FEATURE ARTICLE, JULY 2007

UNSTABLE ASSETS ATTRACT INVESTMENT DOLLARS
Competitiveness of commercial conduit market fuels trend of increasing investment dollars into unstable assets.
Andrew Weiss

With the abundance of capital in today’s real estate investment market, the Mid-Atlantic region – along with other areas around the country – is seeing an increasing amount of investment flowing into so-called unstable assets.

What are unstable assets? These can be assets that have vacancies or assets that present lease rollover opportunities, presenting the property with the potential to be redeveloped or upgraded. The asset may also have space that could be re-leased at higher rents. Unstable assets can be found in all major property types including retail, multifamily and office. For example, national research and consulting firm Real Capital Analytics, Inc., defines a multifamily property as unstable if it has more than 12 percent vacancy, or if it requires major capital improvements at the time it is purchased. The owner will make investments to improve an unstable property. Then he or she will soon be able to attract higher rents and generate greater revenues.

During the past 18 months – in the Mid-Atlantic and across the nation – more unstable deals are being closed, many on a fixed-rate basis. To a considerable degree, this trend is being fueled by the competitiveness of Wall Street conduit lenders, and by competition among those lenders to put money out. A decline in capitalization rates on core assets is also contributing to the appeal of unstable investments. Eighteen months ago, LIBOR was lower; and the commercial conduit market was not as aggressive as it is today. In that environment, there was less advantage to locking in long-term deals priced at a spread over treasuries

Investors seeking to acquire an unstable asset can reap advantages by financing the transaction with longer-term, fixed-rate debt. This approach allows the investor to avoid interest rate risk as 3 to 5 years from now a floating rate loan could very well carry a higher interest rate. Choosing fixed-rate debt also improves the owner’s cash flow.

In the latter part of last year, Meridian Capital Group raised debt and equity for the purchase of an aging multifamily complex in the Washington, D.C., area. The garden apartment community consisted of more than 500 units situated on several dozen acres of property. Built in the mid-1960s, the site is comprised of numerous three- and four-story buildings with a total net rentable area in the 425,000-square-foot range. The purchaser plans to make multiple property improvements – including the renovation of unit interiors and numerous exterior and common area improvements such as the construction of a clubhouse/community center.

The transaction involved institutional joint venture equity, along with first mortgage acquisition financing, for a total of $55.9 million. The net purchase price amounted to $46 million. The first mortgage lender funded 80 percent of cost – at an 88 percent loan-to-value ratio – plus 100 percent of the future capital improvements. The loan was priced at LIBOR plus 105 – with a point in and a point out – over a 36-month term, with an interest reserve for shortfalls. The debt figure was $46 million, with $10 million in equity, of which the investor funded $9 million.

Thus, the client invested in only $1 million on a $55.9 million deal, resulting in 98 percent of the capital coming from other sources. The equity portion came in with a low teens percent preferred return – with various splits – to reach a 60/40 split of the profit. In addition, the developer will be paid a property management fee, as well as a construction management fee. It is safe to say that this garden apartment complex transaction reflects the ultimate in high leverage, with a developer that was obliged to put in only 2 percent of capital on a $55.9 million project.

Late last year, an approximately 250,000-square-foot office building was closed on in the greater Washington D.C. region. The property had been leased to a single, primary tenant whose lease was scheduled to rollover within the next 12 months. The deal was closed with a fixed-rate loan in spite of the imminent rollover. The lender funded 90 percent of cost at acquisition. In addition, the lender agreed to fund 100 percent of the cost of tenant improvements and leasing commissions that might be needed in the future, considering the forthcoming rollover.

In this case, the client would be buying an asset at well below replacement cost. In these circumstances, it is important to emphasize that the transaction featured an attractive acquisition price per foot. These circumstances also made it useful to take steps to stimulate a market for this property. This required knowing what kind of lender would find this type of deal appealing. For example, a long-term fixed-rate conduit would not be attracted to this kind of transaction.

Taking a selective approach, the transaction was marketed to a reasonable list of qualified lenders. It was determined that this particular structure would appeal best to a balance sheet lender. When the transaction ultimately concluded, the spread stood at LIBOR plus 125 – along with an origination fee and an exit fee, depending on when the borrower paid off the loan. Going in, debt service coverage was approximately 1.2, and the borrower was required to put in 10 percent equity, or just under $3 million. And the cash flow – after debt service divided by equity – amounted to a cash-on-cash return of approximately 13 percent.

In the Mid-Atlantic region, mortgage intermediaries’ bulk of the volume has been non-core transactions. Today, it is common for investors to gain 80 percent leverage, along with mezzanine debt or joint venture equity to make up the difference. As seen above, borrowers are able to invest as little as 2 percent of their own equity into these deals because mezzanine lenders and equity partners are so eager to step forward and play a role in the transaction.

In today’s market, there is a huge volume of capital looking for a home. Because of this, capital is not likely to evaporate at the first indication of distress. Under these conditions, unstable investments hold a lot of allure. 

Andrew Weiss is a managing director with Meridian Capital Group in Bethesda, Maryland.


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