Accessing Capital for Commercial Real Estate is Difficult in the New Normal
Todd M. Yates
With the nation’s banks sitting on between $1.2 and $1.3 billion worth of capital, they are nevertheless reluctant to lend on commercial real estate because of the elevated level of risk and current valuations of properties already on their books. Many banks own portfolios of commercial real estate whose valuations have declined significantly and do not want to increase their exposure.
Currently, banks are under pressure to de-leverage and raise their book capital ratios to assure that they have adequate liquidity to cover losses. This is critical because they are carrying approximately $1.6 trillion in loan balances on commercial real estate. This is 14 percent lower than the 2008 peak, which indicates that banks are writing down and selling loans and not lending as much as they did previously.
As long as banks are risk averse, the capital markets will not function at a pace considered to be anywhere near normal. Typically, banks account for half of all lending; CMBS falls between 25 and 30 percent; and insurance companies, Fannie Mae and Freddie Mac combined contribute just 10 percent.
Extremely limited capital is available at present to finance speculative construction or significant land acquisitions. If a project has credit-worthy users and attractive lease terms, capital may be available. Even in these situations, developers might have to submit their proposed plans to upwards of 30 banks before finding a source willing to provide financing. Interest rates are still attractive, but they vary depending on the deal and are likely to be in the 6.5 percent to 7.3 percent range. A 25-year term with a balloon in five years is typical. In some instances, developers may be asked for a personal guarantee. Construction loans are perceived as the riskiest and hardest to attain, experiencing a 60 percent drop in originations since 2008.
Some capital is flowing and is centered on gateway markets like New York City and Washington, D.C. Both markets are experiencing price inflation and cap rate compression, especially for core assets.
One of the challenges is that appraisals are difficult due to minimal deal activity in the investment markets. There is a strong focus on cap rates as the leading value indicator. A strong perspective of replacement cost impact is advisable in case the income approach utilizing cap rates is too low. Loan-to-value ratios of 60 percent are likely to be the norm for the foreseeable future.
The Status of CMBS
Historically, refinancing commercial properties has been accomplished through CMBS. Because this market currently totals only approximately $40 billion, a significant source of that refinancing has disappeared. Compare that to 2008, when CMBS transactions totaled $300 billion. It’s unlikely that CMBS will ever return to the historic high levels it attained between 2000 and 2008.
Thanks to the fall-out of the CMBS market, there is virtually no permanent mortgage market in place. Banks are offering a net term of five-to-10-year debt with the condition that they are able to resell it on the CMBS market. The alternative is hard money lenders who typically are at very low loan-to-value ratios.
It should be noted that CMBS is showing some signs of life and is likely to recover slightly during 2011. Markets are active; lenders and investors are showing renewed interest; owners are willing to deal to close transactions. CMBS issuance reached $11.6 billion in 2010 after a scant $3.1 billion in 2009, according to the weekly newsletter Commercial Mortgage Alert.
What About Equity?
Generally speaking, equity is taking a hit because this is where the initial losses occurred. Transactions with severe equity gaps are not closing. Upper levels of the capital stack — equity, mezzanine debt or participating debt — are being written down. The equity gap is what is fostering much of the delay and the willingness to “kick the can down the road” rather than deal with current valuation vs. the original capital stack valuation.
Several billion-dollar deals recently have made commercial real estate developers and owners more optimistic about the investment market. The FTSE NAREIT (National Association of Real Estate Investment Trusts) reported returns of 27.43 percent in 2009 and 27.58 percent in 2010. Wall Street’s consensus is that commercial real estate values will grow from five to 15 percent this year. Minimal demand for space has cut new construction, giving current buildings the opportunity to recoup some of the value they lost.
The Role of Institutional Investors
Institutional investors have cut back severely on their allocations for commercial real estate. Still, some are aggressively pursuing Class A assets and are able to obtain financing to purchase trophy buildings in top-tier markets. Risk-tolerance is relatively low for these assets, which makes them all the more popular.
On the other side, non-performing and non-stabilized assets in secondary markets are still considered challenging in terms of liquidity for financing and the risk-return matrix for investors. As a result, capital avoids those properties.
— As Senior Vice President of National Development and General Manager of the Southeast Regional office for The Alter Group,Todd Yates directs all build-to-suit and development activities throughout the Southeastern United States. He is also responsible for business development and the coordination of real estate services for corporate clients throughout the country. He has been directly involved in the development of more than 53 office, office, service and industrial buildings totaling more than 3,000,000 SF with a value of over $500,000,000.