Service firms like Chicago-based Jones Lang LaSalle have their fingers on the pulse of what is happening in the land of institutional investing. Last year, JLL’s Capital Markets Group sourced $81.8 billion in transaction volume. As head of the group for the Americas, Earl Webb has more than 25 years of experience working directly with investors of all stripes.
NREI: If you’re wearing an institutional investor’s shoes right now, how do you view today’s commercial real estate marketplace?
Webb: It’s a bit schizophrenic. On the positive side, the fundamentals are still reasonably strong in all the property sectors. And yet, from a capital perspective, it is weak because of the reduction in available financing. There is still plenty of equity that is at least available, but the complementary debt is very hard to come by.
NREI: Institutional investors have money to put in the ground, but are they allocating more dollars to commercial real estate in 2008? And can they find investments to put the money to work?
Webb: There are exceptions, but as a general statement investors are pretty consistent in 2008 with the amount of capital being allocated to real estate investment.
When it comes to putting the money to work, because the amount of transaction flow is dramatically down year over year, there are fewer opportunities to put money to work. But we still find that the institutional investors are in the market and transactions are taking place, albeit at a slower pace. Institutional investors are re-emerging as a true buying source as opposed to the private equity that was dominating the market a year or two ago.
I think institutional investors in 2006 and early 2007 had reached a height of frustration because the returns and the rationale for the returns were so off base relative to what they were used to seeing. It was largely driven by an over abundance of readily available and inexpensive financing that the private equity buyers could avail themselves of and the institutional investors really didn’t need.
NREI: Have their criteria changed much?
Webb: They are underwriting more conservatively. The whole economic situation has caused institutional investors to slightly increase their return expectations, and as a result they are not pricing in quite as aggressive rental increases market by market because of the fear of the recessionary environment.
But we are seeing that they are able to buy, they want to invest, there are opportunities to invest, and quite frankly, because cap rates have increased across the spectrum of investments, there are more attractive yields in the market today on those properties that they are purchasing than there were a year or a year and a half ago.
NREI: Are institutions taking more creative positions up and down the capital stack?
Webb: Yes. They’ve got money, and some are pursuing mezzanine debt, for example, to help meet the wave of refinancing that has to take place over the next two to three years. A lot of these owners are going to have to replace maturing mortgages at pretty high loan-to-values, and so institutional investors may not be able to buy as many properties, but they can help fund the capital stack in a refinance. The institutional investor can bridge the gap between the 60% and 80% of the capital stack with a mezzanine [loan] that has many of the same return characteristics that an equity investment might have.
We’re seeing an increasing desire on the part of institutional investors to play in other areas of the capital stack beyond pure equity. We’re also starting to see them explore buying existing debt in the market, whether they are whole loans being held on the balance sheets of financial institutions or seasoned CMBS issues. The yields on existing debt are pretty attractive, if you’re able to get to the assets and understand the underlying collateral.
NREI: Earlier this year you noted that there would be a “refinancing frenzy” of investors searching for equity infusions this year. Do you see that happening now that we’re a quarter into the new year?
Webb: It is starting to gather momentum. With every quarter that goes by between now and 2010, you’re going to see more and more maturing loans, and some of those loans are interest-only debt that was put on two years or four years ago, five-year interest-only debt that is coming due. As that wave of refinancing takes place, you’re going to have to replace that debt somehow under the constraints of the current market, and that means the first mortgage lender will take a more conservative view of the loan and fund up to 60% or 65% of value, which is going to leave a gap to be refinanced probably between 10% and 20% of value. Institutional investors can help fill that gap through mezzanine debt or through B pieces of structured finance deals and earn pretty healthy rates of return.
NREI: How is the bid/ask spread these days, between what sellers want and buyers are willing to pay?
Webb: We call it the ‘cap gap,’ which is the expectation of the cap rate between buyer and seller. That has widened out quite a bit over the past 12 months. That’s part of the reason you see the lower transaction volume because there isn’t a meeting of the minds right now in terms of what those cap rates should be.
Whether it will continue to widen or not remains to be seen. Cap rates have increased 75 basis points or so over the last 8 months and whether it stands to increase a little bit more or a lot depends on whether there is an increased financing ability in the next six months or so. If not, you could still see a slight additional increase in cap rates.
NREI: So no need for a fire sale just yet?
Webb: That’s right. And a lot of investors who are owners look at the recessionary aspect of this as being temporary. So if part of the reason why values have declined is because the recession is viewed as here or soon to be here, that is a temporary economic phenomenon and should go away by the end of this year. If you have the ability to hold onto property then hopefully the fundamentals stay solid and the vacancies remain low and rental increases will resume once a recession has been flushed through the system.
NREI: Are you in the camp that we’re in a recession?
Webb: Yes. I’m not an economist but I have to believe that we are. And at a minimum what you’re seeing is a decline in consumer confidence, a decline in consumer spending, which has a direct impact on the retail and the manufacturing industries. If you’re not in a recession then you’re really close.
NREI: How long will it last?
Webb: I think anybody who thinks we’re out of this malaise by the summer is kidding themselves. Some of what the Fed is doing appears to be taking root here, so there is capital flowing back into the system. But the CMBS market is still largely closed, and you see hints that it will start to reopen in the next three or four months, but it will take a prolonged opening of the CMBS market and the flow of that capital back into the real estate market before you are going to see a real narrowing of that cap gap.
Our best guesstimate is you are talking about a 2008 that is going to suffer a decline in sheer transaction volume by 50% to 60%. We’re hopeful that by 2009 you will start to see a recovery in the debt markets and as a result of that have a recovery in the overall flow of capital back into the real estate markets and a narrowing of that expectation gap and an increasing transaction flow.
Even institutional investors, both foreign and domestic, eventually have to monetize their assets. They may be able to defer disposition and refinancing decisions for a short period, but over the long haul they need to show true value enhancement and liquefy certain assets to reinvest and modify allocations. If a year goes by like 2008 where you see a 50% to 60% decline in transaction volume, then your expectations for increased flow continue to go up as the years go by.