Denouement for Low Cap Rate Commercial Real Estate Investments

8/14/2019 Denouement for Low Cap Rate Commercial Real Estate Investments

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The Denouement for Low Cap Rate Commercial Real Estate Investments

Or

How to Explain the Current Credit Crisis and the Future Pricing for Commercial Real Estate

The word denouement is French. Denouement is defined by the Oxford English Dictionary

as The unraveling of the complications of a plot, or of a confused situation or mystery; the final

resolution of a play, novel, or other narrative. My colleagues Richard Kusack and David Kopp

thought the word was appropriate to describe the current situation in commercial real estate

due to the effects of the Credit Crisis of 2007.

Although these prognostications are theoretical, we will try to provide support for the

argument that cap rates for investment grade real estate will have to increase in the short run

due to the credit crisis. We are defining short run as the next 6-18 months. The impact on

longer range investment valuation is speculative at this time and is highly dependent on the

availability and cost of capital in the credit markets after the next 12-18 months.

Suffice it to say, that by April 2007 the availability of easy credit for commercial real estate

was at its apex. Investment Banks and the CMBS securitization market were achieving record

volume levels of financing and spreads for various product types were extremely tight (i.e., the

cost of money was relatively cheap for real estate investment and its availability was

widespread). Why was this so?

Most people believe that the credit crisis is solely due to the sub-prime residential lending that

has resulted in many foreclosures and pain for homeowners throughout the U.S. Our feeling is

that the sub-prime residential was a catalyst and harbinger for the eventual problems in both

commercial real estate and corporate debt structures.

The sub-prime residential lending that occurred from around 2003 till early 2007 is based on a

relaxation of traditional lending underwriting for residential property. Specifically, bankers

started to use the underwriting for homes that they used for automobile loans which resulted

in loans that were too aggressively underwritten. In many cases, these loans exceeded thevalue of an already aggressive appraisal for a particular residential property. Many loans were

advertised as 125% of value loans, that were often adjustable rate mortgages that had

onerous escalations built into their terms. In mortgage brokerage language, a prospect merely

had to be warm and breathing to qualify for a home loan. Also, many of the residential loans

made were not to owner-occupants but to investors looking to cash in on the real estate boom.


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Now, when the housing markets have slowed down, the 125% of value loan effectively can

become a loan that is 50% too high due to the restriction of credit. Here is the math:

If a property drops 20% in value and new lending standards limit loans to 75% of the newlyappraised value, the maximum amount of debt drops from 125% to 48% of the original over-

inflated loan. In certain cases, the drop in real estate values is more serious (Florida, parts of

California, Nevada and Arizona). The end result is that there are many over-leveraged

American families due to excessive residential lending (first mortgages and home equity loans).

Politicians are now grappling with how to handle this troublesome situation which is a delicate

balance between necessary help and bail-outs for people who do not deserve them.

The Macro Problem (CDOs and SIVs)

Major money center banks and investment banks (e.g., Citicorp, UBS, Merrill Lynch) made big

bets on assets that they packaged into complex and difficult to understand investment vehicles:

CDOs (Collateralized Debt Obligations) and SIVs (Structured Investment Vehicles). Unlike, the

relatively transparent investment vehicles collectively known as CMBS (Collateralized Mortgage

Backed Securities), CDOs and SIVs are not readily discernible in terms of deciphering

information and the ability to adequately value these assets (they are often marked to model

rather than marked to market which means there may not be any meaningful market for

these assets; hence the magnitude of the Sub-Prime Credit Crisis). Be aware that it is not

simply sub prime residential mortgages that are at risk here, but mortgage insurance

companies like AMBAC and MBIA due to the uncertain valuation of possibly trillions of dollars

of collateral that were sold and insured (or not sold) by banks and investment banks. The

problem is not limited to real estate in that these CDOs and SIVs may contain CLOs

(Collateralized Loan Obligations) that may include corporate debt that is attached to some of

the major private equity buy outs done in the past several years. So, the big question is what

are these assets worth? We do know that today oil is $110 a barrel and gold is hovering around

$1000 per ounce which is quite inflationary compared to prior pricing. Food is also quite

inflationary, but assets like automobiles and real estate are somewhat deflationary. Go figure

How Does All This Affect Commercial Real Estate?

First, the amount of equity required to purchase, develop or re-develop an asset is greatly

increased from as little as 2% in 2004-2007 to a current 40-50% in 2008. In general, equity

requires a greater yield than debt, as debt (especially senior debt) has traditionally been viewed


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as a conservative investment in the province of large investors like commercial banks, insurance

companies and in recent years, most importantly, investment banks.

Investment banks helped bail out commercial real estate in the last major down cycle of 1987

to 1993. Many substantial real estate companies became REITs (Mack-Cali and Reckson cometo mind) and large commercial banks began in early 1995 to begin to be packaged into pools of

loans known as CMBS (see above).

Fast forward to 2008 and we see that investment banks had record originations in the first half

of 2007 and then the business disappeared in the second half of 2007. This slowdown has

resulted in the beginnings of massive layoffs at Investment Banks (with Bear Stearns being the

current most glaring example in its demise and assumption into JP Morgan Chase.)

We have been grappling with the return that equity should require in todays commercial real

estate environment. On the one hand, there is enormous uncertainty in the markets today,

both in terms of consumption and political stability of our country. These factors add a risk

premium to equity investments in commercial real estate. Conversely, in the debt markets

though capital is quite scarce, there is a predilection for very high quality assets. The cost of

Debt for these assets is relatively low (low 5% range for multi-family to just around 7% for many

commercial real estate assets that are not overleveraged).

The general rule that we have used in calculating equity returns is that equity has to be

rewarded for the risk and illiquidity of owning real estate. A riskless investment is generally

viewed as a Treasury note (assuming we do not bankrupt our government). The ten year

Treasury note currently yields 3.54% and senior debt is 5.25-7% for high quality assets. Equity

is subordinate to senior debt and must be afforded a risk premium of 2-4% given its added risk

and illiquidity. Therefore, high quality assets are going to require equity returns ranging from

7.25% (the highest quality Class A real estate) to 11% (B quality assets). Class C assets have

been most hard hit as there is a tendency for investors to have a flight to quality. These Class

C assets have an additional 3-4% risk premium, which would indicate that equity yields for

these assets would be 14-15%. This analysis is predicated on low interest rates (i.e., a ten year

treasury note at 3.54%). If rates go up, then equity rates would rise commensurately.

Another factor that increases the cost of capital is the fact that high leveraged deals are not

possible in todays credit environment. So, instead of equity requirements being 2-25% of total

costs, the situation is now that equity has to be 15-50% of the transaction costs. This higher

equity requirement puts a downward pressure on commercial real estate prices because:


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1) equity traditionally costs more than debt and 2) real estate fundamentals in many markets

are weakening and not strengthening, resulting in decreased cash flow for many properties.

Unlike residential property, commercial property is usually valued on its income potential. This

increased need for equity is also decreasing the prices for commercial real estate because, as

shown above, equity is traditionally more expensive than debt.

Foreign Sources of Capital

The weakness of the U.S. dollar has made commercial real estate seem relatively cheap to

foreigner, especially Euro denominated investors like the Irish, Germans and to a lesser extent,

English and French purchasers and lenders. Middle Eastern and South East Asian investors

traditionally have dipped their toes into U.S. commercial real estate as well. Due to the credit

crisis, Sovereign Wealth Funds in Singapore, Abu Dhabi and China have stepped up to fund

investments in such Financial Service giants as Merrill Lynch, Citicorp and Morgan Stanley.

Savvy commercial real estate companies, like Related Companies, have shored up their capital

through foreign capital investment.

Manhattan has been especially attractive to foreign investors as it is perceived as a safe haven

for many foreign investors, and most very wealthy people like to maintain a residence in

Manhattan. What many people do not realize is that, historically, Manhattan can be quite

volatile during down cycles due to its reliance on the financial service industry, which is often a

driver for other industries like advertising, accounting, legal and other service businesses that

depend upon the financial services engine.

So, to a Euro-denominated investor, U.S. commercial real estate that yields 5% translates into

nearly double that yield and the purchase price of an asset looks like a bargain as well.

Assuming the dollar stays weak and their native economies do not falter, then these investors

will continue to seek U.S. commercial real estate, especially in Manhattan. However, there is a

history that foreign investors, like the Japanese in the late 1980s, are overpaying for much of

the U.S. commercial real estate they are buying much like the bubble economy that Japan

had, which involved their borrowing at 0% against Tokyo Land values that were inflated to

overpay for U.S. commercial real estate. There are elements of this heady investment climate

in the office building and hotel markets especially in Manhattan.


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Commercial Real Estate Loan Work-outs

To date, many commercial banks and investment banks have been loath to dispose of loan

assets at deep discounts in the hopes that markets will improve. Nevertheless, a large amount

of assets have been written down, and not just in the real estate arena. Work-outs forproperties that are over-leveraged are generally not pleasant prospects for both lenders and

borrowers. The securitization process that has made many of the loans currently in the market

is highly structured and has servicers and special servicers that protect the various classes of

bond holders. When a commercial real estate loan goes into default, the special servicer takes

over to protect the first loss piece for an investor that has a junior piece of a commercial real

estate loan. This pieces are often called B pieces but in reality there can be C, D, E, F, N, Z and

so on pieces (also known as tranches) as mortgages got diced and sliced into the complex

array of mortgage backed securities and derivative instruments that banks underwrote and are

now basically unable to sell at a reasonable price, or for that matter at any price.

It should be noted that in the first quarter of 2008, many traditional lenders like insurance

companies actually reduced their loan commitments due to the attractive asset pricing for B

piece type investments which were yielding 16-20%. Why make a traditional whole loan at

6.5% when you could buy a piece of a more seasoned loan at double or triple the yield? The

problem with this reasoning may be that many of these B pieces may be out of the money

if commercial real estate values continue to erode. This flight to high yield already securitized

debt also exacerbated the lack of whole loan mortgage money for commercial real estate.

When a property is very high quality with good sponsorship, there is still money to be lent and

it is relatively cheap, i.e., +/- 6%.

We are starting to see assets become available that were financed between 2004 and 2007 that

were very aggressively underwritten during the commercial real estate boom. These assets

may have no equity value left, no mezzanine debt value left and even some portion of the

senior securitized mortgage may have an impaired value. If a particular property needs

significant new capital to stabilize the asset, the current lenders are extremely reluctant to lend

new money on the asset and the current lending market is not willing to lend under the

previously favorable terms to the borrower (i.e., interest only, non-recourse, high leverage of

say up to 85% of value for senior mortgages). In these distressed property situations, which

require new capital for capital and tenant improvements, senior lenders will have to

accommodate the new money.

We have come up with a strategy that protects the most senior tranches of the capital stack in

the CMBS mortgage pool and subordinates the under water pieces into hope notes th at


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allow the capital that is out of the money to have a chance of recouping their capital but not

earn any current interest on their investment. The new money will probably need IRRs in the

20-25% range and will need current yields of 8-12% depending upon asset quality and the story

behind the original financing. This new money would still be subordinate to a portion of the

senior debt that reflects a valuation equal to the new asset value in todays market. Thesubordinated piece would not receive any money until the new money receives its return of

capital and a negotiated rate of return on that capital. Write-downs for these newly structured

securitized loans will have to be determined by bank regulators with possible help from rating

agencies that will work with servicers to maintain credit ratings for the various mortgage pools.

Our advice to borrowers that are in situations where their equity is no longer viable is to seek

possible new sources of capital from opportunity funds that have been set up to purchase

distressed debt and join forces to successfully restructure existing loans.

There was a saying during the last downturn of the early 1990s loan workouts that the

borrower always pays the most Notwithstanding this axiom, the highly structured nature of

the CMBS market may mandate more drastic liquidation of real estate assets in order to satisfy

regulators and bond investors alike. Remember, the CMBS market was created by Wall Street

to help bail out the Savings and Loan Associations that were going bankrupt in the late 1980s

and early 1990s

Eric Kaufman

Senior Managing Director

Symphony Property Group

Dba EAV Realty Corp

POB 539

Bedford, New York 10506

Tel 914-205-3129

Fax 914-205-4443

Cell 917-750-2215

[email protected]

www.symphonypropertygroup.com

www.welbiltrealty.com
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Denouement for Low Cap Rate Commercial Real Estate Investments