As the strong US recovery attracts a growing and increasingly diverse crowd of real estate lenders, our panel of debt experts talks to Al Barbarino about strategies for beating the rest of the pack to the best deals. Photography by Lea Rubin
But from a lender’s perspective, that means more competition. With distressed opportunities now few and far between, picking the right deals is the name of the game, a topic three debt experts discussed in Real Estate Capital’s first US roundtable.
One approach is to target transitional properties, a tactic Blackstone senior managing director Mike Nash has used to build up the US private equity giant’s Real Estate Debt Strategies arm.
Jack Taylor, Prudential Real Estate Investors’ US head of real estate finance, is focused on high-yielding mezzanine loans. The business is willing to dip into new territory if the fundamentals behind assets and the broader economy remain strong.
Peter Nicoletti, managing director of JLL’s US capital markets group, offered his perspective as an intermediary between borrowers and lenders.
State of the market
Peter Nicoletti: The sheer amount of liquidity means that borrowers have a lot of options. If you’re a strong sponsor in a strong market, it’s definitely possible to dictate the overall structure of your loan. At the end of the day, the rate is the rate, so it comes down to the underlying structure. That’s where borrowers today are able to press the metrics. The number of players entering the space is so prolific that it’s driving more competition.
Mike Nash: Fundamentals, the economy and unemployment have improved and all the things we analyse to make investment judgments are better. People investing in the industry in the past several years have made money, creating more confidence. The fundamentals support more liquidity and growth. There’s more confidence for borrowers to ask for more in the hope that someone will accommodate them.
Jack Taylor: The fundamental real estate proposition remains very positive. The Federal Reserve has been pumping liquidity into the system and we have a functioning economy: the capital formation here around commercial real estate debt is the result of a functioning economy and greater confidence. It’s a sputtering economy, but compared to the rest of the world, it is a safe haven.
PN: As the US continues to grow, albeit sometimes slowly and ‘sputtering’, you’ll continue to see more liquidity in this market.
Liquidity and confidence return
MN: Confidence is highest in major markets, because they are the most liquid and transparent ones. They are most desirable for national banks, CMBS and speciality finance people like us. There is a less robust story in the middle of the country, but liquidity there has improved as the CMBS market has improved in the past five years.
PN: From a national standpoint there’s very little speculative office construction happening – and specifically, only in certain pockets with significant demand drivers: in northern California, Manhattan and Austin. There’s a built-in lack of supply and that’s where tenants want to be.
But overall liquidity has benefited some of the secondary and tertiary markets. Lenders look for yield and they can achieve that now in some of the mid-US markets, such as Chicago, Kansas City and St. Louis, while Dallas is surging again.
MN: We focus on the bigger markets because it’s higher value real estate, with better equity and debt capital participation and more liquidity. To get higher lending yields in the major markets we tend to focus on transitional assets, which usually have less cashflow in place but have business plans that should increase cashflow over time. We take a little more execution risk, but feel the quality of the real estate, sponsorship and business plan support it.
We’re hesitant to do a lot in suburbia, be it offices or hotels. These markets don’t have diversified demand, rents don’t seem to grow and there’s usually expense inflation, so your cashflow margins as an owner dwindle over time.
Liquidity in these markets comes and goes. It’s hard to rely on one industry or a few companies – and that’s typically what you get in suburbia.
JT: We tend to concentrate on institutional sponsors, high-quality sponsors. I’m asked frequently: ‘Why would people with a lot of capital want to borrow from PREI?’ One answer is because it’s a cheaper form of joint-venture equity. We’re comfortable getting our coupon and then getting our 11% for three or four years. While we’re quite able to foreclose, take over a property and manage it, that’s not the goal.
Wall of refinancings
MN: I don’t perceive the US to be a distressed market. Generally the market is liquid, transparent, functioning, working and pricing well.
You can be wowed with stats about the wall of maturities coming in CMBS through to 2017 [there is a $1trn-plus spike in 10-year loan maturities to come in the next two years]. However, there’s not a lot of interesting real estate in that basket; its mostly $5m-25m loans secured by real estate in secondary and tertiary markets.
CMBS can sometimes act as the lender of last resort, so many loans will prove problematic as the cycle continues to age.
JT: The deep discount play now is only in small markets and some of them are recovering. But away from that, I believe a lot of recapitalisation is coming up for a lot of assets. We’re doing them today and we’ll see more over the next four or five years.
It’s true that there is a lot of uninteresting stuff out of that $1.5trn to $1.8trn maturity wall. However, there’s a lot of interesting product out there that will be able to get refinanced, but it will either be by a bank at only 65% or 70%, at Libor plus 150 basis points or Libor plus 200bps, and then mezzanine capital on top of that, or it will be by stretched first-mortgage leverage.
Point in the cycle
JT: If you compare real estate to the stock market over the past decade, stock market prices have appreciated much, much more. Prime real estate looks scarily high because we’re comparing it to the peak in 2007 in major markets and now we’re back at the peak or above it. But you need to compare it over a longer time frame, say, 10 years; then you see that commercial real estate compounded annual price appreciation is around 4%, before adjusting for inflation.
PN: And from an overall market perspective I think we haven’t seen a peak. Pricing might seem to be on the higher side, but there hasn’t been much growth. People are underwriting rental growth across all product types. That’s a good sign.
MN: We had a false peak in 2007 and you can easily argue that today, values are where they are meant to be. In terms of real estate fundamentals, we are still kind of early in the game in terms of getting to a peak. In terms of price appreciation we might be in the fifth inning or something like that.
It’s hard to be a debt investor because we don’t have upside; our best day is getting our money back. We can’t make up for a bad deal with another good one, as that good deal is capped at par. On the equity side, you can compensate for lower-returning deals with better performance in other deals.
JT: I agree that on the equity side it’s a little bit more like venture capital – you can have five mistakes and two really great successes that offset them. In debt lending, depending on where you are in the capital stack, it’s kind of the reverse: one mistake can really hurt you. But the equity side faces a tougher job in many ways. The price volatility and uncertainty is greater for the equity owners.
PN: If you turn the clock back 18 or 24 months, there was a very shallow pool of potential lenders on large construction financings; it would typically be your commercial banks and they would have to syndicate the deal to multiple parties.
In Manhattan today there are a host of new lenders who will do non-recourse financing on large-scale development such as condominium development.
Liquidity requirements have been reduced from 35-40% to 10-15% and in those cases rates have moved correspondingly down. The ability to borrow in terms of loan-to-cost has increased.
This is because not only do you have the mortgage REITs, private institutions and insurers playing in this sort of non-recourse space, there’s also a large mezzanine component willing to take that piece of the stack above what your normal commercial banks would take.
MN: It’s a good time to be a borrower because lenders are competing more aggressively and offering borrowers favourable pricing, structure or both. That allows borrowers to pay more for property.
There are more people in the game compared with three or four years ago, when very few people could borrow and you had to have a lot of equity to buy real estate. In hindsight, those were the people who did the best deals, because there was less capital and competition, creating a better buying (and lending) environment. As always, it’s a cyclical business in that regard.
However, there’s more equity in the deals that we look at today compared with pre-crisis deals. People are very hesitant to borrow too much. We have that conversation all the time with borrowers. We are actually willing to give them more leverage, but they don’t want to take it.
PN: From an underwriting standpoint, investors are more circumspect about where certain markets are headed and a lot of that is governed by the lending side of the business. There’s still a good series of checks and balances in place.
MN: The syndication market is going at a reasonable clip. In our business we don’t perceive ourselves as syndicators, but we will sell the senior interest in a loan to banks.
We get a better return versus what we could buy from a bank that may be originating on their side to sell the mezzanine to their account base. We can do better for our investors by speaking for the whole loan then selling the senior debt to the market – in a sense taking advantage of the liquidity.
Future outlook and concerns
PN: From a major market global perspective, the US remains fairly cheap, so the influx of foreign capital is strong. From the equity side, in Europe, German bonds are at 1% or 2%; people have got to put their money to work, so they’re coming to the US.
It’s the surprises that will shock the market. If we were sitting here 18 months ago I’m sure the consensus would have been that rates would have gone up by now.
MN: The real estate fundamentals are better than people perceive and it is a good anchor for our lending market. Total returns are a little bit lower because of historically low interest rates, but interestingly, credit spreads are still wider than they were in 2005, 2006 and 2007. As a floating-rate lender, that gets you so far, as a good credit spread attached to effectively zero equals a good credit spread and nothing more.
If conventional wisdom holds, we will get an increase in interest rates at some point, although a big worry remains a dramatic and unexpected rise in rates.
JT: Our market responds to broader market forces and events. David Axelrod [an aide to President Obama] was interviewed after a year in the White House and was asked what it’s like. He said there was always the unexpected. When he and the president were informed that pirates off Somalia had abducted some citizens, he said they looked at each other and said, “Pirates?! When’s the last time you thought about a pirate?”
Rates are likely to rise and that will present some surprises in our little world of debt lenders who are not taking that
into account, but it will also present opportunities.
RETURNS: DIFFERENT ROUTES TO DOUBLE DIGITS
Nash and Taylor have differing approaches on how to maintain double-digit returns.
Mike Nash: We’re striving to still achieve low double-digit gross returns — 12-13%. Our targets haven’t changed today, we just get there in a different way, like originating or creating mezzanine investments, versus buying them from banks or through CMBS.
Our mindset remains capital preservation, current income, risk aversion. We’re conscious that the market has changed and higher yields are harder to achieve. But, on the other hand, we don’t want to be the smartest people to not do a deal, so we try to express our view when we have maximum confidence in the assets or situation.
The real estate markets are relatively easy; you can analyse supply and demand patterns and anticipate how markets are changing, and make credit judgements accordingly. We don’t like to chase the dream and take excessive risk to try and get a higher return. We would rather not disappoint our investors, because the risk of failure in our business is so high in terms of a few bad deals really penalising 28 or 30 other performing deals.
Jack Taylor: On gross investment yield, PREI is in the 11-13% range and maybe trending down to the 10.5-12.5% range. The strategy is to produce a high yield that’s very secure. I would say spreads have come down, so we’ve adjusted our return targets and also taken some more property level investment risk. We’ll expand the investment risk from our very conservative stance because we believe it’s a better lending environment than it was in 2010.
People are surprised when I say that it’s a better market now. But I prefer functioning markets and liquidity in the market. I prefer an economy that’s not on the precipice of disaster. There may be an opportunity to take more investment risk on the underlying business plan — currently about 90% of what we’ve lent on so far in the mezzanine funds has been core properties. Secondly, most of what we’ve done has been current pay, so there may be an opportunity to accept more accrual, as the market is in a better place.
Thirdly, maybe expanding more into second-tier cities away from the top five, into the top 25-30 metropolitan areas. A lot of the opportunity is in second-tier markets.
REGULATION SQUEEZES BANKS
Stricter Basel rules are putting banks under pressure to keep leverage down. Meanwhile, the credit risk retention rule, introduced in October by the Federal Deposit Insurance Corporation and five other federal agencies, compels lenders to hold at least 5% of the securitised debt they package or sell.
Mike Nash: When we have a dialogue with our banks, they have triggers and thresholds that can prompt higher capital charges. Sometimes they can structure the deal in a different way, but mostly it has an impact on their willingness to do certain things.
Jack Taylor: The shadow banking market — CMBS, public and private mortgage REITs, private debt funds — are in for large growth in the next five years, because major banks are under pressure to compete on price, not on leverage. The new risk-retention rules will put a damper on the extent of leverage in the CMBS market as well. It will go a long way in preventing people from buying the junior part of a CMBS issue without any real equity at risk.
MN: I agree. There are limitations being a non-deposit-based lender, but generally our role is to fill the liquidity void created by these institutions that used to compete more aggressively, given the shifting regulatory regime and their current level of risk aversion.
Our limited partners ask this question all the time: “Is this just a three- or four-year thing?” I answer no, as speciality finance companies have existed for decades and we’ll remain relevant as the regulations are implemented.
Nicoletti is executive managing director of JLL Capital Markets. He leads the team responsible for debt and equity financing in New York City, overseeing mortgage origination, equity placement and loan sales. Since 2009, the business has sold, advised on and valued more than $54bn in loan assets globally, and in the US places about $20bn of debt a year.
Taylor is Prudential Real Estate Investors’ outgoing head of US real estate finance. Prudential Mortgage Capital Corporation is a big mortgage lender, while PREI, which operates as Pramerica REI in Europe, invests third-
party capital in high-yield debt in the US and Europe. Andrew Radkiewicz leads the European debt business. Taylor’s new role will be at Pine River Capital.
Nash helped found Blackstone Real Estate Debt Strategies in 2008 and is its senior managing director. Its second fund is investing in the US and Europe. BREDS externally manages US mortgage REIT Blackstone Mortgage Trust and has a securities investment trading business that buys and sells CMBS securities. Altogether, BREDS has $9bn under management.