The New Normal in Commercial Real Estate Finance
From a transactional standpoint, each of the past few years has had a palpable feel, both along the way and in hindsight. If 2007 was “the top of the world,” 2008 was evenly divided between “the precipice” and “the abyss.” And 2009 was “the year when nothing happened.”
Last year had more of a transitional feel, with pockets of activity, especially in the second half. However, there were as many false starts as closings, when the skittishness of 2009 reared its head at inopportune moments, often causing deals to fall apart because one participant (whether buyer or seller, investor or lender, loan officer or committee member) got cold feet.
In 2011, we find ourselves in a very different-and welcome-atmosphere. Markets are active; lenders and investors have plans to execute and allocations to fill; CMBS has returned. The question of the day is finally, as it should be, how best to secure assignments on the deals that will close.
From this early vantage point, 2011 appears to be the year in which we have reached “the new normal.” Lenders, investors, buyers, sellers, tenants and landlords have been active for several quarters, and have seen what it takes to get deals done in this new and getting-braver world. Some paradigms and conventions are gone; others never disappeared; and still others have made a quicker-than-expected return.
The reign of fundamentals has been re-established, and yet new interpretations of how to read the fundamentals are appearing from unexpected sources. The portfolio manager of a stalwart domestic institutional owner-investor recently explained the evolution in how his company has been approaching its large equity investments. During the years leading up to 2008, and at the end of a period of consistently positive returns, the company’s investment officers were instructed to seek opportunistic deals, in order to generate larger returns.
Once the credit crisis hit, this financially secure institution anticipated the beginning of a “few-times-in-a-century” opportunity to purchase core assets at inflated cap rates. They planned for a significant accumulation of trophy properties leading eventually to years of outsize returns as a result of programmatic selling at a future point when cap rates had compressed back down to previous norms.
However, the combination of a dearth of assets for sale in 2009 and early 2010, followed by very aggressive pricing for the short list of stabilized/trophy properties that did sell in mid-to-late 2010, prevented this institution from executing its plan. No surprise there.
What is of great interest, however, is how this experience has shaped their plan for 2011. They have capitulated with regard to cap rates-in order to buy in 2011, they realize they will have to pay historically low-to-normal cap rates, and they are prepared to do so. The real shift in thinking is that rather than hoping for capital appreciation through supply-driven cap-rate compression going forward, they are instead looking for properties and markets where they believe that rents remain at depressed levels, and so the focus of their strategy is income growth through rent appreciation.
For an insurance company with hundreds of millions of dollars of annual income that must be invested at yields that match or exceed its long-term obligations, it is necessary to put the money out and to generate sufficient long-term yield. The question is not whether to invest, but rather how to determine the most rational strategy to use in deploying the capital.
In a separate recent conversation with an investment officer for a U.S.-based private-equity fund handling money for Middle Eastern corporations and family offices, the dilemma was the same, but the resulting strategy is different. For this group, capital preservation is the primary objective-they’ve been making huge profits in their own businesses, and just want to get funds into a secure region at a yield that is likely to outpace inflation. If income growth and positive absolute yield can be achieved as well, that will be gravy. Not surprisingly, this group is primarily seeking to acquire single-tenant office properties leased either to U.S. government entities or high investment-grade corporate tenants.
On the debt front, mortgage rates remain extremely low from an historic standpoint, despite a significant rise in treasury yields since last summer’s lows. A wide variety of players have filled the market with attractive financing. Ultra-low leverage deals (under 40 percent LTV) can find spreads that have dropped almost into double digits; more normal low-to-moderate leverage deals (40 to 60 percent LTV) are getting done well below 200 over treasuries; and a significant number of new and reputable sources are entering the market offering solutions for higher LTV needs (up to 80 percent), albeit at considerably higher yields.
All in all, 2011 is shaping up as the year in which we all got back to the business of finding deals and executing them. It’s a welcome change.
Scott A. Singer is principal of the Singer & Bassuk Organization, LLC, and a member of REBNY’s Finance Committee.