A New Era Dawns in Credit-Lease Financing With low-priced, easy money from conduit lenders having substantially disappeared in late 1998, investors and developers of net-leased properties are getting back to the basics of the business. They are scouting nothing but investment-grade tenants, and some of them are returning to traditional sources of real estate capital: life insurance companies, pension funds and commercial banks.

"There are far fewer players in the marketplace today. Below-investment-grade deals that could be easily done three or four months ago are difficult to do today," says David Piasecki, senior managing director of the real estate group at Chicago-based Mesirow Financial.

In a nutshell, the credit-lease finance market has taken a 180-degree turn. Despite low interest rates and growing demand for space, capital has become more expensive. Property values have plummeted. Financing for non-grade and below-investment-grade tenant properties has dried up.

The pendulum has swung in favor of lenders, who have started to look not only at the tenant credit but also at the value of the underlying brick and mortar. Until recently, the major focus of the lender in credit-lease transactions was the financial conditions and credit standing of the tenant rather than the value of the underlying real estate.

In a credit-lease transaction, a property is leased to a single, creditworthy tenant with a "BB" or better rating. These properties, in turn, qualify for financing of between 95% and 100% loan-to-value and a low debt-service coverage with competitive rates.

"It seems that since last August, a lot of net-lease lenders are looking not only at the credit of the tenant but also at real estate values," says Sam Peper, a managing director at Fantini & Gorga, a Boston-based mortgage banking firm.

"Now, they want to make sure what the underlying real estate is really worth," he says. "They are looking more at appraisals and traditional real estate issues."

Overreaction or new era? So what's wrong with today's credit-lease finance market? After all, vacancy is low, rents are rising and the outlook for the economy is moderate, if not robust. Many high-performance retailers are either expanding or moving to freestanding stores that make a perfect fit for net-lease financing.

"There has been an overreaction in the market," Piasecki says. Other industry analysts say what is happening in real estate today has never been seen before and that it may signal a new era in the industry. It's the first time public markets have had such a direct impact on capital flows to real estate.

"When the turmoil in the financial markets started to hit real estate, spreads widened and there was flight to quality, flight to higher-rated credits," says Charles Corson, director of the retail investment group at Staubach Retail Investments, a Dallas-based firm that specializes in the purchase and sale of credit-lease financing. "All investment-grade or better deals are still getting done."

A case in point is Rite Aid drugstores, Corson says. In one of the most tumultuous credit markets in recent history, Corson was able to close the direct sale-leaseback of 44 Rite Aid drugstores valued in excess of $140 million in December in a Staubach-sponsored joint venture.

There is no problem in obtaining financing for investment-grade tenant properties, such as Rite Aid, Walgreens, CVS and Eckerd, says Michael Houge, senior sales associate at Minneapolis-based Towle Real Estate. The problem, he explains, is getting financing for below-investment-grade tenants such as Hollywood Video and others because of the recent volatility in the commercial mortgage-backed securities market.

"The CMBS market has all but dried up. There is no financing for non-investment-grade tenants. The market for investment-grade tenants is still there. There is still money, but it's more expensive," Houge says.

"That is a good thing. Earlier, you could not distinguish between quality and non-graded tenants on returns," Houge adds. "The (sizzling) market had created artificial demand for non-investment grade. There should be a difference between the two. There is more risk to investing in non-graded tenants than in Walgreens. I should get a higher return on Hollywood Video because risks on Hollywood Video are greater."

Cap rates, the industry benchmark that measures the relationship between the net operating income and the price of the property, will have to be adjusted to a bigger spread over the 10-year Treasury in 1999, Houge says. The greater the investment risk resulting from uncertainty in the income stream generated by the property, the larger the return expected by investors to compensate for that risk. Simply stated, the higher the risk, the higher the cap rate.

"Cap rates have already started to go up," he says. "They ranged between 125 and 140 basis points over the 10-year Treasury three months ago. Now, you are seeing between 175 and 250 basis points for the same tenant. Cap rates were artificially low. Cap rates have to be adjusted upward. In 1999, I don't think the market will go away. In the first quarter of 1999, you're going to see a lot of adjustments in cap rates. Money will be more expensive."

Net effect on retailers Corson of Staubach Retail predicts a slowdown in the expansion of some retailers, especially in the areas of electronics, sporting goods and home furnishings operations.

"In 1999, the pace will be brisk, but we will see some pull-backs in the expansion rate from some of the retailers," Corson says. "Drug chains, however, will continue to grow. They are opening over 300 stores a year."

David Fick, an analyst specializing in retail real estate investment trusts at Baltimore-based Legg Mason Woodwalker Inc., says the success of commercial net-lease investors and developers will also depend on the degree of loyalty they have created among their retail tenants.

"Tenants have not had the kind of loyalty they (investors and developers) expected. These guys are not as loyal as they had hoped for," Fick says. "They are going to the cheapest locations and doing deals with anyone who can offer the best deals."

Positive outcome The recent correction in the financial markets may not necessarily be a bad thing for net-lease deals. "The net-lease market had a very tough year," Fick says. "The collapse of the CMBS market will help over the next few months. You will see tenants returning to commercial net-lease players who still have access to capital. It's a healthy correction."

Gary M. Ralston, president of Commercial Net Lease Realty, an Orlando, Fla.-based REIT, is in agreement. "For firms such as Commercial Net Lease Realty, this means a more favorable acquisition environment," he says. "In any event, I believe that changes in interest rates and loan underwriting have had a negative impact of 4% to 7% on the value of net-leased properties."

However, Ralston predicts that financing for net-lease properties from conduit lenders will decline substantially because of the recent shakeout in the CMBS market, where loans were typically originated. Some Wall Street players have either ceased or curtailed their real estate lending, Ralston adds.

Indeed, in a major news development, Nomura Holding America Inc. recently announced plans to exit the commercial real estate lending business. Nomura was considered to be a true pioneer and a dominant player in the CMBS arena throughout much of the 1990s, but faltering global markets and the resulting losses suffered by the company hastened Nomura's departure.

"There were a half-dozen active buyers of CMBS. Today, there is only one: GMAC. CRIIMI Mae Inc., the largest originator of commercial mortgage-backed securities, filed for bankruptcy," Ralston says. "The net-lease part of the CMBS pool will be less than 10%. At any time they were one-third of the CMBS pool. A couple of pools were even able to have 100% net-lease. I don't see that happening in the near future."

In addition to disruption of the CMBS market, the situation was further affected by orientation in the bond market by shorter maturity, Ralston says. Net leases, for example, are typically signed for between 15 years and 25 years and loans are amortized for the same period. Traditionally, commercial loans are bullet loans for a duration of five to 10 years.

"Now, you have a substantial difference. There are very few bond buyers for longer maturity bonds. It further exacerbates the problem. It has a trickle-down effect. It will result in a little credit crunch in net-lease financing," Ralston says. "It's going to make banks more competitive in their lending. You're going to need more equity than you needed six months ago. Debt has gotten a bit more expensive. Now you can borrow a little less than you could before and it will cost a little more."

At the peak of the CMBS market, one could borrow 110% to 120% of the dark values of the net-leased properties, Ralston says.

"Today, you can borrow 90% to 100% on investment-grade tenants," he says."At the very peak, there was also no difference between investment-grade and sub-investment grade tenants."

The recent turmoil in real estate finance, however, should not mean the end of credit-lease financing. As a result of more and more retail companies doing freestanding stores, which fit into the net-lease category, the credit-lease market is likely to remain stable if not grow rapidly as it did in 1997 and early 1998, industry insiders say.

"There is going to be a significant growth in the net-lease market because it presents a more effective form of fixing real estate for retail companies and at the same time allows them to get out of owning real estate and focus on their core competency of retailing," Ralston says. "We now see the opportunity. Next year, we will be able to continue to buy the best-quality assets at a higher return."

Tom Lewis, vice chairman and CEO of Escondido, Calif.-based Realty Income Corp., one of the nation's largest publicly traded owners of freestanding, single-tenant, net-leased retail properties, says the move toward freestanding retail continues unabated.

Lewis says his company plans to continue aggressive acquisitions of net-leased properties from middle- and upper-market retailers whose goods and services are used by consumers every day, such as apparel stores, bookstores, auto service and auto parts stores, childcare centers, convenience stores, consumer electronics stores, and restaurants, among others.

The lack of financing in today's tight credit market has created new opportunities for companies like Realty Income, Lewis says.

He adds that REITs are becoming more involved with the developers of net-leased properties. In some cases, an arrangement with a REIT can eliminate the funding and exit strategy risks of the traditional net-leased development.

"Many developers who are unable to get financing are calling us and telling us, 'We have a transaction right now for you.' Some are saying, 'We have two or three projects to sell,'" Lewis says.

"A lot of properties will come on the market in 1999," he continues. "There will be fewer buyers. We see volume rising and cap rates remaining stable in the first six months of 1999. We're very bullish on 1999."

Paul Domb, vice president of United Trust Fund, a Miami-based REIT that specializes in the purchase and long-term leaseback of corporate real estate, says his firm's corporate sale-leaseback transactions have been rising over the past few years.

With REIT stocks down nearly 20% and with REITs unable to raise capital in public markets through secondary offerings, there are more opportunities for private real estate investment companies that can provide a one-stop shop.

"In the past, our competition has been REITs," Domb says. "With what has gone on in capital markets, we see more opportunities. It puts us in a better position. REITs are not doing many deals these days. A lot of companies are taking advantage of the low-rate environment."

Retailers are risk-averse Dick Collins, senior vice president for portfolio acquisitions at Realty Income, says that with competition rising for net-lease deals, retailers are seeking to obtain lease provisions that limit their risk. Options include shorter lease terms, property substitutions, buybacks, and assigning responsibility for maintaining physical improvements.

In addition, in today's marketplace, many retailers want protection from being locked into an under-performing location. Some retailers have addressed this issue by selling packages of properties to an institutional investor with leases that contain provisions for the substitution of properties or alease-buyout formula.

"An example of this was seen in a lease we recently reviewed, which contained a formula for the repurchase of the property in the event the retailer did not reach a certain unit sales level," Collins says. "The repurchase was written in such a way that it did not unfairly burden either the retailer or the owner, yet it still offered viable alternatives to the retailer."

How a particular lease is structured becomes one of the key issues in net-lease financing, says Jenny Story, vice president at the New York office of Duff & Phelps Credit Rating Co. "If you are going to finance a credit-tenant lease, you have to look at the strength of the lease," she says. "You have to understand any provision that will allow the tenant to terminate its lease. If there are any holes in the lease, such as the tenant's right to terminate the lease in the event of casualty or condemnation, you have to put in place proper structural techniques that would mitigate any of these holes."

Lease holes, also known as "outs," could include casualty, condemnation, structural obligation, exclusivity/non-compete clause, and change in government regulations, among others.

Barry Reiner, managing director of the Commercial Real Estate Finance Group at Charlotte, N.C.-based First Union Capital Markets, says his organization continues to originate and structure a pool of mortgage loans that are fixed-rate, long-term, non-recourse loans backed by multifamily, commercial and credit-tenant-leased assets.

"We have been pretty active in the net-lease financing arena," he says. "Recently there has been some reluctance in credit-lease financing, but that has passed. There is now more focus on how credit-lease financing can be included in securitization. Some people will still view that product somewhat skeptically, but we think it's a very durable product."

The bulk of credit-lease deals consist of acquisitions and refinancing, he says, but some new developments also are being financed.

Credit-lease financing terms A credit lease is defined as a real estate transaction in which the primary focus of the lender centers on the credit standing and financial strength of the tenant rather than the value of the underlying real estate. The property is leased to a single, creditworthy tenant for the long term, usually 15 years or more. The tenant pays the net rent.

* Credit standing: The credit of the tenant is a key factor in all these types of financing. Three types of net leases -- bond type, triple net and double net -- qualify for credit-lease financing, with bond type most desirable, followed by NNN and NN.

* Lease enhancement insurance: The credit-lease enhancement insurance insures against certain losses that arise out of casualty or condemnation of the mortgaged property.

* Lease holes: A commonly used term by credit rating companies, lease holes refer to some deficiencies or shortcomings in the lease. A tenant's right to terminate the lease in the event of casualty or condemnation, for example, may be described as a lease hole. Some capital market pros call it "outs" as well.

* Lease mitigants: Mitigants are commonly referred to as "plugs." These are the steps that a borrower can take to plug the holes. For example, a borrower can obtain a rating-agency approved, lease-enhancement insurance policy to deal with the tenant's right to terminate the lease in the event of casualty.

* Sale-leaseback: In a sale-leaseback, the property owner sells the real estate to an investor, who in turn leases the property back to the seller for the long term, usually for 15 years or more. These leases are preferably net or triple net.

* Synthetic lease: In a synthetic lease, the parent company sets up a single-purpose entity to book the loan. Proceeds from the loan are then used to buy the real estate, which later is leased to the parent company. Such leases are generally for a shorter duration, typically five to seven years.

Types of Leases: Different Vistas Leases are typically described according to how they address operating expenses. However, real estate professionals and capital markets do not share the same perspective on leases. Here are their differing viewpoints:

Real Estate Perspective * Net Lease: All operating expenses (property taxes, insurance, utilities and maintenance) are paid by the tenant.

* Triple Net: The tenant pays for property taxes, insurance and maintenance.

* Double Net: The tenant pays two of the three nets in the triple-net lease: property taxes and insurance; property taxes and maintenance; or insurance and maintenance.

* Gross: All operating expenses are paid by the lessor (owner).

Capital Market Perspective Duff & Phelps, a New York-based credit rating company, for example, assumes the tenant is responsible for all operating expenses. When referring to leases for credit-tenant lease deals, however, the company focuses on their termination and abatement rights. Some common examples are as follows:

* Bondable: The tenant has no termination or abatement rights whatsoever.

* Triple Net: Tenant has the right to terminate or abate rent only if an event of casualty or condemnation occurs. There are no other termination or abatement rights. A lease-enhancement policy must be purchased to pay the outstanding principal balance of the loan in the event the tenant terminates as a result of a casualty or condemnation event.

* Double Net: The tenant has the right to terminate or abate rent in the event that casualty or condemnation occurs. The tenant may also have other termination or abatement rights, such as exclusivity clauses, latent defect clauses, parking ratio restrictions, etc. A lease-enhancement insurance policy must be purchased to cover the casualty and condemnation issues. Structural techniques such as reserves, recourse to the borrower and excess coverage must be employed to deal with the other termination and abatement rights.

1999 MBA Conference focus: 'Riding the Waves' What a difference six months make. At the beginning of 1998, the commercial mortgage-backed securities market was rocketing into the stratosphere. By mid-year, CMBS volume had already equaled last year's record volume of $44 billion and the market seemed without limits.

But then, in late summer, the virtual collapse of Russia's capital markets touched off a global flight from financial risk of all kinds.

The mad rush to dump almost any kind of risk investment brought down even the high-flying CMBS market. Investment banks "temporarily" abandoned the conduit business, which had stoked the CMBS fires over the past two years. In a matter of weeks, the CMBS market had come to a complete standstill, and the repercussions will continue to be felt for months, perhaps years to come.

This is why the Mortgage Bankers Association of America decided to theme its February Commercial Real Estate Finance/Multifamily Housing Conference "Riding the Waves," and the industry is doing so on that sea of change.

The long-running real estate finance conference will take place Feb. 14-17 at the San Diego Marriott Hotel & Marina. Senior executives from all facets of the commercial real estate industry will gather to hear industry experts speak on a wide range of topics, from global capital markets to CMBS servicing.

"I would expect great attendance at this one because of the turmoil that is going on in the market right now," says Jim Murphy, a member of the MBA board of directors and president of New England Realty Resources Inc. in Boston. "Over the past five years, the conference has been a gathering place for those people involved in the finance of commercial real estate. That hasn't changed. But this year, the conference will be helping people deal with the current environment."

In 1991, there were fewer than 400 people at the conference, but last year there were more than 4,000, recalls Shekar Narasimhan, also an MBA board member and president and CEO of the WMF Group based in Vienna, Va. Narasimhan expects a big crowd this year as well.

Why not? Gen. Colin L. Powell will kick off the business portion of the conference with a keynote speech on Monday, Feb. 15. Another important presentation that day will be delivered by John Somers of the Teachers Insurance and Annuity Association, who will share his views regarding what happened in August in the global capital markets and explore the future ramifications for key investment classes.

Panel sessions for Feb. 15 will explore such topics as "The Commercial Mortgage Banker: A Changing Role at the Helm," "Fannie Mae: Preparing for the New Millennium," and "The Changing Tide: CMBS Servicing."

On Tuesday, Feb. 16, the second business day of the conference, Tony Pierson, managing director of CIGNA Investment Management, will be the morning's featured speaker, and the 1999 Affordable Housing Awards Ceremony will be showcased.

Key break-out discussions on Tuesday are featured on the following themes:

* "How I Stopped Worrying ... and Learned to Love Commercial Mortgage Credit Risk Analysis" (property trends, behavioral dynamics of loans);

* "Ginnie Mae: Flight to Quality or Caught in the Undertow" (Ginnie Mae executives share their vision of the market); and

* "Twenty Thousand Leads Under the Sea" (media roundtable to explore commercial real estate finance issues).

The conference will focus on what was learned about capital markets mortgage lending since early fall and how the future of Wall Street financing will be different as a result of what occurred, says Mitchell Sabshon, chairman of MBA's Capital Markets Committee and president and CEO of Archon Financial in Dallas.

For more detailed information about the conference, visit MBA's website at www.mbaa.org.