Real estate capital flows

4 November 2010

In the capital markets, the gulf between the haves and have-nots will become more apparent during 2011. The cash rich and well capitalized should feast off the cash poor and overleveraged. Big lenders should capture more market share, while more small banks nosedive into oblivion. If you are a borrower with bad credit, you're fried. If you are a buyer with dry powder, you should have plenty of options. In 2011, the "huge spin game" of extend and pretend also finally starts to run its course. "We're deferring losses to build up capital, and we want to keep regulators off our backs by maintaining manageable capital ratios," says a leading lending executive. "Regulators know what is going on; [they] just don't want events to force them to notice. But at some point we will be able to take the losses and pull the trigger on writedowns, either when foreclosures can't be avoided or when it's time to refinance."

More Realistic

The odds increase that lenders will drop the hammer on troubled borrowers (the have-nots), and rationally leveraged owners (the haves) will be able to obtain precious refinancing when their loans reach maturity. It all depends on the quality of the asset and the prospects for improving cash flows. In a limbo zone between the haves and have-nots are the "have-lesses." "If you're not good enough to get refinanced and you're not bad enough to get foreclosed, you can get an extension, as long as you can cover debt service"-and live on to have your fate decided down the road. In any case, the debt capital markets become more liquid and get more realistic about asset values, setting the stage for champing-at-the-bit equity players to launch into buying or recapitalizing more challenged properties.

Filling the Void

"Absent a major economic speed bump (like the dreaded double dip), there may be enough capital for refinancing, as long as you have a decent property," confirms another lender. "Life insurers are fully engaged; banks will start to fill more of the void; new debt funds, sovereign wealth funds, and mortgage REITs will help; and, make no mistake, even conduits are coming back." But "realistically, it's a huge gap to fill."

Writedowns and Restructuring

Amid skyrocketing delinquencies, lenders and special servicers have already "started taking more writedowns" on discounted payoffs of debt, borrowers register losses so they can "raise cash to put out another fire," and new asset cost bases take into account higher vacancies and rolling-down rents. Workouts include earn-outs and hope notes; the key for lenders is "can the borrower pay something?" Loan-to-value (LTV) ratios are not as important. "Who really knows what the value of some of these assets is?" Where property metrics deteriorate in the face of tenant losses and borrowers run out of capital, lenders move more expeditiously to foreclose. "They realize it's better to take a hit and create a structure to stabilize the property than suffer greater losses." Banks will feed more distressed assets into sales markets as they can, but in the meantime, "financial structure right-sizing is happening."

Bigger Is Better

For new loans, "it's a very binary market where life companies kill each other to finance core properties" and most everything else goes wanting. The handful of "too-big-to-fail" money-center banks, buttressed by low interest rates and various federal infusions, will become more active. But back-in-the-game lenders will favor institutions and bigger players, and these already better-capitalized owners and buyers then take advantage of mortgage rates that are reasonable, thanks to Fed monetary policy. Smaller players more likely get left out in the cold. "The corporate guy can borrow a lot more," says a Texas sharpshooter. "REITs have a much bigger advantage in getting credit over the small guy."

Achilles' Heel

The brightening outlook for major market financial institutions and their better-capitalized clients does not necessarily extend to hobbled banks based in commodity markets. These regional and local banks, which serve less well-heeled investors, developers, and businesses, must "continue to kick the can down the road," surviving on low interest-rate life support. Either their balance sheets improve or regulators take them over. "It's a failed business model," says a big banker. "Where do they get the money?" While these banks struggle to buy more time, it may be running out for some drowning in underwater construction and land loans to homebuilders and local developers, as well as a flood of defaulting home mortgages. If the housing market remains in intensive care-a likely prospect-more small-fry banks could flatline, straining government agencies like the FDIC, limiting refinancing opportunities for their borrowers, and undermining chances for recovery.

Market Schizophrenia

Emerging Trends surveys capture the essence of market disconnect and bifurcation. More than 55 percent of respondents see equity capital moderately to substantially oversupplied for 2011-a reaction to the recent investment surge into a few 24-hour cities and the multifamily sector. They view this activity as a leading indicator of the depth of sidelined equity "poised to pounce" back into the market, though they question the eagerness to pay up for properties so early in the cycle. But debt capital for both refinancing and acquisitions will continue in undersupply, according to surveys, a result that underscores an unsettling reality: there are many more troubled borrowers with "crappy assets" than rationally leveraged owners with solid properties. In 2011, REITs and well-capitalized private investors should have the best opportunities to take advantage of market imbalances. Life insurers are best positioned on the debt side.

Some Underwriting Slack

The degree of less-rigorous underwriting standards experienced in slowly thawing markets depends on the condition of your financial institution and the state of your balance sheet. After "silence at the banker door" for more than two years, any attention extended to anxious borrowers signals some welcome loosening. Most lenders and equity investors "play it safe," steering clear of trouble, but they will continue to invest in top-tier assets and begin to underwrite more core-plus deals, as well as some value-add opportunities in the apartment sector. Aside from the frenzy over trophy institutional assets, lenders typically will demand significant equity down-payments (LTVs in the 50 to 65 percent range) and recourse.

Banks and Insurers

Without regulators breathing down their necks, the money-center banks will continue to deleverage gradually, building loss reserves, stepping up writedowns, and lending more-mostly to high-credit-rating customers. They "assess asset by asset," preferring well-leased office properties and accommodating multifamily borrowers. But they shy away from hotels and show concern about retail. Some local and regional banks face more daunting challenges: outsized distressed debt portfolios deteriorate further without a vibrant employment outlook and improving demand for housing and commercial space. They cannot sustain restructuring or marking loans to market-"values have declined too much"-and they have little or no capital to refinance or make new loans. Investors waiting to gorge on bank real estate-owned (REO) dispositions may continue to be disappointed until they reduce expectations. "If opportunity funds had a brain, they wouldn't be talking to us; they'd be talking to borrowers," says a money-center banker. "We're not sellers at their prices."

After a decade when banks and upstart conduits relegated insurers to minor status, conservative life companies "temporarily rule the roost" in commercial mortgage markets, and have homed in on their bread and butter-loans on trophy assets in larger markets. Insurers need "to get more dollars out" because the liabilities of favored annuity products match better to mortgages than did old-school whole life policies. An insurance executive admits to aggressive bidding on signature assets, "but getting a 4 percent or 5 percent rate spread with a mortgage looks relatively good compared to sitting on cash in money markets"; values were "so hammered on these properties, today's LTVs will look smart in a recovery." Insurers have also been able to attract borrowers willing to take higher rates than banks offer in return for nonrecourse loans.

Life companies have not escaped distress, but they have helped themselves by lending on a better class of property and dealing proactively with problems. Unlike banks, "we'll shift bad assets into equity portfolios more quickly and have been successful in pressuring borrowers into fronting capital to avoid foreclosures." Still, these institutions "bend over backwards" to avoid red-flagging nervous state regulators, who could raise capital reserve requirements. "Like banks, we don't want foreclosures on our books, and we'll make allowances to borrowers if we must." The life companies also own large CMBS portfolios with plenty of bonds backed by thousands of assets "destined for distressed debt funds." "Nobody underwrote this stuff."

Wall Street

The big Wall Street investment banks look to regroup after taking the brunt of blame for directing capital into overheating property markets through complex securitized loan structures in what turned out to be a value mirage-inspired fee fest. Interviewees expect these firms to return in force once they figure out how to navigate federal regulatory reform. "Real estate needs capital, and the Street provides it." For starters, bankers structure new CMBS deals to kick-start the moribund mortgage securities market and watch for opportunities to take struggling private operators public. "They're resilient and will find a way to get their noses under the tent.

Foreign Investors

Global dollars looking for income returns will continue to gravitate to U.S. real estate in 2011. "We're still viewed as the most stable market." Overseas investors tend to be long-term holders, who like the United States for parking money as a safe haven. It is pretty much the same old story: they concentrate on the familiar brand-name coastal cities with direct airline stops from foreign capitals and business centers.

Offshore buyers have been in the thick of bidding on office buildings in New York City, Washington, D.C., San Francisco, and southern California. "They like to invest in the cities they see back home on TV shows and at the movies." Besides downtown office property, they like retail and hotels (needing a place to stay on visits), and some consider industrial properties at primary seaports. Highlights of interviewee comments about foreign capital flows include:

  • Expect Canadians to step up activity. Their tight markets limit new investment opportunities; the action for them will be south of the border.
  • German institutional investors jumped early into top-tier markets, but they become frustrated because more bidders drive up prices, and some retreat despite pressure to place more money. Secondary and tertiary markets are off-limits: "We're not going there."
  • Germans and other Europeans typically steer clear of apartments. "They're not familiar or comfortable with four-story sticks-and-bricks projects." They question construction quality and do not like the short lease durations.
  • The unsteady U.S. economy and the value of the dollar raise more concerns than usual about currency exchange risk for Eurozone investors.
  • Australian and Irish investors have disappeared temporarily. They overleveraged, bought at the top of the market, and now lick their wounds.
  • "You see more Spanish, French, and Italian high-net-worth money competing for deals, as well as Russian entrepreneurs."
  • Middle East investors remain plentiful, but stay under the radar using U.S. straw men to do business. "They like anonymity; it's difficult to tell how much they are doing."
  • Far East investors and sovereign wealth funds also look for opportunities. The mainland Chinese start to become more of a force.

 

 

Emerging Trends in Real Estate® 2011, a joint venture of PricewaterhouseCoopers (PwC) and the Urban Land Institute (ULI).