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Real Estate Capital Scoreboard – August, 2010

Chicago, Illinois, August 2, 2010 – Mid-year key economic indicators point to a more moderate recovery.  During July, benchmark treasuries moved within a quarter point range and settled lower by about 20 basis points for five-year notes, while ten-year notes moved down less than 10 basis points, respectively.  Mortgage spreads continued to barely tighten, netting slightly lower overall rates.

Throughout the first half of the year, lenders have been scouring the realty markets in search of performing projects with stabilized cash flow.  Yet limited opportunities may be found.  Simultaneously, scant funding options are available for projects without cash flow performance.   Few capital sources reach for deals on longer-term cash flow projects, unless substantial equity exists. 

With mortgage rates starting in the mid-4% range for longer term debt of seven years or greater, borrowers are migrating from floating-rate to fixed-rate debt.  As rates are at historical lows, focus on loan terms – other than pricing – include the following: 

• Loan-to-value sizing dominates underwriting funding limits, as debt service coverage ratios are relatively high due to low rates
• Subordination and non-disturbance agreements are more important to lenders as various players in the capital stack (e.g., mezzanine and preferred equity) take on new positions in situations where developer equity is reduced or eliminated
• Real estate tax and insurance collection conditions are more stringent, with lenders seeking tighter control in case of default
• Property insurance carriers must meet higher standards due to default within the industry
• Unauthorized transfers are no longer covered by most title policies, adding additional recourse carveouts

Skip Perry, Real Estate Capital Institute advisory board member notes that “lenders want quality loans, and are willing to sacrifice yield in return for safety of principal.”  He suggests, “conservatively underwritten income-property loans are precious commodities capturing premium pricing and terms.”

 Chicago, Illinois, August 2, 2010 – Mid-year key economic indicators point to a more moderate recovery.  During July, benchmark treasuries moved within a quarter point range and settled lower by about 20 basis points for five-year notes, while ten-year notes moved down less than 10 basis points, respectively.  Mortgage spreads continued to barely tighten, netting slightly lower overall rates. 

Throughout the first half of the year, lenders have been scouring the realty markets in search of performing projects with stabilized cash flow.  Yet limited opportunities may be found.  Simultaneously, scant funding options are available for projects without cash flow performance.   Few capital sources reach for deals on longer-term cash flow projects, unless substantial equity exists.  

With mortgage rates starting in the mid-4% range for longer term debt of seven years or greater, borrowers are migrating from floating-rate to fixed-rate debt.  As rates are at historical lows, focus on loan terms – other than pricing – include the following: 

• Loan-to-value sizing dominates underwriting funding limits, as debt service coverage ratios are relatively high due to low rates
• Subordination and non-disturbance agreements are more important to lenders as various players in the capital stack (e.g., mezzanine and preferred equity) take on new positions in situations where developer equity is reduced or eliminated
• Real estate tax and insurance collection conditions are more stringent, with lenders seeking tighter control in case of default
• Property insurance carriers must meet higher standards due to default within the industry
• Unauthorized transfers are no longer covered by most title policies, adding additional recourse carveouts

Skip Perry, Real Estate Capital Institute advisory board member notes that “lenders want quality loans, and are willing to sacrifice yield in return for safety of principal.”  He suggests, “conservatively underwritten income-property loans are precious commodities capturing premium pricing and terms.

The Real Estate Capital Scoreboard® – July, 2010

Chicago, Illinois, July 7, 2010 –As stock markets slide downwards, treasury rates follow suit with five and ten-year yields rounding down about 30 basis points lower from June — below 2% and 3%, respectively.  Combined with dropping spreads, borrowers are now enjoying fixed rates in the 4% to 5% range for lower leveraged loans.  Floating-rate loans stay attractive, sometimes below 4%, as fears of inflation dissipate for the time-being.

 Oversupply of funds being mismatched against a much sought-after supply of higher-quality funding opportunities is the theme for much of 2010. However, this issue is evermore pronounced as lenders are under more pressure to fund such assets. Unlike the past two years, the real estate capital markets are more stable as fresh transactions established new value benchmarks helping to remove valuation uncertainty from the underwriting process.  Look to a flurry of aggressive lending at the end of the summer, when most capital sources realize production levels are inadequate.  

While still trying to maintain underwriting discipline, lenders seek creative funding solutions.  For the most part, lenders continue to impose floors to dampen yield erosion.  The yield dams, however, will break as more monies flood the market.   Expect longer amortization schedules (returning to 30 years), leverage approaching 75% or greater and funding flexibility such as partial fundings and forward-delivery loans.  However, debt service coverage will remain at about 125%, since rates are relatively low.

The Real Estate Capital Institute’s director, Jeanne Peck, expects “Qualified borrowers are fast gaining the upper hand in negotiating debt.  Low rates combined with more attractive leverage translate to fantastic cash flow opportunities.”  Adding, “However, the equity markets see such competitive financing as reasons to maintain solid pricing, as refinancing remains a very real option vs. liquidation.”

The Real Estate Capital Scoreboard® -June, 2010

Chicago, Illinois, June 7, 2010 –  More positive news on the realty capital front as recovery from the current downturn is recapitalized by funds which were raised prior to commercial mortgage product being more widely available.  Funding demand is readily available for freshly originated capital  underwritten to currently more stringent standards.  In particular, many non-investment grade credit funds desire new commercial mortgage exposure as secondary market spreads have rallied. 

How does revived realty capital market translate to property-level funding kinetics?  

• New Benchmarks – The Debt Yield (in-place NOI divided by total debt) has now emerged as a popular underwriting index.  This index provides a quick gauge of the debt payment cushion, similar to the debt coverage ratio.  For example, 9.5% to 10% was common yield in during the market peak (2007-2008); now the index falls within the 11-12% for most types of permanent loans. 
• Favorite Fives – The number five seems to be the most favorite digit for tweaking deals.  Funding sources use the number five in many different underwriting scenarios including: 5% more leverage (70% vs. 65% LTV), 5% less debt coverage (120% vs. 125%), 5 years more in amortization (25 years vs. 20 years) and 5% more occupancy in improving markets (90% vs. 85%).
• Floors – In select cases, lenders reduce [or even eliminate] floors and rate protection for floating rate loans on shorter-term debt (e.g., 5 years or less).  Rate protection can be waived for lower leverage loans, generally 50% or less.   Simultaneously, rate floors are dropping to 3.5% to 4%, as funding sources favor quality over more realty risk.
• Thinking Outside the Box – New Market Tax Credits, Private Placement Offerings (e.g., CIS-Sanctioned EB-5 Foreign Nationals Program), Recovery Act funds and other non-conventional funding vehicles are gaining attention, especially for new construction projects requiring substantial subsidies and equity capital.  Such funds can be used for more challenging assets including senior housing, retail and mixed-use as well as lodging properties.  Available on a select basis and in very focused areas, these programs are highly technical and therefore require substantial consulting expertise for processing. 

The Real Estate Capital Institute’s advisory board member Aaron Gruen suggests “Many economic indicators are improving or stabilizing indicating the worst of The Great Recession is slowly moving behind us.  However, while the capital markets are showing improvement and signs of increasing stability and recovery, asset-level performance improvement is spotty and inconsistent.  Heightened volatility and uncertainty continues to reign.”  He adds, “Targeted risk analysis is especially important today, given that uncertainty and ongoing shifts in demographics, consumer behavior and variability in economic and fiscal performance between and within regions that can be expected.”

The Real Estate Capital Scoreboard® – May, 2010

Chicago, Illinois, May 5, 2010 – Capital continues to flooding the markets and few attractive investment opportunities surface.  While many investors see improving conditions for funding, preserving cash flow remains tantamount.  Evolving realty capital market trends include: 

• Capital:  Both debt and equity are both back at levels well above 2009 lows.  Yields are rapidly compressing and good quality projects capture substantial interest with 30 to 50 bidders not being unusual.  Yet, unsecured funding for private developers still somewhat limited, while public funds have ample access.  Projects in second-tier markets, or without cash flow, remain dormant.
• Funding Sources:   Banks will save deals with negative basis, if borrower is a solid and responsive sponsor willing to commit some level of additional liquidity.  Otherwise, land and other non-cash flowing assets will be liquidated over the next few quarters.  Also, newly recapitalized banks [no legacy issues] are starting to advertise debt for income properties.  Meanwhile, life companies increase leverage to 70% or more and multiple CMBS players are back in action. 
• Fresh Faces:  Foreign buyers, including Canadian, Asian and European buyers are bargain-hunting for properties as well as financial institutions.
• Yields: Lowest rates hover in the mid-5% range for long term debt; 4.5% for short-term.  Core investments attract unleveraged returns in the higher-single range, while more entrepreneurial investors are trying for 15% returns, but finding very limited buys in a crowded buyer universe.  Buying mortgage notes emerges as a popular platform for distressed deals with higher yields, but many shy away from risks associated with potential title issues and prolonged court battles.
• New construction:  Need public backing for generating substantial equity.  Also, institutional and multifamily uses are justifiable – retail, office and industrial only on a very selective basis.  Ed[ucation], Fed and Med[ical] are the most attractive realty opportunities.  Also,  many believe it’s the right time to look for entitled urban land as infill remains hard to find.
• Protecting Cash Flow:  Tenants are very price sensitive and will sacrifice quality for substantial rent discounts.  In fact, in many markets commercial-property values declined to levels not seen in nearly two decades.

 Jeanne Peck, the Real Estate Capital Institute’s director, cites “Like Humpty Dumpy, investors sit on piles of cash.  These investors will either find profitable opportunities, or, cushion any financials falls by paying down debt on existing holdings.”

The Real Estate Capital Scoreboard® – April, 2010

Chicago, Illinois, April 1, 2010 – Realty capital markets continue on a slippery path of gradual recovery held up by the Fed’s desire to keep benchmark rates unchanged – a policy upheld since December, 2008.  Yet bond investors are nervous and driving up spreads as fed notes and bonds start to saturate debt markets and ultimately trending towards higher rates.  In the past month, treasury notes rate ranges climbed by 25 to 40 basis points, with shorter-term maturities showing the most movement. 

Ultimately, this trend leads to higher borrowing costs, but pressure to invest is driving down spreads over treasuries.  Bank cost-of-funds are still at record-low levels, but legacy deals and loan workouts take front stage.  Therefore, new construction and higher-leverage funding are still problematic for short-term fundings.

As for longer-term permanent loans, life companies, select CMBS lenders and pension funds are selectively returning to the realty capital markets, but in incremental steps.  Agency lenders remain firmly committed to multifamily lending about 85% market share.  Loan underwriting “tweaks” are now the norm as these lenders want to differentiate themselves in capturing funding opportunities from a limited pool of qualified projects.  Tweaks include:

• Typical bank deals are structured with very attractive spreads over LIBOR (e.g., 350 bps).  However, floors are formulated on the base calculation (LIBOR floor of 1.5%), effectively raising the rate to a base of 5%, for instance.  These floors are starting to be lowered as banks compete more.
• Mezzanine loans are now bundled with agency debt with leverage in excess of 80% becoming commonplace for higher-quality multifamily loans.
• Loans that are 100% or more above value are known as “pretend and extend” situations where lenders are losing hope of full principal recovery.  If more equity is contributed, bringing the leverage levels to 80 to 100%, financial institutions will usually cooperate with loan modification actions.
• Full leverage of as much as 75% of value is offered at premiums of 50 basis points or more in rate.  While the premium is still costly, this tweak signals lenders’ willingness to raise the leverage bar based on current values.

The Real Estate Capital Institute’s Advisory Board member, Gary Duff, notes “In a sign of renewed optimism, Wall Street reenters the markets in its more traditional role of funding large and highly structured transactions, as well as ventures with debt/equity components.”  Duff suggests “Normalcy is returning at levels comparable to the late 1990’s.”

The Real Estate Capital Scoreboard® – March, 2010

Chicago, Illinois, March 2, 2010 – A painfully slow rebound ignites mild excitement in select sectors of the income-property realty markets.  Sparks of hope kindle the industrial and housing sectors as most investors sense the bottom is near, or within the near horizon.  Choice retail properties also suggest a recovery as consumers cautiously return to stores.  Office and lodging assets are bombarded with oversupply linked to shrinking demand, corporate cost-cutting and rising operating costs.

Rising defaults plaque legacy mortgage portfolios and many lenders still choice to stay on the sidelines to workout their portfolios.  Banks are starting to liquidate non-performing assets.  The Agencies are tightening underwriting standards across the board using more conservative income and expenses, lower leverage, high debt service coverage.  Yet hope springs eternal.

Recovering from near-collapse within the past 18 months, the capital markets are ahead of overall real estate fundamentals.  The most important concern?  More money than funding opportunities.  Will the markets return to more liberal conditions?  Probably not very soon, but some positive signs surface: 

• Steady fiscal policy, repayment of government bailout monies, GDP growth, reduced job losses and recovering manufacturing contribute to growing optimism.
• Overall mortgage-rate ranges start just below 180 basis points, starting to approach historical norms.
• Tightening spreads between conventional funding sources and agencies – now about 25 to 75 basis points for select apartment fundings, for instance.
• Overall interest rates and benchmark indices holding steady despite improving economic conditions and fear of inflation as noted by a mild reaction to the Fed’s increase of the emergency lending rates late last month.
• Bidding is very brisk for prime multifamily and credit-deals.  Cap rates are clearly narrowing for “best in class” projects which should bode well for lesser-quality assets as investors move down the food chain.
• More lenders returning to the market including life companies, banks and even CMBS players.  The level of interest is conservatively more than double seen in the past year.
• Agencies and other select sources introducing mezzanine and more structured financing as part of the capital stack – the beginning signs of improving funding terms based on higher leverage.

 

Jeanne Peck, of The Real Estate Capital Institute’s Advisory Board, states “Denial is now being replaced with Decision.  Legacy funding sources and owners are starting to either restructure with fresh equity or liquidate.   2010 looks more like a year of action.”  She predicts, “We should have a very good feel of momentum by mid-year.”

Realty Capital Markets State of the Union

Las Vegas, NV – February 6, 2010 – According to industry leaders gathering in Las Vegas this week, debt capital is readily available for 2010.  Optimism is in the air and the mortgage lenders are starting to offer more generous terms and conditions. 

In summary, timing is excellent for select borrowers in securing debt based on the following conditions:  (1) Recovering economy, (2) Ample supply of capital and (3) Limited supply of financeable real estate assets. 

The following highlights summarize the 2010 state of the realty capital markets including an overall outlook and overall funding program offerings: 

Back to Basics:

•  As lenders workout of their legacy problems, new funding goals surface which are clearly more ambitious than 2009.
• Still underwriting of actual numbers w/o projections, yet inflation fears exist.
• Most lenders are Indifferent to spreads, but not competition.
• Valuing real estate properties in a declining market still a challenge.
• More allocation of funds available above target amounts if deal flow is of sufficient quality

Underwriting Dynamics: 

As has been the case last year, high-quality projects in major markets backed by excellent sponsorship and cash flow characteristics are most desired—especially based on low leverage of 65% of value. 

Location/Property Types:

• Major MSAs strongly preferred for optional pricing and leverage.  Otherwise a substantially most costly financing with lower leverage.
• Preferred property types ranked in order:  (1) Multifamily, (2) Credit-Tenant lease of all property types, (3) Industrial, (4) Retail, (5) Office – however medical office ranks equal to Industrial and (5) Lodging.

Pricing (Permanent Fixed-Rate Loan):

• Agency pricing for apartments starts in the low to mid-5% range for 5 year or greater term.
• Life company pricing starts mid-5% to 6% for 5 years or more term mostly targeted for commercial property pricing (agencies are more competitively priced)
• More entrepreneurial funds start at 7% or more targeting secondary markets, smaller fundings, older properties and lodging assets.
• Add a pricing premium of 25 to 50 basis points for loans below $5 million.
• Yield differential disappearing – typical ($5 to $50 million) vs. larger loans.
• Forward funds available up to a year based on 6 o 8 basis points premium per month.

 Leverage:

• Above 65% LTV on a select basis combined with lower spreads.
• Values based on the lower of: (a) purchase price, (b) appraised value or (c) lender imposed capitalization rate.

Real Estate Capital Market Leaders Cautiously Optimistic

Las Vegas, NV – February 4, 2010 – As lenders gathered here this week to discuss income-property financing programs, nervous optimism filled the air.   The overall forecast is mildly positive — particularly as compared to 2009.   Funding sources were battling liquidity in 2008; rebuilding balance sheets in 2009; and are now earning profits in 2010 which means mortgage investing is back in vogue again. 

However, lenders fear more uncertainty as the capital markets are imbalanced with relationship to income-property supply & demand fundamentals.  Based on key opinions of various lenders an economic outlook relating to realty capital markets is summarized as follows: 

• Modest job growths combined with controlled government spending discussions directly affect the current economic recovery, slowly trickling into the real estate capital markets.  A 10%+ unemployment rate is still problematic, though.
• Slowly recovering economy due to improved CMBS pricing, housing sales and employment statistics.
• Policymakers are also helping by holding interest rates low at levels favorable for real estate markets.
• Industry leaders are reporting a pickup in capital activity including hiring staff, allocating more funds for advertising/marketing and bidding on more transactions.
• Commercial-property problems loom including hanging vacancy (especially office and retail), less space needs, increased operating costs.
• As lenders workout of their legacy problems, new funding goals surface which are clearly more ambitious than 2009. 
• Life companies under less pressure than banks to liquidate assets, if recovery is on the horizon – longer-term balance sheet hold.
• Still a “buyers market” bias due to flat or declining pricing and lower demand, a worrisome scenario for sizing property values.

In summary, industry experts agree that these and other factors will assure that mortgage capital will be readily available in the foreseeable future.  The realty capital markets should continue on a path of greater liquidity.  Yet the biggest trick will be finding suitable real estate investments as the property markets are recovering slower than the capital markets.

The Real Estate Capital Scoreboard® – February, 2010

Modest job growth combined with controlled government spending discussions directly affect the current economic recovery, which is slowly trickling into the real estate capital markets. Policymakers are also helping by holding interest rates low at levels favorable for real estate markets. Funding activity is scant, but signs of new hope are emerging. During the month, some lenders slightly dropped mortgage spreads by at 10 to 25 basis points. Short-term loans remain relatively unchanged, while permanent loans now start at about 5.5% for multifamily assets and 6% for commercial properties.

As lenders workout of their legacy problems, new funding goals surface which are moderately more ambitious than 2009. As has been the case last year, high-quality projects in major markets backed by excellent sponsorship and cash flow characteristics are most desired — especially based on low leverage of 65% of value. Since rates remain low and funds are scarce, lenders resort to more creative solutions to capture such limited opportunities, including offering mezz debt and applying net worth covenants.

A renewed interest is arising in mezzanine programs, particularly for multifamily fundings. On a selective basis, funding sources can dip below the standard 125%-debt-service-coverage threshold for loans already on the lender’s balance sheet. Payment formats based on self-liquidating amortization schedules of 5 to 10 years and a maximum leverage is 80%.

Net worth covenants are required on a selective basis to help protect lenders against problems associated with sponsorship vs. the actual asset. For instance, the sponsorship should maintain a minimum net worth equal to the loan amount of which 10% or more is liquid. Noncompliance results in a loan default which is curable by principal paydown or additional credit support (e.g. letter of credit). This structure is more difficult to enforce for partnerships with different principals, as well as larger institutional-grade transactions.

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The Real Estate Capital Scoreboard® – January 2010

 

Chicago, Illinois, January 11, 2010 – The start of a new decade adds fresh hopes and fears in the realty capital markets.  The Fed’s persistence in supporting lower rates is helping to avert more financial suffering from increased cost of capital.  Investors are encouraged to gravitate from low-yielding governmental debt.  Dual-personality investing prevails as many of these same investors seek relief on legacy assets, while trolling for fresh new assets based on more attractively reset prices. 

How are capital markets positioned for this new decade and what are the key trends starting off the year? 

• Oversubscribed Monies:    More funds exist than placement opportunities.  Buyers expect lower prices and sellers don’t want to realize heavy losses unless under duress.  During the past year public funds (mainly REITs) raised more than twenty-five billion dollars of equity for income properties funds.
• Redefined Pricing Expectations:  Sellers are reluctant to unload legacy assets at deep discounts, contrary to market logic given today’s stagnant economy.  Investors targeting performing assets for traditional property types remain disappointed in trying to acquire seemingly distressed, value-add and Core-plus deals.  Overall returns of 20% or more targeting shorter holding periods are sparse in major markets.  Such investors will need to expand risk horizons and lower return expectations to include longer holding periods, more diverse property types and non-gateway markets. 
• Replacement Cost Metrics:   Investors willing to forgo immediate returns rise as winning bidders.  Mostly private and overseas funds, these players understand values based on replacement costs, as well as currency plays.  Overall returns are ignored, instead focusing on extremely low costs per unit, assuring limited probabilities of competition from new construction over the long term.
• Rising Liquidity:   Last year numerous major investors reported plunging transaction volume levels of as much as 90%.  As 2009, will be remembered for limited activities in the capital markets, this year should see more deals as financial institutions liquidate sub-performing assets.  However a dearth of activity is not expected; rather a modest pace at first.
• Looming Loan Maturities:  As much as a half-trillion dollar of debt will mature this year with limited prospects of refinancing other than the current funding sources, in most cases.  Furthermore, 2011-12 maturities are at similar levels.  Many believe further government intervention will continue as few economically justifiable “rescue capital” solutions surface.

 

The Institute’s Advisory Board Member, John Oharenko believes, “We’re bouncing along the market bottom as values continue to slide, but a less dramatic levels.”  He suggests, “Some of the greatest investment opportunities lie ahead, especially for those buyers willing to sacrifice current return and relying upon overall market momentum to improve during the next three to five years.”

# # #

The Real Estate Capital Scoreboard® – December 2009

Chicago, Illinois, December 1, 2009 – Substantially discounted senior loan levels combined with eroding property values force legacy funding sources into difficult decisions in managing technical defaults, monetary defaults and loan maturities.   The stage is clearly set for workouts and recapitalizations well into next year, while new lenders are seeking high-yield opportunities with fresh capital for workouts/restructures, partner buy-outs, loan purchases and property acquisitions.

Multifamily and senior housing properties continue attracting low-priced/high-leverage funds via the Triple F’s (FNMA, Freddie and FHA).  Otherwise, commercial properties attract capital with mixed results. 

For instance, partially leased, Class-B office ventures are considered only if located in Class-A locations.  Discounted-cash-flow underwriting for such fundings include trended economic vacancy is trended towards historical norms, often below actual figures as investors brace for more economic storms.

In today’s tight credit market, important metrics for any financing ventures include:

• Quality Sponsorship:  Sponsor analysis is tantamount.   Lender must have complete information about a borrower’s portfolio performance and maturity schedule.  Full understanding required of assets, liquidity, liabilities including all contingent liabilities.  All information must be up-to-date, especially valuations and economic performance.
• Reset Valuations:  Commercial real estate prices have dramatically declined by more than 30% from a year ago and well over 40% as compared to peak levels of 2007.  The most shocking is the steep plunge in prices for multifamily assets, historically considered the most immune sector in the industry.  Furthermore, even the most resilient markets in the country (e.g., Northern California) report fundamental weakness in demand.
• Changing Credits:  Although numerous credit tenants are contracting, newly forming tenants emerge including governmental agencies, academic institutions, specialty retailers, etc.
• Additional Leverage:  Mezzanine loans and preferred equity selectively offered for building up the capital stack.  Consideration of additional collateral and partnership interests for leverage enhancement.

In summary, overall market sentiment focuses on avoiding liquefying legacy projects unless absolutely mandatory.

Mark Hayton, an Advisory Board Member of the Real Estate Capital Institute notes, “Credit-tenant commercial properties remain financeable, although strict underwriting standards are necessary.”

Fairly Negotiating Real Estate Placement Fee Splits

INTRODUCTION

Within the real estate capital industry, deciding equitable fee sharing arrangements is often one of the more debated issues between various professionals involved in structuring a specific transaction.  Not to be confused with overall fee structuring, this discussion is completely separate from the actual negotiations with the property owner (e.g., exclusive vs non-exclusive and pricing).  Otherwise known as “fee distribution”, “splits” or “co-brokerage” agreements, fee sharing arrangements cover all types of real estate capital activities including consulting, sales, financings, partial-equity and joint venture assignments.

Fee sharing discussions don’t apply to certain situations, including smaller fees and individual assignments.  Although no fee is too insignificant, for smaller fee assignments that are typically $25,000 or less, fee sharing arrangements are more casual as the depth and scope of such assignments seldom require multiple disciplines.  These fee sharing arrangements are usually more standardized.  Also, capital transactions limited to single individuals and organizations may be irrelevant or subject to internal compensation policies.

Fee sharing discussions are usually structured based upon rules of thumb.  Brokers, investment analysts, administrative personnel, closing professionals and others within an organization — as well as outside parties involved in a transaction — will each have individually-biased views on fee distributions. Such discussions typically lead to heated debates on “fairness”, “reasonable”, “standard”, “market rate”, “customary” and “typical” as defined by each party.   Of course, everyone normally believes that their position is “right.”

THE FAIRNESS DOCTRINE

Rather than debating about right or wrong, or what is considered fair, fee sharing discussions need to center around facts and circumstances.  To avoid conflicts, each party should agree beforehand about the “fairness” of the fee sharing allocations based on determining responsibilities and dedicated resources.  

Needless to say, defining “fairness” in fee sharing arrangements is both an art and science.   The science identifies specific variables in the fee split equation; the art applies the importance of the variables using weighted averages.  For instance, how much importance does experience and market knowledge factor into calculating an individual’s contribution to the transaction?

More often than not, fee sharing agreements are blended with management policies, experience and instinct — normally resulting in “fair” distributions. In most instances whereby fee split allocations are not deemed fair by all parties, conflicts will develop. Therefore, the goal of fee sharing arrangements, like any other business ventures, is based on an equitable “win-win” outcome.

For all parties to view the process as completely fair and unbiased, experience and instinct should be supported by applying clearly defined criteria measuring personnel contributions to the entire real estate capital placement process.  Control and Placement are the two such components forming the basis of measuring time and resource allocations in this process.

CONTROL AND PLACEMENT – THE FOUNDATION OF FEE SHARING DISCUSSIONS

Fee sharing based on fairness guidelines are rooted in Control and Placement.  These two components equally form the balancing point of fee distribution. Control focuses on capturing a real estate capital placement opportunity such as a project sale, mortgage origination or joint venture.   Placement forms the counterweight for successfully completing a funding assignment.  Said another way, Control represents the capturing the opportunity and Placement converts the opportunity into a successful transaction.

Understanding Control and Placement is relatively simple. However, identifying the various components and subcomponents can become a daunting task.  And more often than not, Control and Placement will be interrelated as elements within each of these components mesh together to make the process successful in totality rather than piecemeal.

Control and Placement discussions assume all parties involved in fee sharing discussions are professionally qualified and licensed.  For example, an individual with accounting and real estate analysis software training should be responsible for project cash flow analysis.  Before any sharing arrangements occur, parties must be properly licensed to conduct business and collect fees in the various States where projects exist.  Typical licensing requirements include sales brokerage, appraisal and loan origination.  Otherwise, any agreements are not legally enforceable, regardless of professional qualifications and Control/Placement responsibilities.

In addition to the qualifications and licensing requirements, three other factors to consider in formulating Control and Placement responsibilities to additional professionals while insuring that the client’s best interests are served include:

• Outsourcing services to professionals with specialized expertise for document reviews, physical inspections and demographic reports
• Portfolio vs. single-asset assignments
• Project timelines – how quickly does the assignment need to be completed

 

While few professionals actually break down fee arrangements using such components, more disciplined approaches to these decisions rely upon identifying various subcomponents and applying formulas for calculating contribution/compensation levels apportioned to all parties involved in the transaction. The CAP Fee Sharing Model is one such tool used for identifying and quantifying contributions with the goal of computing fee split allocations to all parties involved in the transaction.

FEE SHARING CALCULATIONS

Realty professionals will certainly have different definitions of how to identify and weight Control and Placement, or other variations of these components.  As a result, The Real Estate Capital Institute interviewed a wide spectrum of industry leaders in the debt and equity capital markets including investment sales specialists, consultants, mortgage bankers and other brokers for the purpose of creating a fee distribution model that reasonably and accurately reflects Control and Placement measurements, resulting in the CAP Fee Sharing Model.

The CAP Fee Sharing Model demystifies the process of systematically computing equitable fee splits.  As mentioned earlier, this model centers on Control and Placement for quantifying fee sharing arrangements.  The goal of this model is to generate interactive fee sharing calculations based on “Win- Win” objectives for all parties.  The calculations require applying weighted-averages to important tasks within the process.

The Model divides Control and Placement on a 50/50 basis, further subdividing these components into subcomponents along with assigning weighted averages.  Control/Placement is a straightforward computation since both components carry equal weight.  Measuring subcomponents is a more challenging task as their respective values are more subjectively analyzed.  Regardless, the modeling formulates a basis for further discussion of the value of services provided by the various parties in the capital placement process. 

The Control variable is subdivided into three components: Referral/Generating Leads, Handling Client Communications and Procurement of Exclusive Agreement — accounting for half of the total fees.  Placement, the other half of the fee split calculation, includes Underwriting, Marketing and Closing subcategories.  Each of these major components and their respective subcomponents are further outlined below, including definitions and weighted average values in relationship to the entire fee.

CONTROL

Control is defined as the ability to secure a transaction for capital placement including sale, refinancing, joint venture, etc. The control results collected efforts in negotiating the agreement (mortgage banking application, exclusive sale agreement).  Control is not necessarily limited to a single individual or organization and often involves multiple groups of professionals, depending upon the scope of the capital placement assignment. 

The key subcategories of Control include: Generating Leads, Handling Client Communication and Procuring an Exclusive. These Control subcomponents are presented in sequence of a typical transaction beginning with identifying the project through obtaining an exclusive.

Referral/Generating Lead (10% of Total Fee):  Generating leads and mining for new client relationships is the initial step necessary in initiating a transaction. Cold-calling is the most common method of finding leads. Attending various real estate seminars and conventions, actively participating in professional organizations and other more effective methods of meeting clients also produce effective results. Regular follow-up based on additional meetings, phone calls, e-mailing campaigns provide continuous links of communication. In some cases this process may take days, months or even years. This activity has a value of about 10% of the entire transaction, and is typically known as a “referral fee” if no other action is taken by the broker involved in the process.

Handling Client Communications (10% of Total Fee):  Naturally speaking, client communications on an ongoing level take the referral process to the next level.  More frequent communications help to establish stronger links with the client, requiring more time and energy, as well as information gathering and analysis work to secure project control. As with the referral process, client communications can be an ongoing situation spanning a long time period. Handling communications is typically interwoven with the referral process and accounts for a total of at least 20% of the fee. 

Procuring the Exclusive (5% of Total Fee): Procuring the exclusive is the final step in successfully establishing project control.  Securing the exclusive, whether a loan application or a listing agreement, indicates that the referral process and client communications have culminated to a fruitful conclusion. Most professionals will agree that tying up an exclusive clearly indicates that half of the fee has been earned. Without this last step, the parties involved in securing the fee are working under more challenging conditions as other non-exclusive brokers may also be competing for the transaction.

PLACEMENT

Upon securing Control, Placement completes the process of successfully marrying capital with a project. Placement subcomponents include Underwriting, Marketing and last but not least, Closing — all discussed as follows:

Underwriting (20% of Total Fee):  As part of securing control and processing the transaction, underwriting bridges the gap between securing and funding the transaction. The key ingredients for underwriting — which accounts for 20% of the fee — include analysis, review of various documents and preparing a complete and detailed offering memorandum for sale, refinancing or other realty capital structure. Each of these components is described as follows:

• Document Reviews: Review of documentation involves reading and understanding key variables in a specific real estate capital transaction including leases, rent rolls, historical performance, physical property information and overall market dynamics such as supply and demand, vacancy, comparable property performance. 
• Financial Analysis:  Simple ratio tests, discounted cash flow analysis and other capital budgeting techniques are used for translating documents into financial ratios for further discussion.
• Offering Memorandum: The last component of underwriting is tying together all of the salient facts of the transaction including document highlights, location and property dynamics, financial analysis and sponsorship information 

 

Marketing (20% of Total Fee):  Marketing is the third component in sequential order, also representing a weighted average of 20% of the total fee. After the project has been secured for Placement and the information has been processed into a detailed offering memorandum, the marketing process begins. The goal of the marketing process is to deliver the optimal capital placement source for the project based upon contacting qualified capital sources, negotiating and filtering offers and conducting tours.

• Contacting Prospects: Contacting prospects is an ongoing process as the marketing team needs to identify the appropriate real estate capital sources including buyers, lenders and joint venture partners. The process is more extensive than simply cold calling as these prospects must be prescreened as to performance and reliability. More often than not, prospect relationships span a number of years and transactions. Furthermore, contacting prospects may also be challenging depending upon market conditions (prosperous economy vs. recession) and property types such as senior living deals and more complex mixed-use developments, for instance.
• Negotiating Offers:  The second step of the marketing process, negotiating offers, is equally as critical as finding the qualified prospects. Market knowledge and negotiating expertise always play key roles in determining the direction and scope.
• Tours and Inspections:  Finally, property tours in various other inspections can mean the difference between success and failure. Overall knowledge of the property, locational dynamics, immediate area, ingress and egress issues as well as overall market conditions, all lead to successful property tours.

Closing (10% of Total Fee):  Without a doubt, the closing must be handled with the same amount of importance as all other elements of the fee placement process. Too many things can go wrong if all parties assume that the transaction is on track by simply passing the closing process to the attorneys, title company and others. However, the transaction team should not provide legal advice unless properly staffed and authorized by the client to do so.  Instead, the responsibility lies in following through on any paperwork flow relating to the key business terms of the transaction based on the following:

 

• Document Review:  As to the business points of the transaction, the documents should be reviewed with the client to be sure that the negotiated items are identified.  Once again, any legal, tax, title or other technical document review issues should be left with experts such as accounts, lawyers and other third-party vendors.

 

• Processing Documents:   Processing the documents includes communications with attorneys, surveyors, municipal officials and other parties involved in documenting the transaction.  However, to the extent that documents need to be collected and assembled for further processing and review, the transaction team’s role will be defined as necessary, depending upon expertise and circumstances.

 

OBSERVATIONS

 

A host of other factors need to be considered when discussing fee sharing arrangements among real estate professionals including teamwork, sliding scales and  of course, qualifications.

Teamwork:  In today’s marketplace, most success real estate capital placements involve integrated teamwork, often in the same office.  In addition, highly specialized disciplines such as hotel consultants and healthcare professionals are involved in packaging and marketing special-purpose assets.  Even more expertise is required when working with single-purpose financing sources such as FHA/HUD and when equipment leasing is included with the property.

Sliding Scales:  Upon completing an initial transaction, various parties may decide to change roles and become more, or less involved. Subsequent transactions involving the same client may have lower fees splits with parties that have already initiated a transaction, but only want to share in the referral process. Other parties would therefore have more responsibilities, and take larger percentages of the fees.

Qualifications:  The skill set and experience are tantamount variables for sizing fee splits.

PROS AND CONS 

The advantages of using the Chicago Fee Distribution Model are as follows:

• Established baseline formula as a tool for further discussions.
• Systematic weighted-average point system providing benchmarks for measuring variables involved in determining equitable fee sharing arrangements.
• “Fine tuning” of key variables present indices for further discussion and weighted averages may be altered depending upon specific circumstances.
• Weighted average is for each variable helps define importance of various levels of resources, including labor allocation.
• Objective and independent methodology available to supplement existing fee arrangement policies within an organization.

 

Limitations include:

• Very difficult to address and weight intangibles such as professional experience, corporate loyalty, and other factors not included in the model.
• Variable and weighted-averages are subject to wide variety of interpretations.
• Weighted-average points are applied subjectively.
• Not all variables may be included.

Measurements are only as good as inputs.

EXAMPLES

Traditional 50/50 Arrangement: The classical example of a fee sharing arrangement assumes two parties, the listing agent and the buyer’s representative, share fees on a 50/50 basis. In this example, the listing agent has Control and the buyer’s agent executes the Placement. Fee Placement modeling is hardly needed as the roles are clearly defined.

Intra-office Arrangement: Medium and larger real estate organizations offering full services such as appraisal, consulting, brokerage and management normally have fee sharing policies. Even so, disputes surface various professionals view their roles differently in fee sharing. For instance, an appraiser who has a long-standing relationship with a property owner can get control of an exclusive listing and performs a substantial amount of investment analysis. Under such a scenario the appraiser would most likely not have a broker’s license, as well as play a very limited role in marketing and processing the closing. 

These circumstances justify a fee split of as much as 40% of the total fee calculated as follows:

• Control 20% – composed of 10% referral and generating lead plus 10% handling client communications and no credit for procuring exclusive as the 30% should be paid to the broker with the license responsible for securing listing and communicating with potential buyers.
• Placement 20% – full credit for underwriting including document review, financial and packaging. Again, the remaining 30% of the total fees relating to marketing and closing are not included in the appraiser’s list of responsibilities.

 

Structured Transaction Arrangement:  The more difficult and technical the realty capital placement assignment, the more scrutiny is required to determine equitable fee sharing arrangements. In the case of highly structured transactions such as joint ventures, land sale leasebacks, mezzanine loans, preferred equity deals and other hybrid debt/equity vehicles, multiple disciplines merge to complete the transaction.

The most common arrangement may include a combination of fee splits along with payments to outside vendors.   These outside vendors — including lawyers, accounting firms and financial consultants – will handle highly technical details relating to the marketing and structuring efforts of such transactions.  Fee sharing arrangements will often include flat-fee, hourly billing or other non-commission type payments.

In summary, structured-transaction fee sharing arrangements are difficult to illustrate.  Yet more often than not, highly sophisticated property owners work with equally sophisticated capital funding sources, demanding highly-professional, multi-level services.

 

 

CONCLUSIONS

The Real Estate Capital Placement Fee Split Model presents a clear and concise that of discussing the sharing of fees and distribution of responsibilities. In and of itself, this process is not a substitute for clear communications between all parties, a rather a guideline of how fees should be shared along with responsibilities.

The most important element within this process is open and honest dialogue. Also, should circumstances change, including allocation of time and resources, all parties need to be flexible on fee sharing modifications.

The Prepayment Fee – The Fine Line between Mortgage Maturities

 

Prepayment penalties can be a substantial latent cost for borrowers, as well as attractive profit protection for lenders.  Borrowers require flexibility, while lenders seek yield preservation.   

Prepayment language is more important today, as the yield curve favors long-term debt with better pricing and terms than shorter maturities.  All things being equal other than term, the major difference between notes rests within the prepayment calculations. 

Nearly all short-term loans of five years or less have liberal prepayment penalties, and in some cases, none.  Long-term debt is often burdened by the prepayment penalties that can cost as much as 10% of the loan balance, depending on the formula used.

Some overall rules about prepayment penalties are as follows:

1)         Usually locked out from prepayment during first half of the term

2)         Negotiable if coupon rate is substantially below current market rate

3)         Minimum penalty typically at one percent

4)         Yield-maintenance formula works best for borrowers expecting lower rates later in the term

5)         Declining Balance formula provides calculated certainty in loan payoffs

6)         Defeasance formula requires costly processing and multiple approvals – more applicable for locked cash flow loans (e.g., long-term, net lease properties)

7)         Types of funding sources have a direct correlation on prepayment formulas (e.g., balance sheet lender has more flexibility than lender intending to sell the note)

The Real Estate Capital Scoreboard® – November 2009

 Chicago, Illinois, November 2, 2009 – The recovering stock market is gradually translating to more favorable conditions in the realty capital markets. While the capital markets are relatively dormant as lenders seek to shore up the balance sheets, select life companies, banks and private funding sources continue conservatively funding transactions.

Furthermore, Mortgage REITs have reentered the market, seeking higher leverage loans, but at larger rate premiums. Greater competition from this sector will continue pressuring other lenders to offer better pricing.

Regardless of pricing, project quality and sponsorship remain tantamount as lenders stay defensive.  As such, current pricing trends include the following:

• During the past month, benchmark treasury yields moved nearly a quarter percent higher, yet rates remained steady as many lenders continue using rate floors for permanent loans. 
• Floating rate debt remained unchanged as prime bank customers pay floating-rate pricing starting at about 4.5%.

• While new transactions are still rare, refinancings and restructuring of loans remains in the forefront of real estate capital markets. Appraisers and investors are using band-of-investment calculations for sizing values and loans absent of any relevant market comparable data.  Given current debt pricing, capitalization rates under such models typical start at 7% for multifamily properties and 8.5% for commercial assets. Multifamily agency pricing favors securitized loans vs. balance sheet debt as the agencies CMBS markets slowly recover.
• Opportunity investors armed with significant equity capital aggressively hunt for bargain price distressed assets with pricing of 20% or more on an overall return basis using five-years or less time horizon.
• Commercial and industrial tenants with specialized space needs and multifamily projects using FHA funds, such as 221(d)(4), are the only sources of new construction demand.  Return-on-cost yields start at 8% for “definable” credit-worthy tenants, otherwise double-digit figures are more representative of current development risk pricing.

 

Aaron Gruen, an Advisory Board Member of the Real Estate Capital Institute notes, “The Great Recession has permanently altered consumer, investment, and governmental behavior.Both public and private sector interests which influence land use and economic development need to reset their models and practices to work out projects and plans affected by the Great Recession and to respond to the opportunities the economic recovery will present.”

The Real Estate Capital Scoreboard® – October 2009

Chicago, Illinois, October 1, 2009 – The Fed announced that the recession is starting to fade away. The real estate capital markets remain in the doldrums, with more news of increasing delinquencies and foreclosures, looming loan maturities with limited refinancing prospects, declining occupancies, tenant bankruptcies, oversupply and contracting space demand well into the foreseeable future. 

Yet fresh transactions are trickling into the markets, filling value data points. As financial markets are recovering and lenders shore up their balance sheets, deals are repriced, sometimes at levels of 20% to 40% lower than the peak era of 2006-07.  This fall’s positive signs shining on the capital markets include the following:

• Substantial amounts of capital funds are flowing into the public markets, mainly into mortgage and equity REITs.  However, finding qualified investments at “distressed” pricing remains the biggest challenge.
• Life companies trickling back into the mortgage market, as overall bond pricing has improved.  As a result, pricing is tightening by at least 25 basis points.  However, many life companies still feel minimal pressure to originate new loans, continuing to adhere to minimum loan floor rates.
• For high-quality assets with conservative leverage, no “cash out” rules are relaxed as funding sources vie for the premium properties.
• As equity positions vanish in newer legacy ventures, mezzanine and other subordinate lenders busily work to maximize their ownership positions, hoping to protect their investments as markets gradually recover.  In many instances, some of the same lenders converting into ownership positions as also raising additional funds for buying other properties to profit from the currently distressed environment. 

Randal Dawson, a member of the Real Estate Capital Institute’s research notes, “Valuation driven by lower-leverage debt pricing and higher equity yields offers the most effective methodology for understanding values in today’s illiquid markets.”   Adding, “Equity yields continue climbing, as commercial property values show more signs of stress.”

The Real Estate Capital Scoreboard® – September 2009

Chicago, Illinois, September 1, 2009 – Declining property values prices reset investment yield boundaries for all types of income-producing properties. No asset classes are immune – ranging the entire spectrum from institutional-quality, credit net lease deals to distress hotel ventures.  With limited exceptions, new construction developments grind to a halt as investors rethink risk/reward because of ever-eroding market fundamentals.

The “Defi Refi,” takes front stage among lenders with legacy loans, whereby debt terms are defensively renegotiated.  All parties try to avoid foreclosures as long as the collateral is reasonably maintained at occupancy levels within the given submarket.  Defi Refi loan sizing is further outlined as follows:

• Other than senior housing in select markets, few properties see any rental growth; protecting existing cash flow remains a top priority in contrast to any increases.
• Pro forma projections are reviewed downward, as owners expect stable or declining rents/occupancies.  For instance, multifamily properties with rental decreases of 3% or more are underwritten and trended downward vs. trailing operating history figures.
• Markets are strained with a special emphasis providing some form of debt relief in key markets (e.g., Florida, the Inland Empire, Phoenix, Austin, Las Vegas, Atlanta, the Upper Midwest).
• Voluntary conversion of debt to partial equity is offered as an additional solution to eroding debt balances, increasing 2% or more on vacancy rates for apartments.
• Roll-in of the prepayment penalty deemed to be a cash-out – defined as an optional cost to “better” their financing – hard line by FNMA – small penalty (e.g., 2%) not a big issue if a couple of 2% on LTV but NOT 75% to 80% jump, for instance.
• Standard provisions include lengthening amortization schedules and loan term, offering interest-only payments, reducing (or removing) non-monetary default provisions such as debt service coverage and loan-to-value covenants and partial forgiveness of debt.

 

The Real Estate Capital Institute’s Advisory Board Member, Harold “Skip” Perry, laments, “The volume of foreclosures and restructuring leads me to believe the end is not in sight for at least one to perhaps two years.”   Skip suggests, “Defensive investment tactics are the norm rather than the exception until more trades occur and properties are marked-to-market based on current conditions.”

The Real Estate Capital Scoreboard® – August 2009

Chicago, Illinois, August 3, 2009 – Mid-summer market madness clouds the real estate capital industry, yet bursts of hope glimmer as more properties are sold and investors are beginning to see a bottom.  As short term rates remain near the bottom, with LIBOR sinking to a record low, plenty of funds are available.  However, funds are sidelined in anticipation of even more favorable pricing in the coming months as distress deals are predicted to flood the market within the next two years.  Other market highlights include the following:

• Pricing readjustments of 20% to 30% below 2007-08 levels emerge as new benchmarks. With rare exception, pro forma valuation is replaced with direct capitalization of actual income. In fact, most investors are revamping net operating income figures with downward income expectations, while expenses are expected to rise — particularly property taxes and utilities.
• The yield curves for secondary-market and older properties are substantially steeper as investors focus on prime-location assets at relatively attractive price levels. Such assets are sized based on overall yields often in excess of 15% or more.
• Mortgage pricing substantially favors multifamily assets as debt is still available at 6% or less for higher leveraged the assets via the Agencies.  Conversely, commercial properties are financed at levels of 60% of value or less with strict cash-out requirements and other provisions (e.g., recourse) previously thought too onerous as lenders cherry-pick deals. 
• With distressed debt deals offering very appealing rates and principal reduction, astute investors redouble efforts in this investment arena.  “Loan to own” opportunities appeal to such buyers, especially those with development and management expertise. Banks and other distressed financial institutions provide an ongoing pipeline of deals.
•  “Hidden” prepayments plaque many acquisition deals with existing, assumable debt as lenders force pay down – along with corresponding penalties – in those cases where the purchase prices create unusually high leverage due to the denominator effect.  Less evident, although just as critical, the same issue applies for lenders requiring pay downs from borrowers, even if no new recapitalization occurs as balance-sheet cleansing continues.

 

Gary Duff, an Advisory Board Member of the Real Estate Capital Institute, remarks that “More market clarity is expected in the fall when investors return from the summer holidays.  For now, most institutions consider asset management as their top priority.”  He suggests, “Many legacy owners are more concerned about losing income stream rather than capturing new opportunity plays.”

The Real Estate Capital Scoreboard® – July 2009

Chicago, Illinois, July 1, 2009 – While the Fed decides to keep interest rates steady, the capital markets reset property values and debt underwriting metrics to levels not seen in nearly a decade.  Meanwhile, lenders focus on recasting legacy deals with preferred borrowing relationships.  As expected, new funding opportunities are extremely limited based on highly conservative leverage of 60% or less for commercial properties with capitalization rates in the high single-digit range.

On other hand, apartment financing funds remain readily available via the Agencies at attractive spreads and leverage.  However, more submarkets are reviewed for possible downgrades as vacancies continue to rise throughout various parts of the country.

While the market activities are generally slow, especially in the mid-summer months, clear signs of readjusting capital markets are evident as noted by the following dynamics:

• As capitalization rates approached 10% for many type of “Core +” investments, pricing on a per unit basis look “right” according to many investors, yet uncertainty remains with respect to rent growth and tenant retention.  The big fear being reduced cash-flow pro forma projections, now known as “re-forma.”
• Landlord underwriting is now an important part of the tenant process to ensure performance on space build-out, payment of commissions and reliable future operations.  Landlords without the ability to demonstrate capital resources are at a competitive disadvantage.
• “Zombie” properties, defined as overvalued performing assets which will be difficult to refinance within the immediate and medium-term timeline, haunt lenders and borrowers alike as to exit strategy reversions.
• Net operating income calculations based on adding capital reserves create more debate between buyers and lenders; lender funding availability and underwriting guidelines overrule any such discussions.
• Active bidders include private funds in various formats such as REITs, opportunistic syndicates and wealthy individuals – few public players hunting today.
• Largest transactions are limited to about $75 million per lender, and few deals are “clubbed” as lenders are remain focused on internal portfolio issues.

 

An advisory board member of the Real Estate Capital Institute, Jim Postweiler, notes that “Smaller properties below $25 million enjoy the most amount of acquisition activity.  Larger projects still create issues for attracting optimum leverage and sufficient funding sources.” Postweiler adds, “Foreign investors, mainly from Europe, are reemerging as buyers for prime investments in major CBD markets.”

The Real Estate Capital Scoreboard® – June 2009

Chicago, Illinois, June 1, 2009 – Late spring realty capital markets are starting to show more signs of life, although caution is the word. The agencies continue to provide liquidity to the multifamily markets, while banks and life companies cherry-pick commercial property loans.

Focal market dynamics include the following:

• Building activity is winding down to trickle levels, particularly in office and commercial construction which includes multi-tenant retail space.  The economic downturn and tight credit conditions dampen any prospects for non-residential construction, at least for the next couple of years as oversupply imbalances prevail.  Moreover, lower prices for commercial real estate as acquisitions are much more viable than development. 
• Bank stress tests are succeeding in mildly boosting confidence by persuading investors that no more major negative news is on the horizon. In fact, many banks scored higher than expected.
• Credit remains tight as a lack of confidence plagues bond ratings. Investors still feel that the Rating Agencies are miscalculating risk with more defaults on the horizon.
• By historical standards, real estate debt pricing is still very widely priced in comparison to treasuries.   Highest-grade corporate bonds are trading as low as 100 to 200 basis points and average investment-grade corporate debt is priced in the 450 basis point range.  Meanwhile, the most favorable pricing for multifamily properties is below 300 basis points; commercial properties start at 450 basis points reflecting the perceived tenancy risk for that type.
• As treasury yields spiked upward most of the month, some lenders are holding down, or reducing spreads by 20 to 30 bps, to maintain reasonable levels of loan production for the highest-quality properties.
• More assets are repriced and lenders are unloading impaired legacy assets at discounts of 30% or more. More assets are expected to enter the market during the remainder of the year as valuation and mark-to-market issues are synchronized.

 

According to Jeanne Peck, an advisory board member of the Real Estate Capital Institute, “sellers without a dire need to for immediate liquidity are taking a ‘wait and see’ position.  Today’s indecision could lead to tomorrow’s panic to sell against upcoming CMBS and bank loan maturities without refinancing options.”

What's wrong with a real estate correction?

About a year ago, the real estate capital markets turned topsy-turvy.  Investors, lenders and real estate professionals alike panicked.  Debt and equity funds nearly evaporated based on false risk/reward expectations.  Nearly all capital markets reached “pricing nirvana,” leaving no room for error as prices peaked to unchartered levels.  Typical income-property loans often were priced within a percent of treasuries — well beyond any historical underwriting guidelines measuring debt coverage margins, leverage and valuations. 

Today, the opposite is true.  Over-reactive fear governs expectations.   The aftermath of the mortgage-backed securities re-pricing and fresh concerns about financial institutions’ real estate portfolios force investors to the sidelines.  Mortgage markets remain dislocated and more problems appear on the horizon.

Are real estate markets in a continuing downward spiral?  Not exactly, if history is any guide. 

Markets are reaching “correct” levels as measured by the past decade.   Many will argue the past five years’ realty capital market conditions were abnormal.  Investors scrabbled from the “tech wreck” in search of new profit frontiers; Wall Street greeted them offering lucrative yields blessed by the rating agencies.  The model worked as long as values continued climbing. 

The rating agencies claimed the new role as risk arbitrators of real estate capital – an untested valuation model for monitoring rapidly expanding mortgage securities market.  Wall Street became Main Street for policing realty supply-and-demand risk fundamentals as well as the traditional role of providing capital.  The judge and the jury.

By the end of 2006, overall commercial property pricing skyrocketed to unsustainable levels as values increased by as much as 40 to 50%, while rent levels remained flat — or even declined.  Investors justified such economics by accepting lower profit thresholds often based on optimistic cash flow projections.

In contrast, more “correct” market conditions existed during the late 1990s.  Project yields were more evenly matched to interest rate costs.  During this era and for most of the Twentieth Century, investment returns normally required positive leverage based on current cash flows, resulting in positive leverage. 

In conclusion, the correction will continue with prices trending downward until investors start capturing more sensible yields in to project and cash flow fundamentals.  The speculative premium needs to be removed from pricing expectations.  This re-pricing is a healthy side effect of excessive capital market behavior.  Measurable, risk-adjusted cash flow will dominate investor’s return expectations — back to basics!

The Real Estate Capital Scoreboard® – May 2009

Chicago, Illinois, May 1, 2009 – Within the past month, rates have continually climbed for longer-term treasuries, nudging upward by more than a quarter point. In the meantime, the most active lenders in the marketplace — the Agencies (Freddie Mac, Fannie Mae and FHA/HUD) — correspondingly dropped mortgage spreads.

As a result, overall interest rates remain relatively competitive for multifamily properties, starting in the mid-five-percent range for ten-year debt.  Leverage levels of 75% of value are still available for this asset class.

In contrast, other income properties, including office, retail and industrial assets are underwritten to extremely stingy standards. Few lenders are actively seeking new origination funding opportunities as workouts and corporate viability issues overshadow mortgage lending goals. Commercial loans are generally funded at levels of 65% or less with overall interest rates starting in the higher-6% range and climbing into the mid-8% range.

Full leverage funding opportunities still exist for credit-anchored projects in all income-property categories, as long as BBB or better rated credit ratings are available with reasonable remaining lease terms.

Bright spots in the capital funding marketplace are also beginning to appear. More life companies, banks, pension funds and other sources not plagued with legacy deals are reemerging.  Initially, the pricing requirements are steep and leverage remains conservative, but some loosening is expected as these players start competing for transactions.

As far as specific benchmarks for any funding opportunities within today’s market, the following items are nearly universal minimum requirements:

• Lower Values:  Property values continued declining as more investors realize operating losses and lenders foreclose on distressed assets.
• Limited Growth:  Few, if any, markets are underwritten with any type of income growth. On the contrary, most lenders are forecasting flat, or declining income conditions with expenses rising.
• Higher coverage:  125% debt service coverage ratio for nearly all properties is a minimum threshold.
• Greater Equity:  For refinancings, borrowers must show at least 20% or more of “real” equity as cashouts are frowned upon.
• More Reserves:  Effective property age concerns are forcing borrowers to set up larger reserves for maintaining and retaining competitiveness.

 

Barry Moss, a Real Estate Capital Institute Advisory Board member, notes “Lenders, borrowers, investors, tenants, developers and nearly everyone in the real estate industry is in a defensive mode.”  He suggests, “As TARP/TALP funds trickle into the financial system and lenders mark down legacy assets to current metrics and sell those assets, more badly-needed liquidity will return to the industry and transaction activity will increase.”

The Real Estate Capital Scoreboard® – April 2009

Chicago, Illinois, April 1, 2009 – Commercial and residential income-property values and mortgage underwriting continues readjusting to more conservative levels not seen in more than a decade.  While most buyers and sellers are tangled in a pricing stalemate, funding sources define debt and equity metrics based on refinancing and renegotiating terms.  However, such metrics substantially vary from the sizing dynamics that many investors have grown accustom to. 

Current underwriting realities mainly include stringent resizing of existing cash flows, higher capitalization rates and lower new-construction costs — all summarized as follows:

Cash Flows Readjustments:

• Best case is assumes annualized with a careful review of recent trailing three months occupancy and collections.
• “Re Forma” vs. Pro Forma – whereby funding sources expect outright lower income in anticipation of more challenging economic conditions.  Numerous lenders expect income levels to drop from 3% to 6% during the year.
• Expense increases – Higher vacancies translate to carrying more common area expenses.  Furthermore, few investors expect meaningful lower taxes and operating costs.

Higher Capitalization Rates:

• 8% is the now new valuation benchmark for most commercial properties; Single-tenant, credit deals secured by longer-term leases hover in the 7% range.
• Below 7% reserved for prime residential and trophy properties or properties with substantial contractual upside.
• Full service lodging starts at 9% to low single-digit range as RevPAR and operating cash flow have been substantially reduced since 2008.
• Smaller projects based on 1031X trades may be priced as much as 50 bps lower than typical capitalization rates, as demand remains brisk.
• Substantial widening for C-Properties by at least 150 basis points or more — moving into the double-digit range.  Price reductions of 30% or more are common as compared to Credit and Class-A/B assets, as this segment of the market remains very illiquid.

 

New Construction Realities:

• Despite public infrastructure spending, construction costs are lower as construction spending has decreased and competition has increased.  Commercial building construction costs have fallen by more than 10% during the past year.
• Return-on-Cost yields are in the double-digit range.  As investors focus on purchasing projects well below replacement costs and higher-leveraged debt is scarce, development yields must be priced 200 basis points or more above cost of debt.

 

According to Aaron Gruen, a member of the Real Estate Capital Institute Advisory Board, “While declining rents, rising capitalization rates, and challenging economic and financial conditions make for black moods for real estate investors and developers, this is a good time to prepare for the return of prosperity.” He adds, “From a longer term perspective, prices are more likely to be bargains, constructions costs are low, and loans are likely to be prudently made and taken.”

The Real Estate Capital Scoreboard® – March 2009

Chicago, Illinois, March 2, 2009 – As the first quarter winds down, the real estate capital markets are filled with caution and anxiety as lenders crave for market stability.  Realty capital markets remain challenged with the following issues in the forefront of discussion:

• Valuation Concerns:  Many investors believe that cap rates will return to higher single-digits — in norm with historical levels.  Institutional-grade assets are valued starting at 7% for multifamily properties and 8% for commercial properties.  Furthermore, lenders require substantial supporting data (recent comps) to justify lower cap rates.  Secondary markets and older properties pricings start at 100 basis points or more with much wider variance.
• Capital Availability/Allocation:  Most financial institutions are playing a defensive role, rather than pursuing aggressive growth and funding strategies.  Shoring-up balance sheets and shedding unwanted loans and other realty assets remain key priorities.  Select sources state that they would like to return to the market by the second quarter and mid-year.  Lenders are allocating substantial portions of funds for refinance and rollover, rather than new loan origination.
• Relative-Value Pricing:  Attractively priced CMBS debt (Triple-A quality) offers the best investment opportunities for investors preferring to capture the most favorable yields, rather than new origination funds.  Such yields are in the lower-double-digit range.  As such, mortgage rates are still favorably priced for borrowers — within the range of 6.5% to 8.5% for conventional properties based on 10-year terms. 
• Delinquencies:  For the most part, loan delinquencies and defaults are at controllable levels.  Retail properties pose the most challenges, as numerous merchants are in either bankruptcy or requesting substantial rent discounts.  Co-tenancy issues also raising concerns for further occupancy reductions. 
• Tighter Funding Standards: Most lenders are strictly enforcing shorter amortization schedules and wider debt coverage ratios (e.g., 1.25X and 25-year maximum) to restrict proceeds, rather than relying on loan-to-values restrictions as a primary underwriting variable.  That said, 55% to 65% is the norm for most institutional-quality, non-multifamily loans.  REITs, pension funds and private equity capital players requiring less leverage enjoy excellent rates and terms.  Leverage-oriented investors are forced to stay with bank lines, hoping for more favorable funding conditions.
• Maturity Risk:  Agencies and many life companies favor longer-term loans in excess of five years as refinance rollover risks are of concern.  Meanwhile, banks mitigate such risks by relying upon recourse and substantial funding deposits, often in excess of 10% of the loan amount.
• Large Loan Vacuum: $50 million + loan funding sources are limited to about a half dozen major life companies.  Otherwise, lenders must syndicate such loans.  Loans under $10 million still offer numerous options including banks, life companies and private capital. 
• “Floor” Rates Prevail:   While lenders are still quoting fixed-rate loans based on treasury spreads, most loans feature floor-rate minimums.   Naturally, floating-rate loans are still quoted floating over Libor, Prime, etc – floors are also imposed on such funding structures.

 

Randal Dawson, a member of the Real Estate Capital Institute Advisory Board declares, “2009 looks to be a year of refinancing and with limited acquisition activity.” Dawson suggests, “Distressed deals will be the norm for most new acquisitions and investors will be overwhelmed with renegotiating overleveraged debt.”

Real Estate Capital Markets 2009 Outlook – More Questions than Answers

 

San Diego, Ca. – February 11, 2009 – Lenders met this week to discuss funding goals and objectives for 2009.   The conference mood was filled with caution and anxiety as the industry craves for market stability in the midst of declining property values.  

Key highlights of changing realty funding dynamics are as follows: 

• Valuation Concerns: By far, the most popular topic of discussion was property values.  Most believe that cap rates will return to higher single-digits — in norm with historical levels.  Institutional-grade assets are valued starting at 7% for multifamily properties and 8% for commercial properties.  Furthermore, lenders require substantial supporting data (recent comps) to justify lower cap rates.  Secondary markets and older properties pricings start at 100 basis points or more with much wider variance.
• Capital Availability/Allocation:  Most financial institutions are playing a defensive role, rather than pursuing aggressive growth and funding strategies.  Shoring-up balance sheets and shedding unwanted loans and other realty assets remain key priorities.  Select sources state that they would like to return to the market by the second quarter and mid-year.  Furthermore, most active lenders are allocating substantial portions of funds for refinance and rollover, rather than new loan origination.  As such, these lenders report lower volume of as much as 50% to 60% or less as compared to 2008 levels.  Loan volume targets are intentionally lower due to market circumstances; many lenders are also allocating substantial funds for refinancing existing loans.
• Relative-Value Pricing:  Attractively priced CMBS debt (Triple-A quality) offers the best investment opportunities for lenders preferring to capture the most favorable yields, rather than new origination funds.  Such yields are in the lower-double-digit range.  As such, mortgage rates are still favorably priced for borrowers — within the range of 6.5% to 8.5% for conventional properties based on 10-year terms.  Agencies and select life companies offer the low end of the range, while the higher-end reflects very large loans and leverage in excess of 65%.   Lenders still prefer to originate new loans to help diversify their investment portfolios.
• Sponsorship Quality:  Key emphasis on sponsorship net worth, local market expertise and existing portfolio performance.  Heavy scrutiny of cash flow performance, portfolio leverage and occupancy levels.  Favorable ratios include a clear credit history, net worth greater than or equal to the loan amount, liquidity of at least 20% and strong “hands on” management. 
• Delinquencies:  For the most part, loan delinquencies and defaults are at controllable levels.  Retail properties pose the most challenges, as numerous merchants are in either bankruptcy or requesting substantial rent discounts.  Co-tenancy issues also raising concerns for further occupancy reductions. 
• Tighter Funding Standards: Most lenders are strictly enforcing shorter amortization schedules and wider debt coverage ratios (e.g., 1.25X and 25-year maximum) to restrict proceeds, rather than relying on loan-to-values restrictions as a primary underwriting variable.  That said, 55% to 65% is the norm for most institutional-quality, non-multifamily loans.  REITs, pension funds and private equity capital players requiring less leverage enjoy excellent rates and terms.  Leverage-oriented investors are forced to stay with bank lines, hoping for more favorable funding conditions.
• Rejected Underwriting:  “Fractured” condos — built as condos and now available for rent – are financeable on a select basis.  “Broken” condos – partially converted and available for rent – are avoided.  Lodging, non-essential retail, land loans (nearly impossible without recourse), overbuilt markets, secondary markets.  Basically any properties that are not currently cash-flowing and with too much “story.”  Also avoided are interest-only, cap rates below 8% (unless multifamily/credit tenant), cash-out on cost (no borrower equity in the deal), leverage much above 65% and pro formas.
• Rate Predictions: Many believe rates will remain somewhat steady for most part of the year.  Opinions vary as for 2010 and beyond, although discussions surfaced about stagflation and inflation fears.
• Maturity Risk:  Agencies and many life companies favor longer-term loans in excess of five years as refinance rollover risks are of concern.  Meanwhile, banks mitigate such risks by relying upon recourse and substantial funding deposits, often in excess of 10% of the loan amount.
• Large Loan Vacuum: $50 million + loan funding sources are limited to about a half dozen major life companies.  Otherwise, lenders must syndicate such loans.  Loans under $10 million still offer numerous options including banks, life companies and private capital. 
• “Floor” Rates Prevail:   While lenders are still quoting fixed-rate loans based on treasury spreads, most loans feature floor-rate minimums.   Naturally, floating-rate loans are still quoted floating over Libor, Prime, etc – floors are also imposed on such funding structures.

 General Observations: 

Similar to a decade ago, life companies, pension funds and select banks dominate the permanent funding arena.  Agencies remain the lifeline of multifamily lending.  Banks are most actively funding short-term loans of five years or less.  Life companies control longer-term funds. 

On the other hand, securitization firms continue laying off staff, with the exception of critical support personnel.  Credit companies are also on the sidelines as redevelopment and new construction financing risks remain high based on depressed pricing of existing inventory.

The Real Estate Capital Scoreboard® – February 2009

Chicago, Illinois, February 2, 2009 – The realty capital markets remain disruptive, raising stress levels for borrowers with pending maturities.  Meanwhile, sellers are unable to generate liquidity as pricing volatility prevails.  Smaller transactions are more fluid with recourse requirements much more common as borrowers weigh their options using shorter-term debt.  Industry leaders expect minimal positive changes in short-term market dynamics as the financial sector digests unsettling news.

Starting this year, evolving trends are as follows:

• Minimum yield requirements – not spreads over benchmark indices — dictate loan pricing.  Mortgage rates are somewhat stable, as lenders set floors on long-term fixed rate debt in the 6.25-to-7.5%+ range for most conventional properties. 
• While rates are within historically favorable limits, continued tightening of other key underwriting parameters restricts meaningful funding volume.  More constraints that are conservative include lower valuations, limited leverage, shorter amortization payment schedules, higher debt coverage and substantial escrow/reserve requirements.
• On the public market debt front, CMBS is unlikely to return in the foreseeable future – at least not in the current format.  Balance-sheet lenders also struggle with the “denominator” effect, limiting overall funds available for real estate investment, as portfolios are devalued.  Furthermore, real estate investments must compete with attractively priced stocks and bonds as astute fund managers hunt among abundant bargains.

• Mezzanine and opportunity funds offer capital, but underwriting is cautious and existing note sales compete for these funds.  Pricing on mezz debt starts in the lower-teens.
• Transaction volume flirts with the lowest levels in decades as capital sources wait on the sidelines in hopes of finding the bottom.  Substantial pricing discounts are expected throughout 2009, in any case. 
• Equity returns are under upward pressure. Overall equity yields for Class A “Core” institutional properties trade from the low to middle teens; “Core Plus” assets trade within the upper-teen range and opportunistic ventures offer returns in excess of 20%.
• Given illiquidity within the equity markets with few comparable trades, numerous lenders are setting valuation parameters for debt fundings.  In general, the 8%-to-9%-capitalization-rate range is a popular appraisal benchmark for higher-quality commercial properties in most markets throughout the country.   Multifamily properties start at 7% cap rates, although limited trading volume prevents identifying clear and reliable pricing trends.

 

Jim Postweiler, advisory board member of the Real Estate Capital Institute, suggests, “Buyers and sellers are still reluctant to transact, mostly due to stingy debt markets.  However signs of improvement are emerging as buyers realize few opportunities for core properties are available.”

The Real Estate Capital Scoreboard® – January 2009

Chicago, Illinois, January 2, 2009 – The last month of the year ended on a dramatic note as the Fed forced key short-term indices into record-low territory. Meanwhile, the ongoing shortage of real estate capital dampens any meaningful mortgage rate reductions.

Important market highlights and trends for 2009 are as follows:

* Funds Resurfacing:  Select life companies are cautiously returning — one of the bright spots in an otherwise bleak market. These institutions are primarily targeting highly conservative opportunities and lower-leverage acquisitions.

* Refinancing Reigns: Since the market remains illiquid with sellers and buyers quite far apart on bid-ask sale negotiations, refinancing is the only option for generating significant loan volume.  For example, borrowers with five and ten-year loans due this year should expect to see rates at about identical levels to the marketplace on ten-year maturities as compared to 1999.  Five-year maturities are about 150 basis points higher than in 2004.

* Absolute Rates:  Due to benchmark rate volatility, most lenders avoid pricing mortgage rates over spreads and instead offer absolute rates.

* Volatile Indices:  Overall mortgage rates drifted slightly upwards for shorter-term fixed-rate maturities (five years), as lenders demand a premium for locking into this highly desirable term.  In contrast, longer-term benchmark rates dropped by about 20 to 50 basis points, while lenders react cautiously to any corresponding mortgage-rate drops.

* Steep Yield Curve: The treasury curve remains steep with short-term yields approaching zero, indicating an extreme desire for safety void of any principal repayment risk. Shorter-term indices dramatically plunged by about 75 basis points or more, particularly LIBOR which dropped by nearly 150 basis points.

* Dominant Players:  The Agencies (FNMA and FreddieMac) overwhelmingly dominate the multifamily lending arena, which is the most active property-funding sector.  The Agencies offer below rates starting below 6% for shorter-term maturities and below 5% for floating-rate debt.  Life insurance companies and banks dominate all other income-property sectors with rates relatively unchanged from the previous month — hovering in the 6%-plus range for five-year term and 7% or more for longer-term loans.

According to Nat Zvislo, Research Director of the Real Estate Capital Institute, “2009 looks to be a year of refinancing and with limited acquisition activity.” Adding, “Distressed deals will be the norm for most new acquisitions and lenders will be overwhelmed with renegotiating overleveraged debt.”

How Long Will Mortgage Gridlock Paralyze Commercial Realty Markets?

[SinglePic not found]Chicago, Illinois, December 9, 2008 –  As the year closes, the dramatic turn of recent events in the U.S. financial markets clearly redefines commercial mortgage metrics to conservative levels not seen in years.  Today, massive structural changes dictate mortgage underwriting based on highly conservative and transparent terms and conditions.  And in particular, with few exceptions lenders are unwilling to provide funds at acceptable leverage levels (e.g., 75%-80% loan-to-value) as compared to the any year within the past decade.   Under such circumstances very few loans are funded, resulting in mortgage market gridlock.

Investors are looking for clues as to how long the gridlock will last.   In other words, when will real estate capital markets return to a “normal” cycle?

According to discussions with advisory board members of the Real Estate Capital Institute, the general consensus regarding the overall direction of today’s realty capital cycle is outlined as follows:

• The Peak:  The overall upward trend started in about 2004 and rapidly accelerated in 2005-06.  The real estate capital markets peaked by the end of 2006 and early 2007. 
• Current Cycle:  Since interest rates and corresponding mortgage spreads continue rising, rate relief is not in site until domestic markets find more stability within the bond markets, in particular.  The remainder of 2008 will be highly tumultuous as investors try to sort of the Wall Street Bailout and access “real” property value.
• The Bottom:  Many believe that the current market doldrums are at least one to two more years in the making with 2009 being a flat, or declining year.
• The Future:  Values will settle to more “normal” levels by about 2011.  Market volatility remains a key concern, but supply and demand dynamics for most types of commercial properties are within general balance.  Longer recoveries are expected in some of the costal markets which were severely overvalued.

 

Given this two-to-three-year outlook, the new real estate cycle slogan might sound like “Tow the line in 2009; If not then, try 2010.”  

Regardless of exactly how long the current malaise continues, everyone agrees the realty capital markets are in for a wild ride the next few years.

The Real Estate Capital Scoreboard® – December 2008

 Chicago, Illinois, December 1, 2008 – The Fed’s aggressive action of pumping more liquidity into financial markets is starting to reinvigorate real estate lending.   Helped by TARP funds, select financial institutions are offering competitive short-term loans. Furthermore the Treasury yield curve moved downward by about a half percent during the past month, easing overall pricing.

Current income-property mortgage pricing and underwriting trends are outlined as follows:

• While liquidity remains a key concern, overall interest rates are moving downward.
• Despite wild fluctuations in key indices (e.g., LIBOR), keeping track of pricing is becoming less challenging as numerous funding sources impose rate floors.
• Floating rate debt starting at 5% is among the most competitive pricing options available, while most types of longer-term financings start at 6%.
• Subsidized by agency funds, multifamily properties attract the lowest price debt, while office, industrial and retail properties capture pricing that is at least 25 to 75 basis points higher. 
• Debt service coverage restrictions start at 120% for acquisitions and 125% or more for refinancings.  And while debt service coverages remain somewhat constant, shorter amortization schedules of 25 years or less are used as additional underwriting safety measures along with overall lower-leverage underwriting of 65% of value (apartments are still funded in excess of 70%).

 

The chart below summarizes overall debt rate ranges for various properties:

The Real Estate Capital Institute’s advisory board member, John Oharenko, comments “Pricing discussions are returning to absolute rates, rather than quoting spreads.”  He argues that the limited universe of active lenders fully dictate terms, including establishing minimum pricing thresholds which are not necessarily linked to specific indices such as Treasurys or LIBOR.  Oharenko adds, “Expect to see lower mortgage rates for 2009 as the Fed continues a monetary blitz of helping banks and other financial institutions return to the market to recreate more competition and liquidity.”

SPECIAL REPORT: MORTGAGE MARKETS IN TURMOIL

Chicago, Illinois, November 21, 2008 — The expanding financial crisis hitting global markets as a result of domestic housing continues to torpedo the income-property mortgage market.  Lenders and borrowers alike are frantically seeking answers to questions about where markets are heading including pricing, values and acceptable leverage levels.

People have more questions than answers including the following:

• How long will the housing crisis last?
• How much leverage is acceptable
• Will securitized mortgage markets return?

 

Regardless of these questions and many other concerns facing the industry, bricks-and-mortar are physically and economically here to stay. Food and shelter are basic necessities with the real estate industry providing shelter for businesses, manufacturing and housing for the general population. Fundamentally real estate is a sound investment and will rebound in tandem with many other sectors of the economy.

The cause for panic is not necessary as repricing to more historically “reasonable” levels sets the stage for tremendous investment opportunities for investors knowing how to use limited leverage and assuming acceptable risks with the following trends emerging relating to yields and pricing:

• Capitalization rates rising by 100 to 150 basis points over from a year ago, translating to a pricing corrections of 10% to nearly 25% or more, depending upon specific submarkets and property types.
• Leverage levels will remain at 65% for permanent debt until lenders see more stability in the equity markets.
• Return-on-cost metrics demonstrate that investors need to see premiums of 150 basis points or more for new developments over and above existing capitalization rates because of attractive alternative investments. Return-on-cost will creep into double digits figures on a more regular basis, as a result.
• Overall “baseline yields” using relative value mortgage bonds are hovering above 7%, indicating a new floor for profitable lending.
• Equity yields for opportunistic properties will need to reflect 20% or more for short-term investments as substantially more attractive investment opportunities abound in the stock market.
• New-construction opportunities limited to all but the most carefully chosen and risk-free projects such as GSA built office buildings, for instance.
• Project downsizing and repositioning continues as condominium projects are reconverted to rentals.  Vacant office buildings as well as retail facilities are in some cases changing to alternative uses such as industrial and multifamily projects.
• “Hesitation investing” prevails as buyers use time as an effective negotiating weapon for catching better terms and conditions.

 

In conclusion, whether or not the markets have been re-priced to reflect current realities, opportunities should continue emerging as many investors look to liquefy their portfolios to maintain defensive ownership strategies in light of a cash-strapped economy.

Mining for Land Loans

 

Chicago, Illinois, November 20, 2008 – In today’s extremely difficult funding environment, financing even the most straightforward types of commercial real estate projects proves to be tricky.  In fact, commercial mortgage originations are nearly at a stand-still as lenders attempt to sort out financing dynamics in such an uncertain funding environment.

Of all realty asset classes seeking financing, land loans are the most difficult to entertain.  Any mention of land loans is the equivalent of discussing financial toxic waste.  The current lending and regulatory environment demands any real estate collateral by secured with proven cash flow and limited leverage – neither work well with land loans.  Under such conditions, land loans are limited to high-risk funding sources demanding extremely pricing premiums. 

The highest rewards (and risk) are available in the land acquisition and development arena.  For the most part, land is burdened with carry costs and seldom has any income.  Future use, including economic feasibility and zoning are yet to be identified.  Also, land is immediately impacted by economic cycles.

Land development and entitlement are exclusively focused on the preparation of site preparation for further development.  Locational, physical, legal, and financial elements are interwoven including typography, environmental standards, change of use (zoning) and community concerns.

Most successful land development models are based on “wholesale” land acquisitions (unentitled, raw land) and “retail” dispositions to users, developers and investors. 

Typical formula or land development is based on purchasing an option for the land, the most profitable method.  The option money is used to explore various zoning and physical issues with the site.  Should the process successful, the developer can then use the remaining part of the option to purchase the land.  Alternatively, if the option is not available because of the land value, a developer needs to prequalify much of the main risk issues including zoning, entitlement, demographic: analysis and physical features such as environmental issues.

Under all of these scenarios, local presence in the market is crucial for success.  Some land deals may take three to five years before any results are shown.  Hence, many national firms use local development expertise to assemble and entitlement.

 Unanticipated problems (e.g., extremely costly environmental cleanup), unrecoverable expenses, cost overruns, illiquidity, lost time,  and damaged relationships with governmental local authorities/community groups are among the numerous issues influencing development yield profiles.  As a result, land development ventures often require overall returns of 25% or more.  Even at such yields, changing market conditions such as the current credit crunch and supply-and-demand dynamics make for highly elusive profits.

 While land investing is extremely challenging, financing is still available even in today’s restrictive lending environment.  In order of importance, current funding parameters are as follows: 

1. Prime sponsorship required with proven track record strong financial statement well in substantially in excess of land value.
2. Full Recourse required and additional collateral often necessary, including projects with current cash flow stream.
3. Well below fifty percent or less of value based on recent valuations adjusted for currently depressed market conditions [e.g., 50% to 80% discount typical based on values of peak market cycle 2005-2007].  Lend in infill locations strongly preferred.
4. Pricing reflects significant premiums as compared to any other real estate asset class.  Terms are similar to other business-lending parameters such as line-of-credit fundings.

  

According to the Real Estate Capital Institute’s Research Director, Nat Zvislo, “Land and development loans present the most challenging fundings.  However if conservatively underwritten, lenders see such loans as excellent opportunities for maintaining and building new client relationships during such difficult times.”

ABOUT US:

The Real Estate Capital Institute is a research organization staffed by industry volunteers who collect and track debt/equity rate data.  The Institute’s website provides daily and historical rates including treasuries and short-term rates.  The Real Estate Capital RateLine (773-227-4825) announces hourly rate updates throughout each business day.

Cash is King in the Real Estate Capital Kingdom

Chicago, Illinois, November 12, 2008 – The old cliché – “Cash Is King” is as true now as ever given the sparse availability of leverage.  Nearly all real estate financings, both acquisition and refinancing, are restricted to funding projects with existing, in-place cash flow.  Cash-flow projections, projects with value calculations based on appreciation (e.g., land) and other ventures lacking sufficient current income ventures are shunned.  Lending is severely restricted as the Real Estate Capital Institute® estimates over 80% of conventional funding sources are temporarily out of the market.

What should be expected when seeking financing today in such a constricted lending atmosphere?

• Cash Flow:  All in all, expect more conservative underwriting across the board when reviewing revenue streams.  In addition to underwriting actual cash flow, lenders are providing further safety nets by including conservative occupancy calculations (using the lower of actual or market vacancy), higher management fees to reflect more hands-on operations, larger operating reserves and richer expenses including escalating property taxes and utilities costs.

 

• Sponsorship:  More important then in any recent years, sponsorship financial net worth, experience and liquidity are tantamount. Even with nonrecourse loans, lenders need to be assured that borrowers have the ability to maintain projects running into operational difficulties.  Borrower net worth should approximate loan amount and liquidity levels of about 25% are typical.

 

• Loan Terms:  Lenders are competitive on rate, rather than leverage or other underwriting variables such as interest-only payments, property types or Earnout formulas. Only standard, income-producing properties such as apartments, shopping centers, office buildings and industrial properties are desirable as lenders have limited appetite for real estate debt in general.  Expect 65% loan-to-value for all properties except apartments, which can reach closer to 75%.  Overall rates are hovering in the 6% to 7.5%, including fixed and floating.

 

The bottom line?

As the markets remain constrained in the foreseeable future, lenders active in the market are extremely selective.  Borrowers must prove themselves creditworthy, both at the project and sponsorship levels.  As such, loan deliverability is the most important variable in today’s real estate capital environment.

The Real Estate Capital Scoreboard® – November 2008

• About 80% +/- of the traditional funding sources (life insurance companies, pension funds and banks) remain sidelined, waiting for more capital market stability.
• Five-year permanent loans are frequently breaking the 7%-mortgage-rate barrier, translating to spreads of about 400 basis points
• 10-year loans, the most common term, are priced 7.5% or more.
• Exceptions apply: Prime multifamily and commercial properties with limited leverage of 50% or less, pricing occasionally reduced by as much as one half of a percent.
• Lenders will only seek conventional property types (apartment, industrial, office and retail); projects with “stories” shunned.
• Funds are still selectively available for refinancing, with a loan restriction of 65% +/- LTV.

 

As a comparison, today’s commercial mortgage terms and conditions reflect pricing not seen since the beginning of the decade (See Historical Mortgage Rates posted since 1983: http://www.ratesdata.com).  However, leverage levels and funding availability are substantially less favorable than that time as owners must post at least 10 to 15% more equity.  

Is There Any Correlation between Capitalization Rates and Years?

Chicago, Illinois, October 22, 2008 — The start of the mortgage meltdown over a year ago continues wrecking havoc on the real estate capital markets.  In particular, accurate property valuation is nearly impossible as buyers and sellers are sidelined due to limited debt availability. 

Few properties are trading hands.  Most investors believe values are trending downward in response to economic malaise, oversupply and lack of affordable debt.  As such, experts are using higher cap rates for valuating assets for most types of commercial and income properties.  Lenders, in particular, are “creating” values by underwriting capitalization rates which may, or may not, reflect current market prices.  These cap rates are typically higher than many sellers are buyers expect, resulting in lower loan proceeds based on loan-to-value restrictions.  Yet, owners often refuse to sell or acknowledge asset values based on lenders’ higher cap rates, choosing to do nothing, instead.

In this stalemate, who’s right and where are cap rates heading? 

An amusing theory discussed by some experts as a humorous factoid suggests that current capitalization rates are directly correlated to the recent year numerical identity as indexed to the current real estate capital boom/bust cycle. Today’s market cycle peaked in 2007, with 2005 and 2006 ranking as the best years for very attractive valuations; in other words, low capitalization rates.

As for 2008, an 8% capitalization rate is the “strike price” for sellers motivated to liquidate properties.  While the markets are illiquid and few transactions leave any proof of value, an 8% capitalization rate reflects a weighted-average premium tied to the cost of capital for most types of income properties.  Applying the same logic in a downward market, 2009 should yield a 9% rate and a 10% cap rate would prevail in 2010.

Linking cap rates to year numerology is certainly an unrealistic discussion for measuring values in the currently volatile market.  Yet as investors search for answers in such uncertain times, numerology adds more theories to an already confusing time.

"Mission Money" Keeps Commercial Realty Markets Afloat

Chicago, Illinois, October 8, 2008 – Swooning financial markets continue dislodging all sectors of real estate capital with a vengeance.  Funding sources retreat from income-property lending on a daily basis because of liquidity concerns, profitability, overexposure and a host of other factors plaguing this sector.  No conventional lenders are immune including banks, life insurance companies, savings institutions and private funding sources.

Yet a few bright stars shine in the otherwise pitch-dark capital markets.  These stars are lenders with funding goals and objectives that are not exclusively driven by profits.  The Real Estate Capital Institute identifies this group of funding sources as “Mission Money” who provide “Policy Proceeds.”  The four highlights of Mission Money are as follows:

1.    Purpose:  Mission fund objectives vary focusing on public policy (e.g., affordable housing, urban renewal), labor creation, specific geographic investing and property types to name a few.  Typical examples include generating jobs through union labor funds, constructing affordable apartments and reinvigorating economically deprived commercial areas.  Often times, many of these objectives are bundled – e.g., affordable housing with union labor in redeveloping urban “infill” areas endowed with heavy tax incentives.

2.    Property Types: Unlike pure non-profit funding sources, Mission Money exclusively targets income properties, namely commercial and multifamily properties. 

3.    Policy Proceeds:  Direct funding structures include construction, interim and permanent loans as well as equity contributions.  Popular indirect fundings include tax credits, tax breaks and rebates.

4.    Sources:  The lending arena includes federal governmental agencies (e.g. Freddie Mac, Fannie Mae, FHA and the Treasury) and local municipalities (tax increment districts), endowments, pension funds, life companies and private capital providing funds directly (construction and permanent funds) and indirectly (tax credits). 

According to John Oharenko, an industry veteran who serves on the advisory board of The Real Estate Capital Institute®, “In 2009 and 2010, Mission Funds will play an even more important role in supporting real estate capital markets as many conventional funds stay sidelined.”  He adds, ” Even as conventional markets recover, Mission Money will remain a reliable source of funds for developers, investors and others willing to learn about and implement these targeted programs.”

Seven Percent – The New Mortgage Rate Benchmark for Income Properties

Chicago, Illinois, October 6, 2008 — The commercial real estate capital markets are tightly strapped into the Wall Street roller coaster with rates jumping up and available funds tumbling down. During the past week mortgage pricing has been rapidly climbing based on spreads over comparable-term treasuries.  Key market highlights are as follows:

• About 80% +/- of the traditional funding sources (life insurance companies, pension funds and banks) remain sidelined, waiting for more capital market stability.
• Five-year permanent loans are frequently breaking the 7%-mortgage-rate barrier, translating to spreads of about 400 basis points
• 10-year loans, the most common term, are priced 7.5% or more.
• Exceptions apply: Prime multifamily and commercial properties with limited leverage of 50% or less, pricing occasionally reduced by as much as one half of a percent.
• Lenders will only seek conventional property types (apartment, industrial, office and retail); projects with “stories” shunned.
• Funds are still selectively available for refinancing, with a loan restriction of 65% +/- LTV.

 

As a comparison, today’s commercial mortgage terms and conditions reflect pricing not seen since the beginning of the decade (See Historical Mortgage Rates posted since 1983: http://www.ratesdata.com).  However, leverage levels and funding availability are substantially less favorable than that time as owners must post at least 10 to 15% more equity.

The Real Estate Capital Scoreboard® – October 2008

Chicago, Illinois, October 1, 2008 – It’s a good news/bad news real estate capital marketplace.  Mortgage markets are plagued by Wall Street market malaise and swooning prices, yet as far as commercial real estate debt is concerned, overall default rates and profit performance remain at historically favorable levels   Funding sources and borrowers alike are very selectively funding and acquiring projects as re-pricing opportunities emerge in the wake of one of the nation’s worst financial crisis.

Dramatic market volatility created by major financial institutions failing along with selective governmental bailouts, wrecks havoc with real estate capital markets with some key trends developing, including:

• Skyrocketing Libor pricing (with rate premiums) now closely reflects domestic Bank Prime rates.
• Funding availability is the primary factor within the lending sector, surpassing pricing and leverage as key variables.
• Numerous balance-sheet lenders are temporarily suspending quoting on new transactions as market re-pricing continues (e.g. “catching a falling knife” syndrome)
• More funding sources are returning to pricing loans based on absolute net yields vs. spreads.
• New construction commercial-property financing is nearly at a halt, unless a substantial preleasing is available to credit tenants with preleasing required positive debt service coverage.
• Lending remains extremely restrictive, particularly for non-conventional property types such as lodging. Special-purpose and recreational properties. 
• Commercial properties (retail, office and industrial) conservatively financed with maximum leverage of 65% based on capitalization rates in the higher single-digit range.
• Multifamily properties remain the most desirable and attractively priced funding opportunities in the capital markets as leverage levels remain close to historical norms and pricing spreads are in the mid-200 basis point range over comparable-term Treasuries.  Government bodies including Freddie Mac, Fannie Mae and FHA/HUD continue providing competitively-priced mortgages for this sector.
• Borrowers are bridging equity gap by providing personal guarantees an additional collateral, perfectly with commercial banks
• Buyers and borrowers who are active in closing deals are rich with liquidity.  Many use recourse and additional collateral to successfully finance projects.

 

According to Jeff Davis, advisory board member of the Real Estate Capital Institute, “Except for select Agency programs such as FHA/HUD, most funding sources are waiting for more clear market signals for the remainder of the year.”  He adds, “Active lenders seem to have met their allocation goals as funds continue drying up within the securitized lending sector.”

The Real Estate Capital Scoreboard® – September 2008

 Chicago, Illinois, September 1, 2008 – Throughout August financial markets digested news about problems in the financial services sector.  Real estate was no exception with Government Sponsored Agency woes capturing daily headlines.  And while unfavorable news dominates, capital continues flowing, although certainly with more caution.

Major realty finance market highlights today are as follows:

• The 5-year and 10-year treasuries dropped just under 20 basis points.
• Fixed rate spreads for portfolio loans of all terms have increased by at least 20 to 40 basis points across most funding platforms including conventional and Agency debt.
• 65% to 70% leverage remains the maximum standard for permanent loans.  Mezz funds bridge the [short-term] gap to about 85% with yields of 12% or more.
• Unless loans are committed and approved with rates and other terms locked, daily market volatility prevents many funding sources from “grandfathering” of loan terms under negotiation.
• Pro forma and projected income streams avoided in favor of actual income as underwriting benchmarks for existing project fundings.
• Hedge funds continue replacing banks for structured short-term floating rate debt.
• Loan syndications required for larger funds, as limited sources exist for loans of $50 million or more.
• Overseas banks (mainly European) active in providing larger-scale letter of credit and other financial enhancements.
• “RE” is the most common buzz realty finance word including remargining, renegotiating, rebalancing and repositioning.
• Sellers are avoiding placing the asking prices on properties, fearing loss of a potential buyer.
• Quality properties still in demand, secondary markets dramatically affected by lack of liquidity.

Advisory board member of the Real Estate Capital Institute, Skip Perry, notes “Low leverage begets low volume.”  Adding, “Until funding sources are more comfortable with financial market stability, debt and equity players will stay close to the sidelines.”

The Real Estate Capital Scoreboard® – August 2008

 Chicago, Illinois, August 1, 2008 – The realty capital markets remain surprisingly steady despite volleys of negative news about financial institutions and government-sponsored enterprises. Mortgage spreads are higher, but stable, with funds available for quality loans.  Life companies and other balance-sheet lenders continue funding deals based on similar underwriting as seen most of the year. 

Mortgage benchmark indices are stable as well.  Treasuries are at nearly identical levels from a month ago, although notes and bonds bounced higher by about 30 to 40 basis points.  In other words, no major changes in the capital marketplace in either mortgage spreads or corresponding benchmark yields. 

Hopefully, the rate stability will set the stage for return of the CMBS lenders in a meaningful way.  Select Wall Street firms announced reentering the marketplace by targeting overlooked markets based on funding mortgages in secondary markets, as well as funding more entrepreneurial properties.

 

Overall rates remain similar to a year ago — albeit at substantially lower leverage levels.  However, more subtle overall trends are evident including the following:

• Funding sources provide competitive rates, but 70% or less of project value remains the norm for mortgage lending. 
• Upward pressure on mortgage spreads as most active lenders meet funding targets for 2008.  As 2009 approaches, fresh allocations along with some additional  CMBS funds should create more liquidity.  At the same time, competition from highest quality corporate debt is forcing mortgage yields to rise.  Many funding sources demand 25 to 50 basis point premiums as compared to purchasing corporate bonds.
• Mezzanine and opportunity funds ramping up as first mortgage lenders tread with caution.  Pricing on mezz debt starts in the lower-teens.
• The large supply of bargain-hunting equity capital is preventing any major pricing discounts from being realized. 
• Equity returns are under upward pressure, but few sellers of prime properties show duress and are reluctant to transact below full price as properties continue performing. Overall equity yields for Class A “Core” institutional properties trade from the low to middle teens; “Core Plus” assets trade within the mid-teen range and opportunistic ventures offer returns in excess of 20%.
• Given illiquidity within the equity markets with few comparable trades, numerous lenders are setting valuation parameters for debt fundings.  In general, the 7%-to-8%-capitalization-rate range is a popular appraisal benchmark for higher-quality commercial properties in most markets throughout the country.   Multifamily properties start at 5.5% cap rates.
• Loans in excess of $50 million per property generally require funding syndications as only a handful of domestic lenders are active in this arena.
• New, speculative projects feature substantial equity of 40% or more of cost.  Development deals limited to finest projects with substantial preleasing (70% or more) with established sponsorship.

 Jim Postweiler, advisory board member of the Real Estate Capital Institute, suggests “Buyers and sellers are still reluctant to transact, mostly due to stingy debt markets.  However signs of improvement are emerging as buyers realize few opportunities for core properties are available.”

Mortgage Lending Reaches Extremes

Chicago, Illinois, July 15, 2008 — Commercial mortgage lenders are becoming more scarce as the second half of the year approaches. Lenders are reluctant to fund projects based on any “conventional” norms. Instead, funding sources reach for two different, and extreme, lending profiles: (1) Low-Leverage and (2) Opportunity financing. Each of these profiles are discussed as follows:

Lower-Leverage:

Even in today’s market, competitive mortgage pricing is selectively available to commercial property and multifamily property owners requiring lower leverage based on:

• Availability: Limited to life insurance companies for terms of five years or longer. Banks and credit companies providing short-term funds.
• Leverage:  Low-leverage is defined as fifty percent or less.  
• Pricing: Starting as low as 350 basis points over comparable term treasuries. On occasion, the agencies may dip below such levels on extremely prime-quality multifamily projects.  However, most common spreads are between 400 to 450 basis points over comparable term treasuries for fixed rate loans. Veritable rate loans are priced over LIBOR or Prime, generally starting at at least 300 basis points above.
• Guarantees: Full personal recourse required for bank deals, while life insurance companies and pension funds continue offering on recourse.

 

Opportunity Financing: 

Opportunity financing represents substantial yield premiums for projects that don’t fit into the “Lower-Leverage” category discussed above. For the most part, this financing format covers second-tier locations, leverage above 65%, older conventional properties and newer, non-conventional properties (e.g., special-purpose and lodging properties).  Pricing starts in the mid-teen-percent range.