FEATURE: Capital considerations

US capital markets have improved dramatically over the past year as lenders once again start hunting for deals. The question is whether the recovery is being driven by capital flows rather than fundamentals. PERE magazine April 2011 issue

Aggressive is not a term you would generally use to describe the US real estate debt markets today. However, for many professionals, an element of aggression has returned to certain sectors of the lending community that hasn’t been seen since 2006 and early 2007.

As the balance sheets of banks and other financial institutions continue to mend, lenders are returning to the market with surprising force, not just in relation to senior loans but commercial mortgage-backed securities transactions as well. Permanent construction loans, which allow investors to draw down capital in stages rather than facing the negative arbitrage of borrowing capital upfront, were non-existent among traditional lenders just one year ago. Together with bridge lending, permanent construction loans are now re-emerging on some bank and life company balance sheets. It is a welcome sign that the US debt markets are on the road to recovery.
Still, the speed of the market’s recovery and the rate at which spreads are being reigned in is prompting some industry veterans to wonder whether financial institutions are once again chasing the market down. The question that follows, of course, is whether underwriting standards are set to follow.

CMBS 2.0

If 2010 was the year when US conduit lenders started to gear back up for business, then 2011 will be the year when the CMBS machinery is actually put to work.

After almost 18 months of no new issuance between mid-2008 and late 2009, the US markets saw about $12 billion of new securitisation in 2010. That figure is expected to grow to at least $35 billion by the end of 2011 and could even go as high as $55 billion to $65 billion. Such is the optimism in the industry that one professional predicted a return to 2004 annual volume levels of more than $80 billion. The latter estimate is unlikely but, with first quarter issuance already at $9 billion, 2011 will undoubtedly be a strong year for conduit lending as it re-emerges from the ashes of the credit crisis.

Many professionals point out that the CMBS machinery needs to be strong as more than $1 trillion of commercial real estate debt – senior loans as well as CMBS – is set to mature over the next three to five years. But it’s not just the future refinancing risk that people are concerned about. For private equity real estate fund managers, a CMBS revival also will be critical for the country’s secondary and tertiary real estate markets. Although sometimes deemed a lending source of last resort, CMBS has proven adept at financing deals involving non-core assets in markets outside the major ones, particularly transitional, value-added opportunities in secondary (and often tertiary) markets.

“There is definitely a need for this kind of financing to come back and be a part of the CMBS world,” says Tom Fink, senior managing director of CMBS data tracker Trepp. “Historically, CMBS has done a good job of dealing with secondary and tertiary markets and making it possible for people who didn’t have a big New York office deal to access credit.”

CMBS is, as one real estate GP adds, “very important for the valuation and stabilisation of secondary and tertiary markets.” As real estate debt markets grow, and as the conduit lending world grows, there will be increasing appetite for secondary assets in secondary locations, “helping them trade on a more stable basis rather than on a distressed one.”

Of course, when it comes to CMBS 2.0 – as the recovery of the securitised lending market has been dubbed – some things are different from the heydays of 2006 and 2007. For Steven Kohn, president of Cushman & Wakefield Sonnenblick Goldman, the primary difference is the focus on cash flow. “The quality of the asset and market have been important in new CMBS deals, but more importantly the industry is very focused on the quality of the cash flow,” he says. “It is more about debt yield [net operating income divided by the loan amount], which translates to debt service coverage.”

However, it is precisely such underwriting standards that are causing concern for many executives. Put another way, it is the fear such standards could quickly disappear as the CMBS market heats up again. All the professionals PERE interviewed expressed surprise at the speed of the recovery of the market, not least the rate at which spreads have tightened in just the past few months. “The CMBS market currently is exercising a lot of caution in putting its money out, but the discipline of better underwriting may not last as long as people would like it to as more people compete for the business,” says Fink.

One potential dampener on the growth of CMBS volume in 2011 could be the lack of B-piece buyers willing to take the riskiest slice of the securitisation. At present, there are three active, large buyers in the market – H2 Capital Partners, BlackRock and Rialto Capital Management – and the scarcity of B-piece investors is creating a potential bottleneck for new issuance.

However, according to another CMBS professional, such a bottleneck has proved beneficial to underwriting standards, at least in the short-term, with some B-piece buyers willing to “kick out” less attractive loans from proposed CMBS pools and forcing originators to go back to the drawing board. “In this environment, when loans are kicked out, you won’t necessarily get a second chance to throw them into another CMBS pool further down the line,” the pro adds.

Senior stack

The fear that today’s conservative underwriting standards could start to be corrupted isn’t just a concern facing CMBS. Industry veterans also note similar worries when it comes to senior lending.

“The banks, life companies and traditional lenders have been very focused on not doing anything crazy,” says Riaz Cassum, senior managing director at HFF, a commercial real estate capital markets advisory firm. “But as the cycle goes on, it will naturally get more aggressive.” Indeed, it may already be happening.

Over the past year, debt yields, which measure net operating income as a percentage of the loan amount and are seen as the most direct method for calculating risk, have come in from roughly 14 percent to between 10 percent and 11 percent, according to various capital markets professionals. In the multifamily sector, where life companies are becoming as, if not more, aggressive than government-sponsored entities, debt yields have fallen to sub-10 percent levels.

Such aggression, however, is generally only being felt in core-like deals, where loans are secured by good assets with good cash flows predominantly in prime markets. “The availability of financing has become a story of the best versus everything else,” according to Spencer Levy, executive managing director for CBRE Capital Markets. “If you have an asset with a good cash flow, even in the secondary and sometimes tertiary markets, you will have a very strong pool of lenders willing to lend you money.”

Indeed, Levy and Cassum both point to the re-emergence of bridge lending for quality assets over the past six months as an indication that traditional lenders are again competing for deals. “If you want a high level of debt, say over 65 percent loan-to-cost, for a value-added transitional asset, it’s not a deep market, but it is an improving one,” Kohn adds. “There are sources of such capital, but the interest rates will be significantly higher than conventional first mortgage rates on the portion above 55 percent or so.”

It is that dichotomy of the lending market that is perhaps causing the most surprise among real estate professionals today. On the one hand, lenders are racing to finance core-like assets – and according to one executive “chasing down” the market in the process – yet real estate fundamentals in the US have yet to catch up. Although the asset class is starting to see some improvement in demand, occupancy and rents, there is a fear that the recovery is being driven by capital flows rather than fundamentals, a scenario that has all the hallmarks of 2007’s lending market.