Securitized financing activity has slowed in both the debt and equity markets this year, but despite the short-term dip, market characteristics show that public market financing has reached a new maturity. No longer driven by the Resolution Trust Corp. (RTC), securitization appears to have increased validity as a source of capital that will grow stronger and operate more efficiently in the long haul.
No longer the only game in town, the commercial mortgage-backed securities () market has become increasingly competitive, vying with whole loan offerings from insurance companies and banks which have aggressively returned to real estate lending as they witness stabilizing property markets.
On the equity front, real estate investment trusts (REITs) have generally cooled off from their previous frenzy, with only one 1995 initial public offering (IPO) as of June, but with conditions pointing to an industry that is not on its deathbed but is catching its breath in order to grow more steadily and healthy.
Capital is returning to the private markets. Institutional lenders -- banks and insurance companies -- "have come roaring back into the market, pushing spreads down to very low levels, almost historical lows," says Sheridan Schechner, vice president at Goldman Sachs in New York. "That has made the business very, very competitive." He explains that just last year, large high-qualitywere "the sole province of the CMBS market." Not anymore.
"We recognized in late 1994 that the environment had changed," says Carl Kane, managing director with E&Y Kenneth Leventhal Real Estate Group in New York. He says the CMBS market suffered "a double whammy." Not only did traditional lenders resurface, but interest rates rose. The market showed signs of softening from its $20 billion peak in 1994. "Now we recognize the clear fact that CMBS in and of itself is a component of commercial real estate financing -- not the only force," he says.
Kane says he does not expect a boom market for the rest of the year, and predicted an approximate 10% decrease in total CMBS offerings -- $15 billion to $18 billion in 1995, with approximately $4 billion of that coming from conduits.
Howard F. Guja, managing director of the real estate investment banking group at Bankers Trust, says although commercial MBS volume is down about 35% from a year ago, Bankers Trust is predicting a second-half surge as many large issues price. "We believe CMBS volume will approach about $15 billion in 1995, off from the $20 billion in 1994, but still strong," Guja says. "Bankers Trust alone is expectiing to close on nearly $1 billion in securitized financings worldwide in the third and fourth quarters, including transactions in Asia, Europe and the United States."
In fact, 1994 was a big year for Guja's group. "Last year, we recorded the largest CMBS deal ever, a $1.8 billion securitization of bonds for Comptoir des Entrepreneurs, a European mortgage bank," he says.
Gaye Beasley, president of The Patrician Financial Co., says that in 1994 the company saw at last 12 to 15 new conduits enter the market, many of them with aggressive underwriting and pricing. However, by the end of the year, many of them failed to accumulate enough volume to profitably securitize their pools. Because of that, many multifamily conduits left the market or focused on other commercial loan product types in early 1995.
"I think the consolidation of the industry is continuing and will continue throughout 1995 and into 1996 leaving only a handful of experienced, stable nationwide multifamily conduits in the marketplace," Beasley says. "Although the conduit market is still highly competitive, there is much less evidence of overly aggressive underwriting and pricing in today's market. It appears that the conduit market is maturing and the resultant longterm stability of the remaining conduits should inure to the benefit of both borrowers and lenders."
Despite the slowdown in the first quarter of 1995 in new CMBS issuance, the market in general is strong, says Jonathan Adams, vice president with the Mortgage Research Group at Prudential Securities Inc., New York. He attributed the recent lull to higher interest rates, increased competition and decreased RTC activity compared to a year ago. (According to E&Y Kenneth Leventhal's Income Property Securitization Survey of 1994, the RTC issued just under $2.2 billion of CMBS in 1994, the second year in a row of declining volume.)
Adams says that as property markets have stabilized, traditional lenders have stepped up their lending. "Several of the largerhave clearly established a mechanism by which they can securitize loans they have originated. It is not clear to me how aggressive they will be, but we will see activity in this area," he says.
Adams explains that the incentive for large institutions to go to the public markets has changed. "Back in 1992 and 1993 large institutions, mostly life companies, went to the public markets as an exit strategy. They needed to unload. In today's environment, I don't think that will be the compelling force," he says. Now the incentive is profit, as they can pool loans and remove them from their books, thus providing the ability to obtain capital and originate more loans, he says. "It is hard to predict how aggressively this will be done, but I think it will become standard, as in the residential real estate market, but not at the same pace," Adams says.
"It will all depend on how long these traditional lenders consider real estate the asset of choice for their marginal investment dollar, as opposed to other fixed-income instruments," says Schechner.
Lenders need more liquidity
Joe Orefice, portfolio manager for Cheslock, Bakker & Associates Inc., believes fewer securitizations will be brought to market as a result of competition from direct institutional lenders, lowering investment spreads and causing further consolidation in the real estate securitization industry. "Long term, we see securitization as a strategy replacing traditional lending by institutions," Orefice says. "It is expected that as risk-weighted capital requirements become more widespread, there will be a need for these lenders to develop more liquidity in their lending portfolio."
Some of these institutional lenders are using "predatory pricing to gain market share at lower rates than the capital markets," says Kane. "But when you take predatorial priced loans and then mark them to market, you have a below-market loan that has to be reserved for, and it has an adverse accounting effect. If they want to dispose of these assets, they would suffer a hit because they made a loan at less-than-interest-rate levels."
Kane says, "Mark-to-market principals and liquidity issues will cause predatory pricing to hit the wall, and the piper will be paid in the next six months." In the long term this will help make the commercial market behave similar to the more established residential lending market. "There will be one market priced on capital markets principals," he says.
In the battle for transactions between Wall Street and private institutions, the Street continues to be more aggressive -- and more experienced -- than banks or big insurance companies, who nonetheless "are seeing the opportunity to buy debt more effectively," says Richard Ader, chairman of U.S. Realty Advisors, a New York-based real estate finance consultancy.
Ader says firms such as Principal Mutual and Northwest Mutual are becoming active in whole loans and participating out the loans to whoever they want -- to pension funds they manage or to Wall Street. "They are new at it and feeling their way," he says, mentioning that the direct lenders are not yet completely comfortable with the process of going to the ratings agencies as opposed to working with the National Association of Insurance Commissioners (NAIC).
U.S. Realty Advisors, in a joint venture with Kennedy-Wilson International, New York, advised the Kaufman Organization, a major New York-based real estate developer, in a $340 million debt and equity transaction earlier this year that packaged four Manhattan office buildings as one entity and provided refinancing and new equity capital. Ader says the deal was unusual in that it was multi-asseted and one of the first large office securitizations to be completed in the 1990s.
Demand grows for office buildings
The capital markets had tried to neglect office buildings in the early 1990s, but now demand is developing, Ader says, mentioning that one reason for the avoidance was because the office market gets scrutinized much closer than other property sectors, and people are more comfortable analyzing it -- including publicizing its weak conditions and failures. But "when lending institutions look at property classes, they already have had enough multifamily projects and significant retail," says Ader. Combine that with increasing absorption in the office space market, and offices have gained more favor.
"The office sector took longer to come back, but improvements should be steady," says Prudential's Adams. "We believe it is recovering and will continue to do so steadily over the next year, barring any major slowdown in economic growth." Adams also says that no single property type is currently seen as "exposed." Hotels are touchable again, and retail property remains a positive. The multifamily sector has topped off, Adams says, adding that he believes any further improvements there will "be much more moderate and that large gains will not be repeated. Most regions are witnessing a sufficient demand for product, and the supply coming on will not overwhelm it."
Since nearly all property types are get ting favorable reviews, pension funds are increasing their interest, becoming more comfortable with investing in securitized mortgage products.
Guja says pension funds will continue to invest in the asset class for both diversification and yield despite recent real estate losses. "Unlike in the 1980s, however, pension funds will demand greater oversight of their direct investments, as well as seek more liquid forms of real estate, such as public real estate investment trusts, for their allocations.
"We also expect pension funds with aggressive return requirements to seek alliances with opportunistic investors who have proven records of performance," Guja says.
Orefice says pension funds will attract institutional lenders to re-enter the public market because of improved economic conditions. "We believe that this trend is likely to continue, especially considering the lower bond yields of recent months," he says.
With their usual conservatism, "pension funds will become more of a player -- not a driving force, but a stable component for demand for CMBS," Adams says. Perhaps one reason their appetites have been whetted is that they have now seen investors who have profited from appreciation of their securities. "Most securities that represent a large diversity of commercial mortgages have performed quite well, and I believe that will continue," Adams says. Pension funds also can realize that in terms of high-rated securities, "CMBS is still cheap compared to corporate bonds, and it offers an advantage for conservative institutions to purchase this type of debt rather than to become involved in property markets in more risky ways."
As for equity, "The IPO market for REITS will continue to be touch-and-go, because the equity markets are always fickle," says Louis Taylor, vice president and senior real estate analyst in the Investment Banking Group at Prudential Securities Inc., New York. "For companies to go public, they must have a compelling story," he says. "It is tougher to get deals done."
That is why the industry stood up and took notice of the $150 million Reckson Associates offering in late May. The 81-property REIT, comprised of 5.6 million rentable square feet, includes 66 industrial, 13 suburban office and two 10,000-square-foot retail properties. CS First Boston, Paine Webber, Alex Brown & Sons and Bear Stearns & Co. served as lead underwriters.
The Reckson offering "is interesting in that they did what no one has done in the last six months -- complete a REIT IPO that is priced favorably to investors," says Mark Decker, president of the National Association of Real Estate Investment Trusts (NAREIT) in Washington, D.C.
May also marked a rally in the REIT market "as a result of the rally in the Treasury market, due to the drop in interest rates as well as the rally in the overall equity markets," says Keith Locker, associate director at Bear Stearns, New York. "Depending on what index you look at, REITs were up 3% to 5% in May," he says.
But Taylor says the market may still be underestimating the growth rate of a lot of REITs, falsely thinking that without acquisitions, these companies cannot grow. But he says he believes growth rates may be closer to 10% to 12% than 5% to 7%, and that this should start showing up later this year.
"REIT stocks have not reflected what is happening to the underlying real estate assets," says Ader. "Asset values have picked up, but that is not reflected in terms of current cash returns," he says, mentioning that there are tighter markets with no overbuilding. "What happens when the next cycle starts remains to be seen, but in the short term -- two to three years -- it should be interesting, as REITs are now trading at only 40% to 50% of book value, and appreciation is not reflected. Real estate has never been a good stock market vehicle because people don't understand it, and it isn't earnings driven," Ader says.
That is one of two major problems for REITs, Decker says. The industry is fighting a leftover ignorance on the part of many potential investors who Decker says don't seem to know what REITs are and base their thinking on their memories of the 1970s.
"They don't know why today's industry is different. It is not a '70s crash waiting to take place. These are very different companies," he says. The difference is that real estate "is a much less swashbuckling, entrepreneurial operation" than it was from the 1950s through the 1970s. Instead of the adage "location, location, location," Decker says, the value of today's real estate is rightfully based on "management, management, management." And REITs have what Decker says are some of "the best and the brightest" management teams in the real estate industry, with others sure to follow. He mentioned that some C corporations, such as Rouse, may convert to REIT status as well as some strong public companies that first have to burn off losses.
A second problem Decker says he sees is that the REIT industry has in the last two years outgrown its investors, and "needs a broader, deeper investor base that includes both domestic and to some degree foreign pension funds as well as financial planners and other retailwho sell REITs to individual investors who are looking to diversify their portfolios. But those intermediaries are still in the dark about this industry, and we are trying to educate them and take the mystery out of the REIT."
The fundamental "deep sea change in the fabric of the REIT industry" is that it now includes "the best and the brightest," he says, mentioning top names like Simon, Taubman, Carr, DeBartolo and Walstein. The scions of these old line real estate families are leading their firms into a new world where real estate is more institutionalized and less transaction oriented. "They are operating companies who are operating a portfolio, which is good for both real estate and investors," Decker says. "There is no question that real estate is the greatest wealth-producing asset in this country, and the small investor now has the chance to participate in it."
REITs went through 35 years of trial and error and "sputtered and stubbed their toe along the way," Decker says. But they've survived and are now seasoned. The maturity is evident in "market valuation and liquidity in the public sector."
David Murdoch, Nomura Securities International Inc. vice president for whole loan trading, predicts an increasing amount of real estate in the U.S. will be owned by REITs. Murdoch says the growth is due to capital markets afforded by the REIT structure which provides a competitive advantage over many private forms of ownership. "I expect there to be more IPOs this year," Murdoch says, "but I believe the long-term trend will be more toward consolidation within the industry to fewer but much larger REITs rather than growth by increasing the number of companies."
Heavy REITs refinancing predicted
Murdoch says the markets have shown a preference for larger companies with deep management teams and that many of the smaller REITs will be forced to merge in order to gain access to capital.
While no one reports that they expect many new REIT issues in the near future, refinancing, however, should be booming. Schechner says he expects "a huge amount of REIT refinancing. Now is the time to do it, as interest rates have dropped down to a great level for borrowers."
Ron Wexler, executive managing director of Fitch Investors, is optimistic about company business for the immediate future. "Our volume is about the same as it was last year," Wexler says, "We're looking forward to a busy second half."
Stephen Wang, managing director for Caruso Affiliated Holdings, believes REITs are going to be around for a while. "REITs are going to continue to be a viable exit strategy for holders of large amounts of property as long as the private market is mispriced," he says.
However, Orefice disagrees with the prospect of a rosy REITs future. "Although supported by stronger real estate market economics, we believe that new REITs will have difficulty attracting investor financial support as a result of poor stock price performances of existing REITs," he says.
Nomura currently has several fixed rate REIT financings in process due to the recent drop in interest rates, Murdoch says. "Lower long-term interest rates in conjunction with short-term rates staying high have created an environment where REITs can replace floating-rate debt with fixed-rate debt with little or no cost in terms of FFO," he says. "Since the analyst community has been highly critical of floating-rate debt, replacing floating-rate debt with long-term fixed rate debt should have a positive impact on the REITs' stock price."
Locker says, "Given the rally in the Treasury market, a number of REITs will focus on refinancing floating-rate bank lines and lock in attractive fixed-rate capital in the form of senior unsecured debt, secured mortgage financing as well as medium-term note programs."
Locker mentions three other trends that Bear Stearns expects to see through the end of 1995. One is "a continuance of secondary or follow-on equity offerings for REITs with strong earnings and justified use of funds." He says that $1.7 billion has been raised in secondary offerings from January to early June.
A second happening is "a continuation and increase in merger and acquisition activity, primarily private to public transactions, whereby medium and largesized private companies will be merged into existing REITs." The third trend is a continuation of "increased interest in REITs by the pension fund and real estate advisory community in the form of both private placements and open market buying," he says, adding that "interest from offshore accounts, including Europe and the Middle East, should continue, yet at a moderate pace."
This year "is just the beginning of a participation from the pension fund segment for the next three to five years," Prudential's Taylor says, adding that securitized equity product gives pension funds diversification and liquidity advantages.
Decker says that the 25,000 small pension funds that are not currently investing in real estate now have "a liquid option," adding that major strides have been made in educating the pension fund community to view real estate like any other industry sector rather than as a separate asset class -- a view that traditionally had been spoon-fed to pension funds to attract their capital, he says.
"I think barriers will fall like the Berlin Wall in the next few years," Decker says, referring to retraining the thinking of pension funds and financial planners who think REITs are just repeats of tired old partnerships. Taylor, too, says that REITs should become "a normal part of the normal equity markets."
"There are still a lot of myths and erroneous perceptions about the REIT industry. But with all of our warts, there are so many positive things that it is hard not to be optimistic," Decker says, adding that he expects REITs to eventually increase their market share from the current 2% level of real estate equity to up to 20% to 25%.
"It is still a very young industry in the early stages of a long-term growth cycle, always with up-and-down equity market cycles and up-and-down real estate cycles," Decker says. "But you can't paint a picture where this industry cannot grow and be a bigger player. In comparison to other industries, real estate has stayed behind in terms of the public market. It is one of the last frontiers."
Conduits hit $2.2 billion in 1994 and they are expected to be a major growth area of CMBS throughout 1995. Now that they have learned what it takes to service, originate and close a loan, conduits have developed different product niches and specializations, says Carl Kane, managing director with E&Y Kenneth Leventhal Real Estate Group, New York.
This follows the big flurry of conduit participants who entered the market about two years ago, many of whom are no longer players. "I think it has weaned a lot. Many conduits failed or couldn't get the necessary mass of loans needed to securitize. The concept of conduits was to create a large enough mass to rate the whole higher than the parts, but collecting the mass was not easy, and the assets involved tended not to be the higher end of product. But that was the whole concept of conduits," says Richard Ader, chairman of U.S. Realty Advisors.
But it appears that those remaining in the conduit market have matured, with specialists working on different property types. They may be a prime source of a growing trend in CMBS -- securitized loans that are backed up by more exotic assets -- property types that have not been the traditional realm of big lenders or have not yet had a totally comfortable fit in the securitization sphere.
"Since major property types are performing well, we have heard a great deal of discussion that profits lie in offbeat property types," says Jonathan Adams, vice president with the Mortgage Research Group at Prudential Securities Inc.
"My guess is that those property types that are not standard will receive the most attention if they connect themselves with one of the more traditional property types, such as multifamilies," he says. In other words, if you can convince a lender or ratings agency that a mobile home park is nothing more than a kind of multifamily situation and back it with statistics, it will help establish a standard, "provide a bridge and comfort level," he says.
Adams says he does not foresee big in surance companies that are looking for regional malls to suddenly start going for mobile home parks. "But conduits and commercial banks, especially smaller banks, probably will open their lines to that type of product much more readily." He cited self-storage facilities as another example. "Are they warehouses? You canmake the case and make the connection."
But some property types don't fit into anybody's cookie cutter, just as raw land and new construction are not things that easily fit into the existing categories for securitization. "Exotic property types will get soaked into generic mold or either be ignored," Adams says.
Adams says it is a given that new construction lending will return, and that banks will be a part of it. "The question is whether ratings agencies can get comfortable lending for new construction and securitizing that type of loan. This should be an interesting development over the next two years. Can you securitize new construction? If the answer is yes, it will be a more exciting twist on the existing market," he says.