COVER STORY, JANUARY/FEBRUARY 2011

DEBT, EQUITY & OPPORTUNITY
Perspectives on lending and investing.
By Jaime Lackey

As property fundamentals show signs of improvement and the commercial real estate markets see movement, everyone is looking for the advantage — and many are looking for financing. What do lenders foresee for 2011 and where are the opportunities for investors? Northeast Real Estate Business asked John Cannon, executive vice president – head of conventional and GSE loan originations with Horsham, Pennsylvania-based Berkadia Commercial Mortgage; Spencer Levy, senior managing director, with the Baltimore office of CB Richard Ellis; Brian Stoffers, president of CBRE Capital Markets and based in Houston; Lawrence Kestin, founding partner and managing principal of Glenmont Capital Management, a New York City-based institutional private equity firm; and Spencer Garfield, managing director of Hudson Realty Capital LLC, a New York City-based real estate fund manager.

NREB: From a debt perspective, what can we expect from 2011?

Garfield: There will be a tremendous pick-up in debt investing this year, especially discounted debt, which is expected to be sold at more “distressed” pricing. As the economy stabilizes — and, in some secondary markets, recovers — there will be many opportunities to finance borrowers seeking to buy back their own debt at a discount, as well as those seeking to add additional value to their assets. 

Cannon: We expect more debt providers to enter the market in 2011, notably the reemergence of CMBS lenders and insurance companies as players in the fixed-rate, permanent segment. The GSEs [government-sponsored enterprises] and HUD [U.S. Department of Housing and Urban Development] should maintain volume, but are likely to lose some market share as new players compete for multifamily assets.

Kestin: CMBS origination volume for cash-flowing assets with stable operating history will continue to improve, albeit at lower loan-to-value ratios than those seen during the market peak. In addition, insurance companies will continue to ease lending restrictions and will become more competitive with the agencies. High-cost mezzanine financing with equity-like terms will continue to be available in the market for distressed acquisitions, though in most cases, this type of leverage is cost-prohibitive and carries a high risk of default.

Levy and Stoffers: Risk tolerance will increase on the part of lenders; however, conservative foundation of underwriting still prevails. The Fed is choosing to keep long-term rates low through a second round of quantitative easing, which may provide a great opportunity for borrowers who are about to make acquisitions or reset deal capital structures to lock-in low mortgage rates. Without doubt, monetary policy continues to support historically low rates, especially over the short-term. Eventually, as Treasury rates rise over the longer term, an assumable, below-market rate mortgage may provide its own value in addition to the value of the real estate being acquired.

NREB: From an equity perspective, what will we see in 2011?

Garfield: Equity investing will [significantly increase] over last year as the focus shifts from Class A properties in top-tier markets outward to different asset classes in the middle market. Albeit prudent, there will be a significant increase in activity, especially on the retail and hospitality side. Projections indicate this year’s equity investing levels should be similar to that of 2003 and 2004.

Kestin: We believe that, in the short term, smaller investment opportunities requiring $15 million or less in equity will be more prevalent in the market as community and regional banks are finally coming to terms with the true value of their distressed loans.

NREB: What are your predictions for CMBS loans?

Levy and Stoffers: The Federal Reserve has re-capitalized the largest banks and deployed leverage facilities such as the Term Asset-Backed Securities Loan Facility (TALF) in order to jumpstart lending in the asset-backed and CMBS markets. Also a good sign, Fitch has scaled back its previous prediction that delinquencies on CMBS would peak at 12 percent in 2012, scaling it back to suggest it won't rise above 10 percent. Currently, CMBS delinquencies are at 8.23 percent, near their high water mark of 8.66 percent in September.

Some of the decrease in delinquencies was due to a large increase in the number of legacy CMBS loans that were modified ("worked out") or sold as notes by the bank and special servicing community. We would expect the trend of workouts and note sales to continue which will impact the overall legacy CMBS delinquency rate.

Garfield: As trade volume increases, and lenders dispense more capital, the market will have greater clarity in valuation. Emerging, new firms are expected to enter the market, bringing even more capital to drive the rise in transactions. Subscribing to a disciplined approach, lenders will expand from larger "trophy" assets to smaller, balance sheet loans to close the lending gap in B and C markets, where financing was non-existent in 2009 and 2010.

Kestin: While CMBS origination will increase, loan-to-value thresholds will not reach prior peak levels. Lower valuations combined with lower loan-to-value thresholds will leave a gap in the capital stack, thereby increasing repayment defaults. “Extend and pretend” will continue for cash-flowing assets. For non-cash-flowing assets, owners will continue to walk and receivers will remain busy.

NREB: Where are the opportunities in 2011?

Cannon: For suppliers of debt, the 2011 “vintage” is likely to be pretty good — with solid LTVs, DSCRs and real cash equity in transactions. Property fundamentals will likely make debt metrics on this vintage improve over time. That said, spreads will decrease as more debt providers re-enter the market.

Kestin: We expect that distressed investment opportunities will continue to be prevalent in 2011, especially in the hospitality space as construction loans mature and borrowers are unable to refinance. Investors with the ability to acquire notes on an all-cash basis will continue to see opportunities, specifically in the middle market as community and regional banks come to terms with reality and sell distressed notes at true market prices rather than completing the foreclosure process or taking title to properties through a deed in lieu of foreclosure. Debt markets are slowly returning, though the market for financing non-cash flowing assets is virtually non-existent with the exception of high-cost/high-risk of default mezzanine money where you may see 15 percent-plus interest rates. Finally, as operating performance of assets begins to stabilize, all-cash buyers will have the opportunity to leverage their previous investments and re-deploy equity capital into new opportunities.

Levy and Stoffers: Many capital markets participants appear increasingly optimistic that the flow of asset sales and dispositions will improve as 2011 unfolds. Liquidity spurred from new life company and CMBS appetites will continue to drive cap rates down for the highest quality assets.

In 2010, investment property sales were expected to surpass $100 billion, close to double the amount recorded in 2009, according to Real Capital Analytics. With sales momentum gaining pace in recent months along with increasing signs that property fundamentals have bottomed, it is likely that prospects for sales and financing demand will continue to trend higher in 2011.

In addition to traditional equity sales, 2010 also saw a tremendous rise in the number of note sales from the bank and special servicing communities. We expect this trend to continue as demand for notes (both large institutional quality properties and large pools) materially outstrips supply.

However, capital market participants must recognize that the basics of economic growth (GDP, unemployment, etc.) remain sluggish and the risks of capital market volatility and disruptions (such as those emanating from emerging European economies) will continue to remain high, at least over the near term.

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