress malls and grocery-anchored retail are fine because they are shopper destinations; generic big box centers, on the other hand, are easy to bypass.

Edward Coco, senior managing director, North American Debt, GE Capital Real Estate, said that GE got back into the market last year and expects to place $3 billion in originations in 2012, including bridge and structured financing. It has completed two mezzanine deals with Blackstone.

In his view, suburban retail is struggling a little more than urban, because many young people are moving to CBDs. “The key is to not overleverage; 80 percent leverage on any real estate deal is suicide. If you lose a couple of tenants, you can’t cover your costs.”

Mark Wilsmann, managing director and head of Real Estate Portfolio Management at MetLife Insurance Company, said that MetLife has placed $7 billion in debt thus far in 2012. Its activity is concentrated on financially stable assets and he acknowledged that “the rate environment creates a challenge for life insurance companies,” he said, adding that 70 percent of its activity now is floating rate.

P. Sheridan “Shecky” Schechner, managing director and co-head of Americas Real Estate Investment Banking at Barclays Capital, said that CMBS spreads have declined from 325 to 350 points over swaps at the beginning of 2012 to “275-ish now.” That translates to a rate of 4.5 percent for a 70 percent LTV loan, which means they are “getting closer to where the life companies are.”

In financing for retail centers that are not grocery anchored, the answer is slightly lower leverage: the low 60s, with higher than 10 percent debt yield.

“If your property can handle that, you’ll definitely find people aggressively pursuing it,” said Schechner. But the difference between financing for a fortress mall, versus an unanchored center, is not prohibitive. The fortress mall could get financing at 4.25 percent; an unanchored center could be in the 4.75 to five percent range.

The Structured Finance Panel

Andrea Balkan, managing partner of Brookfield Real Estate Financial Partners, is fund manager for three Brookfield real estate funds with $1.6 billion in committed capital and a focus on mezzanine debt; its newest fund totals $500 million. Brookfield is active in the 60 to 80 percent segment of the capital stack, for office, industrial, multifamily and retail, and looks to provide $30 to $50 million loans.

Pension funds are investors in these funds. “Since 2002, we have done 70 loans and only four have defaulted. Returns are in the 12 to 15 percent range. We’ve never walked away from a deal and still do multi-tranche transactions, but are veering away from them,” said Balkan.

Gregory Breskin, director of WestRiver Capital Management, explained that the company has a $200 million debt fund and invests in B notes and mezzanine debt. The firm expects to place $85 million by the end of 2012. “We are a fixed-rate, five- to seven-year lender.”

This year has been “feast and famine,” he said, with more competitive pressure. “We try to be a little less opportunistic on property but more in the capital stack: A/B properties in A/B locations, the Charlottes and Seattles of the world. WestRiver believes that “an 11 percent deal for five years is better than 19 percent for two years.”

Scott Miller, managing director of Redwood Trust, Inc., said the mortgage REIT invests in mezzanine, preferred equity and B notes for 10-year terms. Its goal is to place $50 to $75 million a quarter and it looks for nine to 11 percent yields. “There are more entrants into the lower risk mezzanine space,” he said, adding that “insurance companies have created allocations within their portfolios.”

Real Estate Capital Flows and How They’re Being Deployed

Paul McEvoy, senior managing director of DRA Advisors, LLC, which has over $9 billion in assets under management, reported that there are now very large investors in the market that have not historically invested in real estate. Among them: Norges Bank (from Norway), China Investment Corporation and the Texas Municipal Retirement System. He also reported that larger institutions are increasingly focusing on direct investments, separate accounts and joint ventures or co-investments.

“It’s a brutally competitive fundraising environment,” he said, meaning that it takes longer to raise money in private equity funds. At the same time, however, according to a Preqin report, there is $100 billion of dry powder invested in private equity funds that has yet to be deployed.

Phil Riordan, senior managing director of GE Asset Management, noted that the company seeks equity-like returns and pays a premium for “sustainable, predictable assets.” He termed the major office market today “a little lumpy,” and prefers retail, industrial and multifamily risk-adjusted returns.

GE is focusing on managing its real estate and not just passively investing. “Fundamentally, we are real estate investors,” Riordan said. “It’s not that common among corporate pension plans, but we are maintaining that allocation to equity real estate.”

Edward Schwartz, principal of ORG Portfolio Management LLC, said that large pension funds have shifted dramatically to core gateway strategies, for the perceived safety. Going-in yields there are in the low fours and below. Schwartz noted that markets like Atlanta and Houston, which can be categorized as somewhere between core and secondary, present opportunities.

(Editor’s note: for more on the ICSC/NAIOP Capital Marketplace Conference, including perspectives by developers and owners on joint ventures and commercial real estate, see the article on “Competition for Quality Assets Spurs Creative Investment Strategies.")