Capital Markets 2012
CCIM Commercial Investment Real Estate Magazine
March – April 2012 Issue
This article was edited by Sara Drummond, executive editor of Commercial Investment Real Estate.
Many economic issues converged late last year to slow commercial real estate‘s recovery. In addition, the uncertainty of vintage commercial mortgage-backed securities loans coming due this year and for the next several years has buyers, sellers, and investors speculating on the continuing availability of capital. To get a clearer picture of the capital markets’ activity this year, Commercial Investment Real Estate asked an economist and two mortgage banking executives to weigh in on the subject.
George Ratiu is manager of quantitative and commercial research for the National Association of Realtors in Washington, D.C. Contact him at economistsoutlook.blogs.realtor.org.
David Rifkind is principal and managing director for George Smith Partners, a real estate investment banking firm located in Los Angeles. Contact him at email@example.com.
James R. Kirkpatrick, CCIM, is vice president of production for Grandbridge Real Estate Capital in Houston. Contact him at firstname.lastname@example.org.
Q: More than $55 billion in CMBS loans are set to mature this year, the most of any year to date, according to Standard & Poor’s. Of them, $19 billion are five-year loans originated in 2007, at the height of the market. How is this going to affect the lending environment for commercial real estate?
George Ratiu: The main impact of maturing debt will be felt in the banking sector, which has had to contend with these loans for the past three years. And based on both bank practice and regulator guidance, banks have been extending or restructuring loans based on multiple factors, such as asset performance, market, and management. Overall, given banks’ post-financial crisis aversion toward commercial loans, the lending environment will likely remain tight in 2012, with private and equity capital continuing to serve as the main source of funding.
David Rifkind: 2012 is the beginning of the refinance wave, fueled by historically low interest rates. The peak will be somewhere between fourth quarter 2013 and second quarter 2014. Every healthy lender is prepared to compete for a piece of this business. We are actively tracking maturities for our clients. This is the leading theme of the mortgage banking business for the near and intermediate term.
Jim Kirkpatrick, CCIM: The bottom line is that in a yield-hungry world, real estate is looked upon favorably. A lot of lenders are underallocated in real estate and we are seeing new CMBS platforms emerging. Assuming continued economic growth, the lending environment for the foreseeable future should remain strong.
Q: As this tsunami of loans continues, reaching its peak in 2017, will it have any other effects on the commercial real estate market? Will specific capital sources, cities/regions, or property types be affected?
Ratiu: Some of the effects have been manifesting over the past year. Capital has been chasing high-quality, stabilized properties in gateway cities such as New York, Boston, San Francisco, Washington, D.C., and Chicago. This has led to an increase in prices in these markets and a decline in capitalization rates.
Secondary and tertiary markets have been contending with a lack of financing due to the underlying strength of local economies and weaker fundamentals. As the supply of investment-grade properties in top markets dwindled, some secondary markets became attractive to investors looking for higher yields. A broad improvement in macroeconomic conditions will likely boost this trend, providing increased flows of capital to these markets.
Rifkind: The maturity wave is drawing money and attention back to the commercial real estate markets. Three themes are converging to create what may become a powerful new market cycle. First is low rates/liquidity: Capital is aggressively seeking yield at every point on the risk curve. Banks must book positive loan growth and many are aggressive. Life companies and pension funds have reallocated large amounts of capital to commercial real estate. CMBS wants to come back and be a force in the real estate capital markets. Opportunity funds and real estate investment trusts are innovating to participate higher up in the capital stack.
Second is the return of fundamentals. Rents and occupancy levels are stabilizing in many markets. With little new supply over the past five years, there is a solid case for a positive trend in property performance. The distress theme is still relevant and there will still be transactional opportunities motivated by debt maturities. This is especially true for properties in markets where fundamentals have not yet recovered to a level to qualify for loans from the primary debt providers.
There is enough liquidity to address the capital needs of the market going forward. As long as the underlying fundamentals continue to improve, we should see a robust recovery in many markets.
Kirkpatrick: I am based in Texas and we have been blessed with a strong economy and the accompanying job growth. Going into the recession, we had very little overbuilding so our real estate markets are in fairly good shape. Most of the refinance opportunities we are seeing will underwrite and those that don’t can mostly be accommodated with some of the new mezzanine platforms that are coming out. In other words, the owner does not need to write a check to get their loan refinanced.
I wish I could say our good fortune extends across the country, but my guess is that it doesn’t. Those loans maturing in 2012 that were originally highly leveraged or with little to no amortization over the term and in regions of the country with limited economic growth/high unemployment are probably going to require the infusion of some fresh equity to get them refinanced. Therefore, by extension, the ability of ownership to write these checks could impact real estate values.
Q: What other factors are affecting the capital markets this year?
Ratiu: The European banking concerns will likely remain a major factor for U.S. capital markets. Some U.S. banks do have exposure to European sovereign debt, which will likely impact their overall willingness to extend capital for commercial projects. In addition, the Dodd-Frank Act and the yet-to-be drafted regulations will continue to provide a source of uncertainty in 2012, as regulators work to enact and implement new rules. Against this backdrop, commercial banks are expected to remain cautious on commercial lending.
Rifkind: The leading factors are macroeconomics and politics. These are the same factors that have provided head winds for the past six months. How the European liquidity crisis plays out is important. The upcoming U.S. elections are important.
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Kirkpatrick: Where are interest rates going? I tend to side with the camp that says interest rates have to go up, but as I write this, the benchmark 10-year Treasury is 1.97 percent, virtually unchanged from August when Standard & Poor’s downgraded U.S. credit. Sticking to my guns, when rates do go up, a steady climb can be accommodated, but sharp spikes, particularly in some of the short-term money such as Libor, could wreak real havoc.
In addition, continued growth of the CMBS markets will affect capital markets, but more to the point, what is the underwriting that will be necessary to drive this growth?
Q: Will buyers and investors have difficulty finding financing in 2012?
Ratiu: Given the 2011 bifurcation in commercial markets along property values, buyers at the top end of the market will continue to find access to financing in 2012. With record amounts of cash and the ability to issue bonds or equity for financing, large corporations and equity funds are expected to remain active in the market this year. Buyers at the other end of the valuation spectrum will likely encounter a similar environment in 2012 as last year: restricted capital availability, relatively tight underwriting standards, and a higher risk aversion on the part of lending institutions.
Rifkind: Buyers will have less difficulty finding financing this year. Qualifying for new loans will remain difficult for some. Credit requirements remain strict. Borrowers need strong reserve liquidity and credit to obtain loans. Property level underwriting is also very conservative and leverage will remain relatively low, requiring a larger equity contribution from the buyer. Ultimately, this is healthy for the markets and I hope lenders will continue with disciplined underwriting standards as competition for loans heats up.
Kirkpatrick: There should be plenty of money available to refinance those loans coming due, as well as to finance new acquisitions or development. At the end of the day, the real question is whether or not the owner/borrower is prepared for all of the scrutiny associated with borrowing in today’s environment.
Q: While the general economy seems to be recovering at a quicker pace than originally predicted, commercial real estate activity retreated during the second half of 2011. What is the cause of the disconnect between the two? What factors may spur a similar uptick in commercial real estate’s recovery this year?
Ratiu: Commercial real estate investment activity tends to be more sensitive to developments in financial markets. As the European sovereign debt crisis unfolded, it took a darker turn in the second half of the year. Concern of a resolution moved farther away, prompting capital markets and investors to scale back the pace of acquisitions. In addition, until the tail end of the year, stubbornly high unemployment figures remained at the forefront of economic news, as signs of a robust recovery proved feeble. Moreover, actions in the international and political environment added reasons for investor concern.
For 2012, a continuing rise in economic growth coupled with improving fundamentals in commercial markets would go a long way toward shoring up last year’s moderate rebound. In addition, the prospect of the resolution of the presidential election cycle is likely to provide a clearer medium-term horizon for investors.
Rifkind: I don’t see a disconnect. The U.S. economy slowed significantly in the second half of 2011. Commercial real estate activity also slowed down from its initial burst of activity. Capital markets’ volatility came into play in the middle of 2011 with the debt ceiling debate and the downgrade of the U.S. debt rating. This was followed closely by Greece and the EU liquidity crisis. This raised the caution flag and slowed activity.
Commercial real estate is a long-term store of value and not a quick trade. It is difficult to view it with a short-term lens. Recoveries are not always linear. 2011 was no exception. The market healed significantly in 2011 and this trend will continue.
Kirkpatrick: In my opinion, the disconnect between the improving economy and the retreat of commercial real estate activity was the result of two factors. Too much money was chasing those deals that came to market. With all of this competition, the result was predictable: Prices increased and yields fell. In the latter part of 2011, I think many investors decided to take a step back to see if rent growth would actually materialize to justify the going-in yields being paid.
Then, after a fast start in 2011, the CMBS market stumbled — many of the new CMBS platforms shut down, some commitments were not honored, and for those that remained, spreads widened dramatically. The message here is that CMBS is an important part of the commercial real estate equation.
The good news is that the U.S. economy continues to improve. Jobs are being added, which in turn will lead to increased demand for commercial real estate. It will just be a matter of time before investors return to the market. On the debt side, CMBS has settled down. Spreads have come in and investors seem to have reached a comfort level with current underwriting. Banks and life insurance companies seem to be actively pursuing new lending opportunities. I wouldn’t look for a return of 2006, but 2012 has the makings of being a solid year for commercial real estate.