Capital Flows

Real estate handily outperformed other investment sectors in 2002. But what does the flow of additional capital into real estate mean for the industry?

Last year was a banner year for all things related to real estate finance. Long-term interest rates were at the lowest level since the Eisenhower Administration. Short-term rates spent most of the year below the spreads offered on conduit loans back in 1994. And loan volume was solid, with delinquencies remaining close to nonexistent.

Investment-grade commercial mortgage–backed securities (CMBSs) were the best-performing sector of the Lehman Brothers Aggregate Bond Index, with a total return of 15.45 percent. Meanwhile, whole loans registered a 15.26 percent total return for 2002, according to the Giliberto-Levy Commercial Mortgage Performance Index. To put performance in perspective, the Lehman Brothers Triple-B Bond Index weighed in at 8.28 percent (despite huge losses on certain corporate bonds), the NAREIT Composite Index returned 5.22 percent, and the S&P 500 Index was down 22.1 percent for the year—its third consecutive loss.

To put it bluntly, real estate loans performed admirably while corporate bonds suffered headline risk, and the stock market took a pounding. Many observers will remember 2002 as the year real estate wore a white hat. But the stellar performance is only a part of the story.

In 2002, a year that saw abundant problems in corporate stocks and bonds, capital rushed into real estate, creating some higher-leverage opportunities as well as aggressive, unprecedented pricing. What is noteworthy is that this all occurred while the economy sputtered, employment contracted, vacancies rose, and rental rates fell. In short, real estate fundamentals began to deteriorate.

Today, there is growing unease among investors that today’s real estate market suffers from a latent defect—a “disconnect” between real estate fundamentals and pricing. Despite growing investor anxiety, borrowers seeking high-octane capital will find more available capital for higher-leverage equity and mezzanine debt than ever before.

Where We Are Going

But is there really a latent defect in today’s real estate market? Many analysts and economists talk about a weakening of real estate fundamentals, but there is scant proof of it in the low number of loan delinquencies nowadays. Delinquencies for fixed-rate conduit loans at the end of 2002 totaled a mere 1.66 percent, nearly unchanged from six months earlier and up only a tad from 1.49 percent as of January 1, 2002, according to Trepp, LLC, a Manhattan-based firm specializing in CMBS analytics and pricing. American Council of Life Insurance data for the third quarter showed a similar trend. Delinquencies were 0.31 percent for whole loans as of September 30, 2002, and as of January 1, 2002, they were slightly lower, at a miniscule 0.12 percent.

To be sure, not all property types are created equal. As of December 31, 2002, loans secured by office properties had a delinquency rate of 0.59 percent; loans secured by multifamily properties clocked in at 1.02 percent; loans secured by industrial properties weighed in at 1.16 percent; retail property loans were at 1.81 percent; and loans secured by lodging properties—accounting for close to 10 percent of all delinquencies by value—had a delinquency rate of 5.24 percent, according to Trepp.

Moody’s special report on CMBS delinquencies published last December found several interesting patterns. Perhaps the most intriguing finding was that “CMBS delinquencies are higher in towns too small to be designated an MSA [less than 50,000 in population], and this pattern prevails across all property types.” Also true: the smaller the town, the larger the delinquency problem. And, the report revealed, the larger the city, the less likely it was to have delinquencies. Moody’s also noted that both the largest and the smallest loans tended to have the fewest problems. While the report is useful in evaluating the story behind the numbers, industry participants should keep in mind that many of the delinquencies tracked so far are not so much the result of cyclical stress as they are event and borrower related.

Hotels, however, are an exception. The lodging industry is normally the first to feel the impact of a shift in the economy because its leases are literally night to night. Although hints of a softening economy began to surface in late 2000 and early 2001, when hotel loan delinquencies exceeded 2 percent, the major accelerator was the terrorist attacks of 9/11. Hotels had an extraordinarily weak fourth quarter, with delinquency rates peaking at close to 6 percent in December 2001. The early months of 2002 were not much better, though they showed some improvement. It is only within the past four to six months that hotels have received any consideration from the lending community. But the current war in the gulf is setting the hotel industry back.

If the hotel sector has suffered the most, how have other property types fared? Interestingly, office loans have the lowest current delinquency rate in the CMBS universe; history indicates that out of the four major property types, office properties tend to take the longest amount of time to recover once they are down, an axiom witnessed during the early 1990s.

The Giliberto-Levy Commercial Mortgage Performance Index, with data back to 1972, demonstrates that while office loan losses were at 0.58 percent in 1986 and gradually got worse, total returns for office loans did not become negative until 1991 and remained that way for two years. When property-type returns are tracked for the five years ending December 31, 1995, office returns ranked dead last, with total annual return after credit losses of 4.84 percent. Multifamily loans performed much better: loans secured by multifamily properties had only one negative-return quarter between 1991 and 1995, and registered the best performance, with total return after loan losses of 10.32 percent, annually for the five years ended December 31, 1995. Loans secured by industrial and retail properties returned 9.22 percent and 10.25 percent, respectively, over the same five-year period.

Industry experts now predict that it may be several years before the full effect of suffering net operating incomes (NOIs) is felt at the property loan loss level. The reason for this delay is that many buildings at present are benefiting from leases that were signed when market rents were much higher. When the time comes to renew these now-above-market-rate leases, tenants may benefit from dramatically lower rents. This eventual “mark-to-market” in rents, when combined with rising operating expenses, will squeeze NOIs, referred to by Boston-based Torto Wheaton Research as the “NOI cycle.” If it materializes, it will be the cyclical stress that so far has been absent from delinquency data. It also may be the undoing of the office sector and its current status as the low-rate leader in delinquencies.

If softening rent and occupancy levels are a given, do firming property values represent a disconnect? Or, given a historical perspective, is it merely rational pricing? Taking the latter position, Patrick Corcoran, principal of CMBS research at J.P. Morgan, indicates that capitalization rates should, indeed, be more aggressive when NOI is at a cyclical trough (implied to be 2002–2003.) Further, he argues that the ongoing shift of money out of stocks and into real estate will continue to make property values hold.

Taking a different view, Tad Philipp, managing director of Moody’s CMBS Group, comes to a different conclusion. He claims that there is a disconnect between today’s lower cap rates and the weakening cash flows, and that real estate prices are being supported through the abundant use of low interest rate leverage.

What Is New

The current rush of capital into commercial real estate clearly is keeping property values high and delinquencies low, despite weakening real estate fundamentals. More important for borrowers, excessive capital coming into real estate creates both lower-rate first-mortgage financing opportunities as well as some very creative, higher-octane debt and equity opportunities.

At present, long-term first-mortgage rates are being fixed around 6 percent. For a borrower choosing a 15-year, self-liquidating loan, the loan constant is just a scant more than 10 percent! Some five-year mortgages are getting priced below 5 percent and LIBOR-based variable-rate loans may well be priced in the 3 percent range. Low interest rates in general mean that debt service coverage ratios are much higher today than what they averaged just a few years ago. The most immediate effect of the lower rates and the higher loan leverage is that the risk of a borrower defaulting during the term of the loan is reduced.

Today, insurance companies are struggling to meet an ever-increasing allocation to real estate, and simultaneously meet yield requirements that may not be achievable in the market. Many institutions have found themselves setting floor interest rates only to reset them when their loan pipeline shuts down. Life company investment officers must constantly match the stream of cash flows from real estate investments against the outflow for annuities, dividends, and other products—a daunting task.

The problem is equally difficult for institutional investors who are not affiliated with life insurers. A number of them are looking to enhance yield, and this has led to a significant inflow of capital into mezzanine, preferred equity, and other forms of real estate investing that are at the riskier end of the capital structure. Never before has a borrower had so many options to assist in levering acquisitions, rehabilitations, or ground-up construction. There are even options for adding dollars to a seasoned loan.

While there has been a large amount of mezzanine and equity capital available for Class A projects of significant size, less-than-A-quality assets or projects that require only $2 million to $6 million in equity or mezzanine debt have had great difficulty in attracting institutional equity capital. Recently, though, institutional capital has begun to pay more attention to these smaller projects.

Despite greater institutional interest as of late, the market is not well defined and remains very thin. There are several new programs for developers needing equity of less than $5 million. For example, John B. Levy & Company, Inc., a real estate investment banking firm, recently closed a transaction in which the first mortgage represented 93 percent of the total capital needed to purchase, rehabilitate, and retenant a Class C apartment property in the Raleigh-Durham/Research Triangle Park area. The transaction was noteworthy not only because of its relatively small total capitalization (less than $8 million), but also because the Research Triangle Park “A” apartment market is overbuilt and employment has contracted there.

In this case, the institution offered a floating-rate first mortgage that was really a combination first-mortgage/mezzanine loan. The pricing was extremely attractive given the developer’s aggressive plan of rehabilitation and the market’s softness. The developer had negotiated a very favorable purchase price that reflected the weakness in the A market, but the property and its immediate competitors had been able to keep stable high occupancies.

The opportunity involved upgrading the property from its current C-quality to a B or B-minus position and reducing operating expenses through the installation of newer systems that are more efficient or that allow tenants to pay the utility charges. The developer’s track record and a convincing analysis of the submarket reassured the lender that, when the rehabilitation was completed, the property could be easily refinanced with permanent debt that would pay off the combination first-mortgage/mezzanine loan. Sponsorship strength, a clear investment opportunity, and a fail-safe exit strategy made the transaction successful.

The above-described property was unleveraged upon acquisition, which made the transaction less complicated. Challenges arise when a property is encumbered by a first mortgage that either has a huge prepayment penalty or does not allow additional debt, or both. It is in this situation that preferred equity shines. The $2 million to $6 million market for preferred equity is quite thin, especially behind a highly restrictive first mortgage that does not permit an assignment of partnership interests. However, a handful of institutional groups do provide this type of capital.

The main issue with preferred equity is control. How does an investor gain control of a property if the developer defaults or is not managing it effectively? The answer lies in the operating agreement. The investor becomes a part of the operating entity that owns the property. The investor is provided a dividend based on the capital invested and an option to be bought out after a future date. In essence, this structure offers additional capital to the borrower without triggering a recourse carve-out violation or a loan default because of additional financing.

A preferred equity transaction must be based on sound real estate with an extremely experienced sponsor. For taking the risk, investors can achieve a yield in the mid-teens. However, preferred equity transactions can cause excessive “brain damage” due to difficult structuring and legal issues, which have kept many groups out of the market.

Many first-mortgage transactions are being financed today with such low rates that some borrowers believe these low rates could be a positive selling point down the road if a new buyer assumes the debt. The problem is that asking a buyer to assume debt that could be only 50 to 70 percent of the capital structure greatly dilutes equity returns. Properly priced and underwritten mezzanine and preferred equity programs can fill in the leverage gap and solve many an investor’s problems. With capital flowing into the market and lenders seeking higher yields, it is expected that various derivations of this program will blossom.

John B. Levy and Andrew R. Little are principals of Richmond, Virginia–based John B. Levy & Company, Inc.

© 2003 ULI–the Urban Land Institute, all rights reserved.