FEATURE: Restocking the loan shops

The US debt market is no longer like an under-stocked ice cream shop, but that doesn’t necessarily mean borrowers have an abundance of choice just yet. PERE magazine, March 2012 issue

When characterising how the commercial real estate financing landscape in the US looked just a few years ago, Kevin Chisholm likes to compare the lending market at the time to a bunch of under-stocked ice cream shops. “It wasn’t that long ago when every lender we spoke with was offering the same type of loan, which was pretty much just one scoop and one flavor,” says Chisholm, a principal and managing director at Savanna, a New York-based private equity real estate firm. Loans – if lenders were considering any new loans at all – generally had a going-in debt yield of about 10 percent. 

Today, US real estate financing has improved noticeably, although it still is far from the heady days at the height of the market. “We have not seen a return to bull market underwriting by lenders, but we have definitely seen lenders’ underwriting standards, loan covenants and overall structure loosen up a bit,” Chisholm notes. “Now, we see people actively marketing note-on-note lending programmes and marketing the fact that they underwrite ‘value’ versus ‘cash flow’.”

As almost every opportunity fund manager has experienced, during the credit crunch, lenders only would underwrite properties based on cash flow rather than value, so loans for vacant buildings, even those located in the middle of Manhattan, were difficult to obtain. However, over the past 18 months or so, fund managers have seen certain types of lenders become more open to underwriting potential upsides rather than in-place cash flow.

In addition, a growing field of lenders are advertising programmes for note-on-note financing of defaulted or underperforming senior loans. However, unlike at the height of the market, note-on-note financing is available for senior mortgages only, with few options available for financing junior debt.

On the up and up

After an up-and-down year in 2011, commercial real estate lending activity in the US is poised to gain momentum this year, thanks in part to greater stability and confidence in the domestic economy. This increased availability of financing is expected to help private equity real estate borrowers execute more deals, although some lenders says tougher competition may come from institutional buyers.

“In the past 18 to 24 months, I’ve seen the mood in the financial markets swing around a lot,” says a real estate lender at one large investment bank. At the beginning of last year, “there was a euphoria building up among CMBS shops,” but lending hit a bump in the road over the summer. As the European debt crisis came to a head, “there was a shutdown or pullback, where all the balance sheet lenders as well as securitisation lenders stepped back,” he explains.

Financing activity in the US then started to rebound in the fall, and “now there’s an abundance of financing sources out there,” says the lender. “Any transaction that comes up, there’s usually two or three parties competing for the financing right now.”

This year, commercial and multifamily mortgage originations in the US are projected to hit $230 billion, up 17 percent from 2011 volumes, according to a new forecast from the Mortgage Bankers Association (MBA). Lending activity is expected to remain on an upswing over the next several years, rising to $245 billion in 2013, $264 billion in 2014 and $290 billion in 2015.

“Our forecast anticipates continued strength in lending by life companies and government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, increased lending by banks and a slow but steady return in commercial mortgage-backed securities (CMBS) activity,” according to a statement by Jamie Woodwell, MBA’s vice president of commercial real estate research. 

During the fourth quarter of 2011, commercial bank loans rose by 122 percent from the same period one year prior, while financing from GSEs increased by 17 percent from the fourth quarter of 2010, according to MBA. Life insurance company originations declined by 13 percent, and loans by conduits for CMBS dropped by 50 percent.

In a report issued in late January, Cushman & Wakefield Sonnenblick Goldman, a New York-based real estate investment banking firm, predicted that CMBS issuance would range between $40 billion and $50 billion in 2012, up from $30 billion in 2011. Insurers are expected to originate about $55 billion in mortgages this year, similar to their activity level in 2011. Debt funds are projected to issue as much as $20 billion in loans, compared to $10 billion last year. Banks will be the largest players in the market, accounting for more than $100 billion in new loans to properties, developments and REITs this year, up more than 25 percent relative to 2011. 

Accommodation and competition

The private equity real estate industry in particular can expect more financing to be available for value-added assets than there has been over the last three or four years. “Transaction activity in the value-added and core-plus part of the market dropped significantly because there wasn’t enough debt capital available to make deals work for either new investors or owners trying to recapitalise,” says Douglas Hercher, executive vice president and principal at Cushman & Wakefield Sonnenblick Goldman. 

The debt markets are more receptive to value-added deals today. However, in today’s market, assets requiring a significant amount of leasing or renovation will still need to generate opportunistic returns – typically 17 percent or higher – to attract capital. 

In major markets such as New York and Washington DC, as well as secondary markets like Nashville and Miami, some lenders have become more aggressive on loan sizing and pricing, even for buildings with sizable vacancies. That is “going to allow the private equity shops to be more active,” adds Hercher.

At the same time, the deleveraging by larger institutional buyers and REITs in 2011 is expected to continue into this year as a result of easier access to cheaper equity capital. “This capital access, and the ability to use less debt in acquisitions or development, gives institutional buyers an important advantage over their private equity counterparts,” says David Durning, senior managing director of Prudential Mortgage Capital, the commercial mortgage lending business of Prudential Financial.

In addition, pricing for attractive commercial real estate assets has risen because of stronger demand from investors, lower interest rates and more aggressive loans by lenders.  “With real estate buyers and lenders likely to be even more aggressive in 2012, we expect that the dance between private equity and lenders will heat up further as they join together to win more deals and to compete more effectively with institutional capital,” adds Durning. 

Deal factors

While financing is available from a variety of lenders, “the lender mix tends to shift depending on deal size and cash flow,” says Savanna’s Chisholm, whose firm tends to borrow only from balance sheet lenders and on a non-recourse basis. The firm typically avoids the CMBS market because, “with securitised loans, the originating lender is almost never involved with servicing the loan,” he explains. “It is possible to end up speaking with someone who has never visited the property and is not familiar with Savanna and our business plan.”

Savanna, which typically seeks a 2:1 leverage ratio on its purchases of “transitional,” or non-stabilised, office and retail assets, has purchased 10 office buildings in New York since May 2010. These include 80 Broad Street, a 36-story, 417,000-square-foot office building in Manhattan, the acquisition and renovation of which was financed by a $65.3 million loan from Mesa West Capital.

For loans up to $75 million with a going-in debt yield of at least 6.5 percent, Savanna sees a lot of interest from commercial banks, debt funds, finance companies and investment banks. However, “commercial banks have had the most compelling quotes recently, both in terms of covenants and economics,” says Chisholm. Because commercial banks have a lower cost of capital than many other types of lenders, a lender with a higher cost of capital needs to charge borrowers a higher rate to earn the same margin. In addition, while some borrowers may be able to secure more than $75 million from one lender on a transaction, many lenders have limits – typically around $75 million – on how much capital they can put into a single deal.

Indeed, each lender type offers its own set of advantages and disadvantages. Commercial banks generally provide greater flexibility and lower rates, but most bank loans have shorter terms, usually three to five years, and often require personal recourse. Life companies appeal to strong borrowers who are not trying to maximise their loan proceeds because insurers typically are nonrecourse lenders that originate loans at slightly lower proceeds with attractive fixed-rate pricing. 

Most debt funds offer fixed-rate, non-recourse loans for longer terms than banks, usually from five to 10 years, and also are more willing to lend in markets and for assets that banks and life companies may shy away from. However, debt funds typically require higher loan rates to compensate them for the additional risk they are assuming. Securitised lenders are focused on fixed-rate loans with five-, seven- and 10-year maturities and rates that generally are slightly higher than life companies but lower than debt funds.

Although more lenders are out competing for deals, financing still isn’t readily available for certain private equity real estate transactions. Much depends on the amount of leverage being sought for a deal, the property type and the market where the asset is located. 

“Once you push the LTV on transitional assets above 65 percent and you leave the major markets, the air gets thinner,” says Chisholm. Some property types, such as multifamily, industrial and retail, are relatively safe bets for lenders, while others, particularly office, will be much more challenging to finance because of the unpredictability of tenant demand, adds Hercher.

Market unknowns

The commercial real estate finance market in the US will likely be on more stable footing in 2012 than it was last year. Given the US economy has seen about 20 months of sustained improvement, including six or seven months of real GDP growth, “I think investors in real estate are now looking and saying, ‘Okay, I don’t how fast the economy is going to grow, but I’m not really worried about a double dip and that makes a big difference’,” Hercher says.

That said, “there’s this unstated volatility that has been a constant for the past four or five years,” according to the unnamed real estate lender. “There’s so many externalities out there,” including the unpredictability surrounding Europe, “you’ve got be very careful,” he says. “Pricing loans is difficult.”