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.