FEATURE ARTICLE, AUGUST 2008

REAL ESTATE INVESTORS TURN TO TRADITIONAL BANKS FOR FINANCING
Matt Duckett

The commercial mortgage-backed securities market came to a screeching halt in early 2008, forcing real estate investors to scramble for alternative financing sources. The disappearance of CMBS vehicles, which had dominated the market in recent years, left borrowers with three financing options: life insurance companies, traditional banks, and agencies such as Fannie Mae and Freddie Mac, which focus on multifamily financing.

In the first quarter of 2008, CMBS originations were down 95 percent compared to the volume of deals closed in the fourth quarter of 2007. During the same time period, loan originations through  traditional banks were down 56 percent, and financing provided by life insurance companies had fallen by 27 percent.

Buyers are seeking ways to compensate for the lack of financing options. Life insurance companies only finance a certain amount of product each year, and many of them have already completed their allocations for the year. The insurers that are still issuing debt are cherry picking the best deals with terms that are not overly competitive.

A select few of the big Wall Street banks are offering on-balance sheet financing to key clients with the assumption that the CMBS market will reopen for business sometime in the near future. They hope to take the loans they are originating now and refinance those loans in the CMBS market when it returns. Most of the loans being originated by the big banks are 3- to 5-year term loans with some including interest-only terms.

Many buyers and investors have turned to traditional banks for financing. Some banks are actively lending, some are not providing any debt at all, and others are in and out of the market.

The traditional banks that are offering financing are being inundated with loan applications. At the same time, federal regulators are examining the banks, carefully scrutinizing all of the loans on their books. Many banks have no choice but to take write-downs on bad loans and shrink their balance sheets. Others are trying to raise more capital to offset the bad loans and issue new ones. The banks actively lending, however, are demanding more from their borrowers than they did just a few months ago.

One of the many attractive features of CMBS financing was that it offered borrowers non-recourse debt. Under the CMBS structure, the loan was secured by the real estate, but the loan issuer could not go after the borrower for repayment in the event that the borrower defaulted, with the exception of intentional bad acts by the borrower.

Not surprisingly, traditional banks are balking at providing non-recourse debt. Many of them are requiring at least some recourse — typically ranging from 35 percent recourse to full recourse. This can be a serious issue for buyers and investors, depending upon how the equity portion of the transaction was structured.

Given the structure of the deals DBSI completes and the due diligence it performs, the company has not asked investors to provide recourse. DBSI takes on the burden itself as the majority of its 1031 exchange deals are sold with a master lease. The company is already responsible for the management and operation of the property, so DBSI is willing to take the recourse position.

Many tenant-in-common investors are unwilling to agree to financing that includes recourse. Each TIC investor owns a separate and distinct share of the property and, in many cases, does not interact with other investors in a meaningful manner. With some TIC properties having as many as 35 co-owners, individual TIC co-owners are often not comfortable signing for recourse debt with other investors they do not know. The sponsors selling these transactions are being forced to consider taking on the recourse debt themselves, even though they are selling the property.

When the CMBS market was in full swing, borrowers were able to originate long-term (up to 10 years), interest-only debt. Now that banks are originating shorter-term loans with required amortization, equity returns have been squeezed. Real estate sellers are slower to adjust pricing than are the capital markets. Cap rates are rising at a slower pace than the cost debt funds are increasing, which results in a lower equity yield to the investors.

Real estate prices are also declining, which results in cap rates increasing. This trend has caused potential sellers that do not have to dispose of their real estate to reconsider selling in the current market. Some owners must sell, due to maturing loans and the inability to obtain sufficient loan proceeds to refinance.

Buyers and investors that are completing 1031 exchanges must find a replacement property within 45 days of selling their property or they will be required to pay capital gains taxes. Depending upon their tax basis in the relinquished property and the tax consequences of not completing an exchange, many investors are accepting recourse debt and current market debt terms when faced with paying the taxes as the alternative. With many potential exchangers sitting on their current real estate investments, the number of 1031 exchanges being completed is significantly reduced compared to the volume of deals closed in 2007.

It will take some time for the turmoil within the financial markets to quiet, but things will eventually settle down. Financing is still available, albeit more expensive and more difficult to obtain. Nonetheless, profitable deals are still being completed by Spectrus and many other companies. Real estate runs in cycles and many players are waiting to see more stability before diving back into the markets.

Matt Duckett is a vice president of Finance at DBSI, which currently manages a property portfolio valued at some $2.65 billion. DBSI comprises several companies dedicated to locating, acquiring, developing, leasing, and managing institutional-grade real estate throughout the nation.

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