A Summer of Reruns For the Street?

A crisis brewing in the Eurozone. Employment growth in the US that started out well in January only to peter out in the spring. Deadlock in Congress over tax and budget issues. A rating agency threatens to downgrade US credit unless said tax and budget issues are resolved. Rock-bottom interest rates that make any investment a better prospect than T-bills. If one didn't know any better, this could easily be late summer of 2011.

It is, of course, the start of the summer of 2012 and while all of the ingredients are the same as last year, there is hope that the pause on Wall Street that occurred in August 2011 won't be repeated. The money, in short, is likely to keep flowing, barring outright economic turmoil.

Ziad Hammodi, for one, hopes that's the case. The New York City-based deputy Real Estate Practice Group leader at Reed Smith cites a CMBS deal he is currently reviewing. The lender, an active CMBS player, has inserted a floor to the floating rate, something that Hammodi is seeing more of.

That could be disconcerting, or at least discouraging, to those hoping to see the CMBS market regain its former robust lending flow. The deal is also based on assets in second-tier markets, which hikes the risk to the lender. Still, Hammodi says, all is good: low interest rates will help to protect the borrower, and the assets are spread across the country and provide a strong cash flow.

Hammodi's position is clear. The continued low interest rate environment is here to stay, at least for the foreseeable future. "There are clearly risks in the economy now," he says, "but it doesn't matter as long as the deal is tied to Treasury." Even Libor has been fairly stable. "Base rates are so low that even if spreads thicken up a bit, it's not likely to impact you."

"Because it's been difficult for investors to find acceptable returns on their money, there's strong demand for real estate," says Gary M. Meltzer, equity partner and real estate practice cochair at Meltzer, Lippe, Goldstein & Breitstone LLP in Mineola, NY. "As such, raising money by the sponsor of a sound real estate project is easier today and the preferred and guaranteed returns that sponsors need to offer are lower than they've been."

In today's market, it is not unusual to get a 300-basis-point return on investment, precisely because the cost of funds is so low, says Matthew E. Galligan, executive vice president and group head of CIT Real Estate Finance in New York City. "If you charge 350 over Libor, that puts you at 4%," he says. "Four percent with amortization will get all-in cost of money of below 6%."

This reasoning, Meltzer adds, is why REITs are attracting capital at record levels and stepping up their lending activities. Investors are attracted by the dividend yields and the chances for appreciation. REITs can also refi debt at favorable rates, which are often lower than the rates in the loans that are being refinanced. And since many REITs have strong cash positions, they can meet the lenders' equity requirements and take advantage of the low interest rates.

Starwood Property Trust is a case in point. For the past year or two, the REIT has focused on underwriting loans that are solid despite some kind of hiccup, perhaps in the cash flow, says Boyd W. Fellows, San Francisco-based president and managing director. "The borrowers need flexibility," he notes. "These aren't fixed-rate conduit loans or life insurance financings."

Perhaps the property needs to be repositioned or it lost a tenant. Whatever the scenario, "there's a transition period that needs to be covered while the cash flow is down," says Chris Tokarski, chief credit officer and managing director of SPT Management LLC. In May, it originated a $170-million first mortgage on One SoHo Square, a twobuilding class B office asset in Manhattan's SoHo district.

The financing is packaged as a first mortgage of $135 million, with $35 million available for future advances to pay for TIs, leasing commissions and redevelopment costs. The interest rate is based on Libor plus 5% and the loan has an LTV of 65%.

The buyer plans to expand the 600,000-square-foot-plus property to add more office space and 20,000 feet of retail, hence the need for Starwood's particular blend of financing. It will consolidate six separate elevator banks into one location and move a nearby loading dock. There will also be two penthouse floors added. "It's a significant value-add redevelopment, and our loan has a construction component to it that will finance that activity," Fellows says.

The REIT's sweet spot for such loans is between $75 million and $100 million. It doesn't go below $40 million for whole loans or $10 million for mezz. Its returns for whole loans can range between 5% and 7% and between 10.5% to 13% for mezzanine.

If that sounds low compared to the pre-crash days, that's because it is. That too, of course, is a function of the interest-rate environment and a reason why Wall Street is likely to keep up its lending activities—finally, investors have accepted what is possible in this economy.

"For a lot of the deals we're seeing, investors' expectations have been aligned downward," says Jahn Brodwin, a senior managing director in the FTI Real Estate Solutions practice in New York City. "Five years ago private equity and similar funds were targeting the high teens to the low 20s. Now, their expectations are in the high single digits to low teens." Also, the core assets in top markets such as New York, Los Angeles, Boston and Washington, DC are now pricing at high levels, further lowering return expectations.

Similar trends are playing out in CMBS—Wall Street's raison d'être as far as commercial real estate is concerned. In the big picture, the CMBS market is doing well considering the events of the past four to five years, says Ken Cohen, head of the CMBS group at UBS in New York City. "The market has made some major strides getting back to earlier volumes," he says. "It's been a positive development for borrowers and owners."

That said, there have certainly been some distinct and even sharp ebbs and flows, especially over the course of the past few weeks and months. For example, the beginning of June was marked by some difficulty in moving 10-year AAA paper as Treasury rates dropped to new lows. "This isn't a function of concern about credit," Cohen says. "It's about the yield," especially for fixed-income CMBS. "Given how low yields are, long-duration AAA is more difficult to move than it was in the past."

He points to reports of a $1-billion CMBS that Wells Fargo and RBS brought to market in June, which did well—that is, after the banks converted the offering to a floating-rate deal from a fixed rate.

A week, a month, a year from now, the story will surely be different, Cohen says: "If it's difficult to sell long-duration fixed-rate bonds right now and easier to sell floating-rate ones, you can bet that at another point in time the reverse will be true." Overall, things looks good for CMBS. "We have a number of investors for investment-grade tranches as well as belowinvestment grade investors.

"The B piece is very robust now," he adds. "We're coming to market shortly on a deal and we're having a strong dialogue with several B-piece buyers." There are between eight and 10 active B-piece buyers now, Cohen says.

Another difference this year is that private equity has become more aggressive in its demands, says Jeffrey Sweeney, CEO of San Francisco-based private investment bank US Capital Partners. Family offices and both public and private funds are finding they can no longer rely fully on their typical investment approach, even for minimally acceptable yields. "These groups are becoming increasingly desperate to deploy capital in a more transparent way, while getting some yield," he says.

The answer? "Some of these funds are forming larger pools of capital to spread the risk in order to do higher-cost deals, with higher LTVs," he explains.

The difference between these pools and their predecessors, FTI's Brodwin says, is that the equity investors are demanding far more control and discretion over the investment. "The typical investment platform was a traditional two-and-20," he says, meaning the investor would pay a 2% fee for capital and the sponsor would get a 20% promote after a 7% return. "Today investors are willing to drop fees, and while they're still paying promotes of 20%, they require a lot more discretion in investment."

The Blackstones and KKRs of the private equity world can still operate with a blank check, he says. "The vast majority of equity funds, though, cannot. So they're forming strategic alliances with investment partners who then dictate the need to invest in certain markets or properties. They'll say, "I want you to target returns of a certain percent and I want to have veto rights while I'm at it.' "

The flight to control is also one reason behind the liquidity for REITs, says Jackson Hsieh, the New York City-based managing director and head of the US Real Estate, Lodging and Leisure Investment Banking group at UBS. The bank served as a bookrunner for the recent Liberty Property Trust offering of $400 million in unsecured 10-year, senior notes. It launched at $300 million and within 30 minutes the deal was upsized to $400 million, Hsieh says. "The result was a $400-million deal that was five times oversubscribed at a 4.125% coupon," he states, "the lowest coupon in Liberty Property's capital structure."

Public Storage is another example, he says. It recently priced a public offering of 10 million shares for $100 million. Demand drove the deal to be upsized to $250 million and it priced at the tight end of the guidance.

"We'll see continued liquidity and demand for higher quality issuers in the REIT space," Hsieh predicts. "REITs will have strong access to capital via unsecured bonds, preferred and common stock throughout the course of this year."

They almost always do, of course, and that's a good thing. This year, for REITs and most other players, is all about looking good compared to anything that the US Treasury could offer.