Scaling the wall of capital in a maturing US real estate cycle

Our panel of real estate lenders debate how long the US commercial real estate market will stay in its ‘sweet spot’ and how to wring out current and future opportunities. 

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L to R: Otten, Giraldo, Fishbach

It is as sure as the sun setting that a commercial real estate cycle will end: the question is ‘when,’ not ‘if’. Put three commercial real estate experts in a room together and the answer is still anybody’s guess.

Gary Otten, head of MetLife’s real estate debt platform, points out that the average cycle over the past 150 years has extended almost threefold. Extrapolate the data and it suggests that, six-years into this one, the US has hit a ‘sweet spot,’ with a good few years of strong performance left.

Randy Giraldo, a managing director with TIAA-CREF, says it might be time to start preparing for a “potential slowdown in market performance”, though he maintains that the prospects for commercial real estate in 2015 remain bright.

Rounding off our panel is Raphael Fishbach, a principal with lender Mesa West Capital, who notes that “space is leasing – and faster than we thought”, suggesting that we must be in the middle of the cycle.

The end of the cycle may be unpredictable, but therein lies much of the excitement in commercial real estate. Here’s what else the trio of executives had to say about the cycle, how it guides their investment philosophies and the state of the market.

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Randy Giraldo: Some of TIAA-CREF’s largest accounts are open-ended and focus on core. In that space it’s about full-cycle outperformance of industry benchmarks and broad national averages. The in-house thesis is that through market selection, diligent, focused research and the construction of portfolios over full cycles, we’ll outperform the national average. We don’t say we will provide a minimum income or total return in the fund I manage; our goal is to outperform the NCREIF ODCE index of more than 20 open-ended funds.

In terms of debt, our fund has a guideline limit not exceeding 30% at portfolio level or 70% at asset level. We seek to keep a mix of fixed and floating-rate debt – about 75% to 25%. Right now we’re seeking to extend duration on our portfolio and lock in long-term, low interest rates.

[We take a] rigorous approach to markets but won’t be stretching to secondary and third-tier markets in search of that last couple of years of cycle performance or 50 basis points of cap rate.

Gary Otten: Our first mortgage lending platform is always a core element of our portfolio, which may be supplemented by mezzanine or higher-yielding investments. But the top-tier markets are producing the most competition, so to hit yield targets or find relative value you distend where you look for opportunities, whether by property type or market.

For example, relative to our life company peers, we are comfortable with the hotel sector, so we may have higher allocations there. Revenues per available room have been fantastic since the downturn. Catching that upswing is good for our business model, which does a lot of floating-rate debt.

Floating-rate terms are typically three to five years, so during this period you’re riding the cycle up and getting taken out of your loans. Nobody ever likes their portfolio to be too rapidly paid off, but any repayments are good news to a lender.

Raphael Fishbach: Our sole focus is originating first mortgage debt for assets with a story. We try to earn business from institutional clients that were generally financed in the past by banks – to win business from those names as banks became more risk averse towards transitional assets.

We have a closed-ended, value-added fund and launched an open-ended fund with a core-like focus. Firms with sharper elbows are comfortable taking higher leverage, as  they are also equity owners [and could take an asset back on the equity side]. We’re debt guys, so we just want to get paid back.

GO: We have a large equity platform and that conversation comes up from time to time, but it’s not driving the decision to do a deal. A foreclosure is regrettable for a lender, no matter how you spin it.


RG: As we’re in the sixth year of the real estate recovery, we are improving portfolio quality and perhaps not chasing risk as much as others, preparing for a potential slowdown in market performance. But for the remainder of 2015, prospects for commercial real estate are bright.

The questions are: when will market pricing halt and when will we reach a cap rate floor? Looking at broad US averages, cap rates are still compressing. But if they stabilise, we could move into a period where fundamental underwriting assumptions are more aggressive, and that can drive pricing. This strong trend in core returns can continue, but we don’t know for how long.

GO: It’s very logical to feel that way. I agree we’re six years into the cycle and that alone gives you pause. But I believe we’re entering a very sweet spot in the cycle that could last for several years, as momentum in the general economy and in real estate are still on the upswing.

We continue to monitor the risks – supply and demand, capital flows, pricing versus fundamentals, the things that drive the cycle – but think those risks remain fairly low.

In the past 150 years, the average cycle lasted 3.5 years; in the past seven cycles, the average was six or 6.2 years [according to a JLL report]. The past three cycles’ duration was almost eight years. If you look at that on a line graph, one might conclude we’ve got at least eight or nine years [in this cycle].

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RF: For a while it felt like capital markets were way ahead of the fundamentals. There was a voracious appetite for real estate but not enough demand to back up the business plans investors were taking on.

However, now assets are really performing. On deals we’ve done with real leasing risk, space is leasing – and leasing faster than we thought. I believe capital markets have kept ahead of fundamentals, but fundamentals are catching up, which is a good thing. So I feel we’re somewhere in the middle of the cycle.

GO: Our real estate team definitely focuses on market trends and we spend a lot of time studying both the micro-economic climate as well as real estate market cycles.

This cycle is definitely different in terms of discipline on the equity and debt sides. Folks on the equity side that had fun before the last cycle now recognise how detrimental too much debt or the wrong debt can be. There’s still some institutional memory of that past cycle and it is helping control the debt and equity side of the equation.


RF: There is always going to be pressure on returns, but I believe our market and investment profile are very healthy. A lot of people are trying to get into our space. Some are equity funds who say: “Why can’t we go do the same thing?”

But that doesn’t really move the needle. When you lump together all the debt funds like ours that have been raised with private equity capital, we don’t touch what just came out of the market with, say, a GE [and the liquidation of GE Capital]. Those are the real needle movers.

A negative factor would be if large national banks started to make a large commitment to providing floating-rate, transitional debt, but I don’t expect that to happen any time soon.

While the spreads on transitional assets have come down, it is the low Libor rate that is driving lower returns. At the end of the last cycle people probably priced transitional real estate deals at Libor plus 150-200bps. Debt on those types of risky, transitional assets is today priced at between 350bps and 500bps over, which I think is healthy.

GO: We’re not going head-to-head with Raphael; we’re not going to be as high-yielding or in double digits. As the cycle matures, we will consider pulling back from high-risk and higher-yielding mezzanine lending business. Those yields right now, no matter who you ask, are inside 4% on tier-one assets.

At the start of last year, core debt spreads definitely tightened and since then have been quite stable and more controlled by underlying treasury yields. In Raphael’s space it’s far more competitive. Spreads have moved in for subordinate debt a lot quicker than for core debt.

RG: Multi-family housing lenders [Fannie Mae and Freddie Mac] have become less competitive on pricing because they have exhausted their allocations over the past couple of years. That market is being filled in by life insurance companies and banks.

But for our types of loans, spreads have generally been plus or minus a few points in the same band for couple of years. I haven’t noticed any marked increase in aggression, but we generally don’t seek any more than 55% loan-to-value ratios on any asset.

Right now we are not looking to deleverage and are keeping our fund in the mid-20% range. Some outliers go north of 30% when seeking to get a bit of edge versus the benchmark.


RF: It’s very aggressive out there, as lenders spill off into new markets. Borrowers now have a menu of options: a lower-leverage bank quote, a debt fund quote, a lower-leverage bank plus a mezzanine quote. They are not forced to take the average of those quotes; they ask for the best from each.

But equity investors continue to put significant equity chunks into transitional or core deals; we’re seeing a minimum of 30%. One of the issues towards the end of the last cycle was that [sponsors] were putting 90% leverage in to get extra yield and putting in just 10% equity. But I’m cautiously optimistic that there will continue to be discipline.

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GO: In the public markets and the securitisation market, as more entrants come in, you get less discipline because they’re not long-term holders. In the last cycle you saw LTV levels for securitisation constantly creeping up, and they are now. But on the life company side, you actually saw LTV levels going in the other direction up until the cycle ended in ’07 or ’08.

RG: There are many things we can do to prepare for increased volatility: you can seek to improve credit quality in your rent roll, extend lease durations and try and have your leases roll beyond any period of projected turbulence, or improve overall portfolio quality.

At this part of the cycle you might think about selling your weakest assets – ones that aren’t long-term, durable real estate.


RG: The influx of foreign capital is a net positive for the industry, contributing more cross-border transaction activity and liquidity. In the past two or three years foreign investors have gotten more and more comfortable. They’ve started to expand out. First maybe it was a fund structure, then joint ventures and then they went direct.

Part of it is the comfort and part of it is that they have so much money to invest. Generally foreign investors are seeking an additional return and that could be why they’re starting to branch off into other markets and property types. For example, you have recent Chinese investors partnering with a US firm in Boston on a multi-family housing development, or a partnership on the large industrial transaction to purchase KTR [Capital Partners] industrial… that’s not a sexy Park Avenue office building.

GO: It’s increasing every day – particularly as the cost of funds for overseas capital providers goes way down, based on  the low yields on government bonds across Europe and Asia.

They don’t have to take a lot more risk to do a heck of a lot better than they do at home. That’s driving a lot of the international capital coming over into the US.


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