Excess capital in equity and debt financing markets delivered an eventful 2006, and promises more of the same in 2007. But the commercial real estate finance story to look for this year is the brutal competition among investors to snap up unstabilized properties — particularly those assets found in secondary and tertiary markets.
Margins of return on stabilized properties in primary markets have been thinning over the past 36 months, but lenders remain committed to providing enough liquidity to help investors achieve higher returns in a super-competitive marketplace. For instance, CB Richard Ellis figures show that average cap rates on stabilized Class-A multifamily assets dropped from 6.4% in 2004 to 5.8% by the end of the third quarter of 2006.
In the recent past, the stories that stole the headlines, such as Vornado Realty Trust's involvement in the Toys ‘R’ Us real estate deal, reinforces the position of many analysts that deals for transition assets will grow significantly in the coming months. With expectations for more of these M&A activities in 2007, commercial real estate will surely be in the thick of things.
Look for private equity and high-yield real estate investment funds to have significant influence on how deals are done. Borrowers will also look to aggressive financing to complete even the riskiest of deals, in the riskiest of regional markets. Add in the growing availability of structured finance products, and it's easy to see why institutional players and small building owners alike are excited about getting debt and equity financing for their unstabilized deals.
Wall Street innovation
Structured finance — the process of taking a single real estate loan and breaking it up into multiple levels of investment risk — has become so prevalent that entire blocks of real estate lending and investment funds have been established to finance such deals. Unstabilized deals are ideal for these high-risk, high-return seeking funds as they allow lenders to price loans based on specific risk, and deliver maximum loan proceeds to investors.
Structured products for high-risk deals are a natural evolution from the booming commercial mortgage-backed securities (CMBS) market, which is evolving and adapting to the larger number of unstabilized deals financed today. However, lower returns from the higher-rated CMBS market are losing appeal with institutional investors, who are being driven to alternative products for yield.
By the end of the third quarter of 2006, CMBS spreads had narrowed to a mere 10 basis points on AAA-rated floating products, while spreads on comparable commercial real estate collateralized debt obligations (CDOs) were a little over 30 basis points. These numbers become even more compelling when considering the BBB-rated and subsequent lower classes of securities.
Searching for yield
So the business of buying buildings with dark space, acquiring assets in need of rehabilitation, and properties where lease renegotiations are critical to their future stability, is now attracting the CDO world. This alternative real estate finance segment — which is on target to deliver its highest level of loan and equity proceeds to the marketplace this year — is aiming to be one of the largest capital suppliers for these types of deals. CDO issuance is estimated to reach the $50 billion mark in 2006 compared with $20 billion in 2005, and $6.5 billion in 2004.
Unlike the vanilla world of CMBS, CDOs provide opportunity to securitize loans backed by higher-risk deals, including construction, bridge, mezzanine, and condo conversion loans. Commonly referred to as “deals with hair on them,” unstabilized commercial real estate loans are ideal candidates for financing through CDOs.
They provide an opportunity for substantial upside potential to both property investor and fund lender. These deals also have higher margins, shorter investment cycles, and provide ample opportunity to negotiate favorable borrowing terms through risk management tools, such as borrower earnouts, phased financing, and property lease-up controls.
Lenders are ultimately attracted to these features because they provide an alternative product to feed the insatiable appetite among CMBS investors to hold high-yield, real estate-related assets.
The short-term nature of unstabilized deals affords lenders the chance to make risky loans, control the asset stabilization process, and be first in line to refinance those loans with fixed, long-term financing. These fixed products are often designed to feed the ever-hungry loan securitization machines of these very lenders.
W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.