Alex Finkelstein is co-editor of Debt & Equity Journal, from which this article is excerpted.

Chicago—Endless streams of cash are flooding commercial real estate and reshaping global property markets. "This is a tidal wave," notes Michael Goldman, senior vice president of acquisitions and finance at Chicago-based Golub & Co. "Describing the flow as strong would be a relief. Too much money has been raised for both debt and equity and it is not going to be returned any time soon."

Clifford N. Mendelson, senior managing director of the structured finance group at Transwestern Commercial Services in Bethesda, MD, says, "From a debt perspective, the flow is huge." He notes the recent $36 billion deal between Equity Office Properties Trust and the Blackstone Group "shows the equity flow is huge, as well." Mendelson says the issue to consider is whether spreads may widen because of an excess demand for money in the first quarter of 2007 with a debt requirement of more than $30 billion from Blackstone alone.

David R. Brown, president and CEO of ORIX Real Estate Capital Inc. in Chicago, says cash flow is robust "for debt and equity and everything in between." He continues, "On the equity side, the only buyers getting priced out are the ones who previously were using high LTV loans with low short-term floaters when Libor was lower than 2%." On the debt side, "the advent of CDOs is making it even more competitive. This is expected to grow dramatically during the next couple of years," along with increasing conduit volume.

"Everyone is flush with cash," says Nat Zvislo, research director at Real Estate Capital Institute, also in Chicago. "Conduits control market share. Banks provide aggressive construction proceeds. Life companies offer fixed-rate debt with balance-sheet flexibility." The obvious winners are borrowers, he concludes. Generating the unabated cash flow are long-term interest rates, which continue to drop, Zvislo adds. "Funding sources are more creative and aggressive than at any time this year," he says. Five-year and 10-year benchmark Treasuries increased by nearly 25 basis points during November, settling at around the same levels as a month ago. "The 10-year Treasury converged with the five-year, a continuation of a flat-yield curve," he says. The prime rate has remained unchanged since August, while Libor increased slightly.

Capital flows have been largely private to public on the acquisition side, explains Gilbert G. Menna, partner and chairperson of the real estate capital markets group at Procter Goodwin LLP in Boston. "But there have been some recent public to private capital flows, such as REIT IPOs, which suggest the public is still very much interested in real estate as an asset class." As an example, Menna cites the Douglas Emmet Inc. IPO, which was "very much over-subscribed."

Menna says the recent public REIT IPOs "have gone out with a dividend rate below their cost of capital. That suggests there is huge demand for the securities." As a comparison, Menna recalls the 1990s when "REITs were able to grow by arbitrating their cost of capital against their dividend rate. In other words, the cost of debt capital was below their dividend rate, so they grew their enterprise value by borrowing as much debt as they could and not issuing equity securities."

According to published reports, private equity real estate funds will raise about $55 billion in 2006 versus $37 billion in 2005. Factoring in debt financing, the funds raised in 2006 have buying power in excess of $160 billion, industry experts say. They further note the amount of capital in the global private equity real estate markets is forcing firms to seek a wider array of investment opportunities, from REIT privatizations in the US to apartment buildings in Russia and China to industrial properties in Brazil.

On other capital markets issues:

Industry experts have mixed views on cap rates.

"Without sounding like a broken record, with the pressure the market's liquidity is providing, we can see cap rates generally going lower," Golub says. "However, if you look in greater detail, the cap rate movement is typically a 'Tale of Two Cities.' Deals that are considered core to even core plus may see cap rates hold steady at worst, but are more likely to dip lower. Deals with real or perceived physical challenges or location issues may have cap rates stabilize or go higher." Mendelson feels cap rates "should be stable following the movement of the 10-year Treasury, unless something in our economy changes." Menna thinks cap rates are "at an all-time low." Brown sees "a higher probability cap rates will be higher than they are now in the future."

There are potential risks of overpaying in a falling-cap rate market.

"Almost by definition, if you buy today you are overpaying by most recent traditional standards," Goldman says. "The idea is to buy something that won't make you look bad in a year. The only way to mitigate the risk is to purchase well-located buildings at prices well below replacement cost." Mendelson says, "There is always a danger of overpaying in a declining cap rate market, but it is mitigated if you can hold long-term." Brown says there is always a risk of overpaying "when someone is focused on allocating capital and investing in market deals, rather than focusing on value creation opportunities on an asset-by-asset basis." To cope with that situation, buyers should count on their abilities to generate higher income at the property level through leaseup or increased rents, Brown adds.

Investors may hold properties longer or try to raise rents through an extended period before unloading assets.

Brown says, "The trading level during the past few years has been very high because sellers could flip out for huge gains and buyers were able to finance with cheaper and cheaper rates. The trading levels are starting to normalize from their unsustainable levels of the last few years. This is especially true on the residential side, especially single-family." Goldman notes, "There are both investors taking advantage of the frothy sales market and those who won't sell because they don't want to have to re-invest the proceeds." Mendelson says investors will probably be holding properties longer.

Instant Insights /

Borrowers Come Out on Top in Cash Flood

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