COVER STORY, APRIL 2004

Real Estate Capital Market Trends in the Southeast
Lending in interesting times — a blessing or a curse?
Philip Carroll

May you live in interesting times, or so the saying goes. Today’s commercial real estate lenders couldn’t ask for a more rapidly evolving market — but it is up to each organization to decide if interesting times are a blessing or a curse. A business model that offers borrowers a steady hand in changing times can tip the scales.

It’s no secret that with venture capital and publicly traded securities on shaky ground, investment bankers have flocked in droves to the commercial real estate arena. When these new capital sources moved to take advantage of attractive borrowing rates and reduced costs of capital, competition for investment properties increased virtually across the board. The current environment has also produced new and unexpected changes, not just in the volume of business, but in the ways that lenders and borrowers conduct business. The effects of these trends will take years to unfold.

Interesting New Players

Where there once existed a well-known subset of investors interested in commercial real estate transactions, a wide range of players are now finding safe haven for their capital, and sharing financial risk, through increased interests in this sector. But these new investors should be aware that although commercial real estate is living up to its reputation as a stable investment choice, the current state of real estate capital markets has moved away from equilibrium. Furthermore, investors should be aware that real estate investments require careful timing and selection, and are intensive to underwrite and expensive to acquire and manage.

Currently, while market conditions remain soft for certain property types, such as office, sales prices remain relatively steady and higher than might otherwise be expected. This seems to go against traditional market fundamentals, where the outlook for reduced tenant demand would lead to lower property values. However, in this type of environment, it becomes difficult to rationalize value without considering the relative availability of investment properties to the availability of inexpensive investment capital. In short, sellers are able to command higher prices for their properties, due to reduced borrowing costs in this low interest rate environment.

Sophisticated Transaction Structures

The onslaught of capital channeled through the investment banking world has connected with more traditional real estate investors, and sophisticated financial solutions from the world of corporate finance have become standard options for financing real estate transactions. This has led to increasingly complex transaction structures involving both investment equity and project debt, where acceptable returns on investment can be generated from previously marginal opportunities.

Mortgage banking products have also become more complex, creative and competitive thanks to this new environment. Loans are intensely shopped in a highly competitive environment, where a few basis points in pricing can be a deal-breaker. As sophisticated solutions become the norm, borrowers are also becoming more educated about the options available. As an example, KeyBank recently closed a loan in north Florida for the acquisition and conversion of an apartment project into a condominium community. The high acquisition price made it difficult to provide sufficient senior debt to meet the client’s needs, so KeyBank brought in its “in-house” mezzanine debt group to bridge the capital needs gap, until unit sales provided support for a higher senior debt piece. The senior debt had flexibility to increase and take out the mezzanine when the market proved the project was viable. This provided the client access to a sophisticated financing structure typically available only to institutional-sized developers.

Attractive Borrowing Rates Enhancing ROI

Exceptionally low senior debt borrowing rates in recent years have facilitated positive leverage, where the cost of debt is less than the capitalization rate of the asset being financed. This enhances the leveraged return on investment and, at the same time, facilitates a higher loan advance rate. However, lenders have recognized current market conditions facilitate higher leverage, because of higher valuations, and have kept matters in check by focusing on cash flow underwriting and debt coverage ratios. After all, it is cash flow that covers the monthly mortgage rather than liquidation value.

This positive leverage situation has likely contributed downward pressure on capitalization rates as arbitrage opportunities are exploited and the market becomes more efficient by pricing in such arbitrage into asset values. In other words, buyers will continue to use arbitrage in the market by pushing cap rates down to the level equal to their cost of capital, and a financing benefit will remain until such parity is reached. These fundamentals will ebb and flow with the changing interest rate environment, which has brought good fortune to many real estate investors through predictable short-term interest rates in recent years. The disciplined borrower will be sensitive to match borrowing strategy (floating versus fixed-rate and loan term) to asset strategy (short-term sale versus long-term hold) or risk being on the wrong end of the rate and leverage hammers when the market shifts. It can happen quickly, and it will be too late once rates start moving.

Lack of Equilibrium

Equity and mezzanine money providers have proliferated in the last few years. The growth of market players has been primarily through large institutions. The resulting onslaught of investment capital, coupled with inexpensive senior debt and a deal-deprived environment, has created intense competition among capital providers as well as property buyers. In this scenario, the true winners have been property sellers. This environment has facilitated financially engineered returns on investment that would not otherwise be achievable in a capital market operating closer to equilibrium.

One way to explain this state of the market is that the influx of capital has chased capitalization rates down, and at the same time, compressed yields. The market is arbitrating any remaining incremental profit out of each deal through financial engineering, and the fulcrum to this see-saw is the cost of capital. It is noteworthy that the group most insulated from these unstable property markets is developers. Because they create value through entitlements and asset creation — rather than arbitrating pricing and yield inefficiencies — they are best positioned to ride out market shifts.

The hangover of highly tiered capital structures involving multiple third-party capital providers is a highly complex workout situation should a deal go wrong. To avoid the pain later, the capital providers and property owners should figure out up-front where the chairs will rest when the music stops. Borrowers should keep in mind that longer timeframes are now required to assemble and execute capital components, and exit strategies from complex transactions tend to be more complicated. For example, a typical mortgage closing averages 60 to 75 days to close. When a more sophisticated solution, such as an inter-creditor agreement, is put into place, finalizing the transaction can take 30 to 45 days longer, although the results can be well worth the time.

Tapping into the Capital Stream

The proliferation of capital has been facilitated by a broadened array of sophisticated financial services that have gone mainstream, where even the local boutique developer or private investor has easy access to sophisticated real estate financial services. This has happened because capital sources such as institutional investors and investment banks have chased the client base downstream in search of higher returns and stronger deal flow. For example, investors that would once make a single investment in a multifamily property with more than 200 units are now attracted to multiple investments in properties in the 50-unit range. While the investors lose the economies of scale, there are more opportunities in the smaller deal range now that so much capital is chasing the larger deals. By taking advantage of the smaller deals, these investors realize the higher returns that are possible in this market.

For lenders, this trend means that it is becoming tough to justify one-off deals when competitive forces are compressing yields on capital. It is now crucial for lenders to establish long-term relationships with development partners and real estate investors who will bring repeat business over time.

Currently, low cap rates and decreased return on investment expectations reflect today’s short-term interest rates. That makes sense for real estate investors planning to hold assets for 1 to 3 years, which many are. Market behavior strongly suggests properties are being held on a speculative basis. The relevant benchmark is long-term rates, which are more in line with typical investor hold periods. Currently, long-term rates would suggest that certain property classes, such as multifamily, are overpriced.

Re-inventing Commercial Real Estate Investment Banking

The increased sophistication of transactions is affecting not just individual deals, but also the way financial services are delivered. The real estate investment banking and commercial banking communities are moving toward one-stop, full-service delivery of investment, commercial banking and mortgage banking services. Business models applied by capital sources that can best meet their customers’ full range of needs will ultimately prevail — and savvy banks and other capital sources are assessing their service delivery methods. In the next 5 years, the lending world will undergo an evolution as institutions re-invent themselves to remain competitive and profitable.

These trends are some of the many effects of the multitude of influences acting on the world of commercial real estate finance in today’s unpredictable business environment. Only time will tell the lasting effects of these trends. However, it is safe to say that as the market fluctuates and eventually returns to a state of equilibrium, the ways that capital changes hands during these ‘interesting times’ will have evolved into a new and more complex set of norms, to be followed even when the market returns to a more stable environment.

Philip Carroll is executive vice president and Southeast regional manager with KeyBank Real Estate Capital.

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