CREFC US Conference: Rate rise fear is cloud on bright US debt horizon

Anticipation of interest rate rise takes edge off delegates’ enthusiasm, writes Al Barbarino

The 1,200 attendees from all corners of the industry who gathered at the Commercial Real Estate Finance Council’s 2014 New York conference last month in general agreed that the US lending market is back – thanks in no small part to the low interest rate environment.

Speakers and attendees were gung ho regarding the resurgence of debt markets. A majority considered that low interest rates have served their purpose in stimulating the economy. Developers have proceeded with plans that were all but crushed by the recession and foreign money is seeking out the US as a safe haven.

But the question of what will happen when – not if – rates rise at times capped some of the event’s enthusiasm. “We all know it’s coming,” one panellist said. The question led to jitters and further questions. Rising interest rates could both heighten the term risk of new CMBS deals and the refinancing risk of those outstanding, leading to defaults.

A spike in interest rates and subsequently cap rates would, of course, also shrink the gap with treasuries. “I don’t understand how you’re doing so much quoting with treasuries so low and everyone thinking that rates are going to go up in the long term,” one delegate said, addressing a panel of lenders. “Why are they borrowing?”

Sam Zell, one of the event’s keynote speakers, said artificially low interest rates have caused the cost of capital to go “materially lower than the inflation rate”. Without “a major alteration”, a large amount of US debt will roll into a dramatically different market, he noted.

Jared Kushner, Kushner companies

Boom or gloom scenarios

While the tone of the panel discussions swung, at times, between boom and gloom scenarios, some were still clinging to hopes that interest rates in fact will not rise soon. “Everyone thought that by 2013 rates would go up,” said one speaker at the high-yield distressed realty assets forum.
“That hasn’t happened yet, so there might be a few years left.”

Another speaker added: “If interest rates stay relatively benign, a lot of stuff we thought was going to struggle to get financed will get bailed out.” However, perhaps the most feared scenario would be one that no one will have anticipated: an event such as a shock coming from abroad, as the world outside the US seems to grow increasingly unstable, or a terrorist attack at home or abroad.

“No one can predict that,” said Kevin Warsh, a former governor on the Federal Reserve board, advising that in the event of quick interest rate rises, the best protection is to be as liquid as possible. “Ask yourself, do I have enough liquidity to survive?” On the positive side, while many
conference attendees revelled in the return of CMBS, the borrowers in the mix made it clear that banks are back too.

Several owners of commercial real estate across asset types and classes stressed their preference for relationship lenders that offer a hand in partnerships. “The best lending solution is community banks,” said Jared Kushner, chief executive officer of Kushner Companies, regarding
his company’s residential portfolio. “We find that they understand the product, so if something [changes] with the asset you can
just talk to them.”

Banks have originated more commercial real estate debt in 2013 than CMBS, unlike the boom years, when the reverse was true. In December 2013, they held nearly half of US commercial real estate debt, while CMBS accounted for just 18%. Banks act as a partner in many ways,
particularly in this post-recession environment, said speakers in the ‘Who’s your lending daddy?’ panel discussion. By contrast, the CMBS market – while highly liquid, cost effective and convenient – doesn’t offer the same risk protections that come with a more traditional lender.

responsible cmbs attitudes

“If you don’t hit the targets you said you were going to hit, they’ll pull you back,” one delegate said. “They are doing some things that are responsible and I think they reflect on the market in a positive way.” Leading an organisation traditionally focused on managing offices, he noted that since the recession his firm has moved into the transitional property market, which is a better match for banks and their additional relationship-based services.

“Previously we bought more stabilised properties, so we did an awful lot of CMBS – even though we think of ourselves as relationship borrowers,” he said. “More recently, over the past year, we’ve done more than $1bn in financing and that was about 95% bank financing.” CMBS certainly has its draws, however. While conventional wisdom has it that CMBS is both inherently riskier and better geared towards riskier assets, many believe stricter underwriting and increased scrutiny from ratings agencies has reduced the risk.

In fact, panellists said CMBS is a more fitting solution for deals involving stable assets or stand-alone real estate with loans in place, noting that with larger deals, it is often a faster process with smoother execution. Kushner noted a personal preference for CMBS when it comes to offices.

higher cmbs risk premiums

Risk premiums embedded in CMBS coupons are higher now than in 2007. Spreads are, of course, a factor in decisions on whether to use CMBS rather than traditional banks and lenders, but panellists insisted that a few basis points – and even millions of dollars – aren’t worth the risk
when it comes to properties that don’t match the CMBS profile.

David Schonbraun, SL Green Realty

On the question of how many basis points in savings would be necessary before speakers would consider CMBS financing, estimates stretched from 10bps to 25bps. “We tend to prefer relationship and balance-sheet capital on mid-size deals,” said David Schonbraun, co-chief investment
officer with SL Green Realty Corp. “In the larger, $750m to $1bn range deals, CMBS is sometimes more efficient.”

While taking a majority share of the market, banks and CMBS aren’t the only games in town, of course. The post-recession environment has created more room for debt funds, willing to take on a piece of the capital stack that didn’t exist before: stressed senior debt.

One speaker concluded: “A lot of them have equity backgrounds so they understand the big perspective. We’re willing to pay a little bit more to have that execution risk taken away, rather than ending up with someone who doesn’t understand our business plan when things change.”

Zell turns down invitation to single-family rental party

The single-family rental (SFR) market will make big institutional buyers such as Blackstone some one-shot profits, but billionaire Sam Zell is passing on the emerging asset class because he says it lacks long-term viability. Even as investors react with excitement to single-family rental bond issues and major institutional buyers begin to reap rewards, the chairman of Equity Group Investments was sceptical. “The idea of creating public companies focused on owning single-family houses makes no sense to me at all,” he said.

Large institutional buyers have begun to more aggressively securitise the roughly 200,000 homes scooped out of foreclosure since the recession. Blackstone’s $993m Invitation Homes 2014 SFR 1 issue in May was larger than the previous three SFR deals combined and was considered a big hit. However, Zell argued that the business is inefficient in the long run. The segmented nature of the assets hinder economies of scale and the one-shot nature of a house sale creates a capital gain, not a boost to income.

“Almost every major bank offered me the opportunity to buy a billion dollars-worth of houses they owned and they even offered to finance me,” he said. “I said thank you very much, but I didn’t believe it was a business.” Zell admitted that “most of the guys that bought these houses will sell them for more than they bought them for”. He said Blackstone was sure to make money, but questioned the product’s long-term viability and profitability.

Zell & Flexner

“Almost by definition every public company operates under the thesis that one-time gains don’t count,” he said. “If you own 1,000 houses
and go public and maybe sell a house, the gain is a capital gain so doesn’t add to your income. But more importantly, you can’t replace it, because in effect you bought that at the bottom of the market. If you’re going to go into the house speculation business, that’s a different story, and one I wouldn’t endorse.”

He noted that Equity Residential properties on average contain 350 homes. The same 350 homes scattered across single-family residences country-wide are harder to manage. It is not only inefficient, but a recipe for a decline in management standards — and ultimately the quality of the renters. “You have 350 different heating, ventilation and air conditioning systems in 350 different houses,” he said. “Taking care of this will be very difficult and as time goes on the quality of the renter will go down as more and more renters qualify. So I’m not terribly optimistic.”

Zell is a REIT pioneer nicknamed the “gravedigger” for his distressed-asset investing. He has bet big on emerging markets globally, mainly through Equity International, which has raised an estimated $2bn to invest in property across countries such as Brazil, India, China, Colombia and Mexico. It is no wonder that he cited political instability — in Syria, Iran, Russia, Venezuela, Crimea and Argentina — as his number-one worry. “I don’t remember a period when there was as much ‘disturbance’ around the world,” he said. “What would it take for something to happen in Crimea, the Ukraine or Russia and all of a sudden we’ve got a real shooting war? We’re pretty close to that already.”

Investors mine New York City land in latest investment gold rush

A willingness to seek distressed assets still pays dividends for determined investors, but a mad land grab across New York City presents
a true “gold mine”, according to panellists on the conference’s high-yield distressed realty assets forum. Yields may be lower than they were, but investors “still have money to put out and even though they might not be satisfied with returns, they will put that money out there”, one real estate investor said.

Failed construction mezzanine loans were highlighted as one sector that still offers high yields for those willing to take significant risks. “If you want to take the risk you can get the yield and you’re seeing that with construction deals right now,” said Bill O’Connor, a real estate attorney with Thompson & Knight. “We closed on one at 14%, because the building had every check off the box… asbestos, check… right down the line.”

However, the real treasure trove exists in land deals across major US cities, particularly in New York, where pricing is skyrocketing and
bidding wars have ensued between lenders. “I have never experienced what we are experiencing today,” said Johnathan Schultz, co-founder and managing partner at real estate investor Onyx Equities, on the subject of New York City land prices. “The pricing is almost double what it was at the peak… it’s like finding a gold mine.”

high line park

Another panellist equated competition for land across New York City to “the wild west”, noting that pricing per square foot is in some
cases far higher than during the peak years. In the red-hot Chelsea neighbourhood, where end-user residential sales are peaking in the $4,000 per square foot range, a bidding war over four lots just a few blocks apart had a surprising result.

“We quoted a very aggressive, above 80% loan-to-cost, with 10% coupon — and we lost it,” one delegate said. While distressed assets are still out there, with the cash available to bail them out, the investment professionals noted that in many cases the risk on the debt side is not worth
current yields.

“In 2009 we were getting 20% yields, but that has continued to decline,” one speaker said. “It has become a relative term.” With junior mezzanine debt offering only single-digit returns, conditions aren’t “terribly satisfying for an investor, based on the risk”, he noted. “Debt can only go so far. Where we are today, equity is the place to be.”