Capital Availability — Market Sustainability
The availability of capital for retail transactions is affecting deal volume and velocity, say lenders and brokers.
Randall Shearin

Most of the talk around the shopping center industry today revolves around money. The availability of capital strongly affects the industry’s tempo. If it’s hard to get a loan, or if lenders are tightening up, activity won’t be as strong as it has been in years’ past. Shopping Center Business spoke to brokers and lenders about how the changing rules of capital will affect the industry in 2008.

What’s Causing The Slowdown

While the impact of the subprime housing market has had an effect on the availability of capital for commercial real estate, there is no direct effect on the underlying assets. This is good news for borrowers, as the properties themselves are holding their value and their weight with lenders. The capital crunch has had an impact on the availability of financing. Spreads have widened and underwriting guidelines have changed, leading to a substantial reduction in the availability of funds, says Clay Sublett, executive vice president and head of CMBS for KeyBank.

“Those dynamics have to have an impact on the [commercial] real estate market in general, in terms of the contraction of the availability of funds,” he says. “There has also been a reduction in the terms of the number of transactions and a reduction in the prices that people are willing to pay. But, there has been no impact on the basic underlying real estate. Without a doubt, there has been a change in the availability of financing and the cost of financing.”

Lenders first saw the cost of capital increase in June 2007, then another increase at the end of October. Sublett estimates the cost of capital increased 175 basis points (1.75 percent) from July to November. As a CMBS lender, Sublett was quoting spreads 100 basis points over Treasury rates before the crunch, and is now able to quote between 250 to 275 basis points over Treasury rates. While CMBS is on the expensive side, other lenders may seem more attractive. Sublett reports that life companies are quoting spreads at 220 to 240 basis points over Treasuries, and traditional bank loans are back in play for most acquisitions. Toward the end of 2007, CMBS borrowers and lenders almost took a break from the market, it seemed, because the market was moving so quickly it was hard for lenders to commit to terms. And, of course, for the borrower, there’s always hope that when things are changing fast, the cost of capital may fall.

“There’s been a double whammy,” says Sublett. “Not only has the cost of capital increased, but the underwriting guidelines are not as aggressive as they once were.”

The change in underwriting guidelines is something that the industry didn’t see during the last capital crunch in 1998.

Smith

“Underwriting parameters have gotten more conservative,” says Dan Smith, managing director of real estate for RBC Capital Markets. “Rollover reserves, for instance, are now being collected. There is less pro-forma income, which is more forward looking income that is used to size a loan, than there has been in the past. Lenders are more apt to be sized based on existing cash flow. The end result is that buyers are not getting as much money as they have in the past.”

RBC Capital Markets has also been more conservative in making loans to tenant-in-common structures. While it will lend on TICs, it wants to make sure there is more cash in the deal than in the past. RBC Capital Markets is also requiring more in terms of amortization from borrowers than in the past.

“We’ve adjusted our terms just as the market has,” says Smith. “We want reserves collected, we want cash equity in the transaction and we are scrutinizing, as we always have, the appraisals of the centers.” 

The Frenzy Is Over

From 2004 to 2007, many brokers feel that the industry was in a perfect storm for intense activity. Money was readily available, cap rates were low, and the lack of performance in the stock market saw a number of new investors looking to place their money in commercial real estate assets. That heated market was a frenzy for lenders.

Knoll

“There was a great amount of money in the market,” says Whitney Knoll, senior managing director of Staubach Capital Markets’ East Coast Investment Team. “Rates were going down and terms were very aggressive. Interest-only loans and few requirements for reserves were dominant. The debt markets were extremely attractive. There were also plenty of properties for sale. You could be very aggressive in your pricing and still get a reasonable return on your equity investment.”

“The last 2 years just saw a bubble in the underwriting,” says Smith.

Things have quickly returned to the way they were before that boom. Key Bank’s Sublett is seeing few interest-only deals pass his desk. For low leveraged loans now, lenders are only offering minimal or no interest for 2 to 3 years, a major adjustment from just a year ago, when borrowers could get a loan that was 80 percent leverage at interest-only for the entire term of the loan.

“We have seen a pull back from the aggressiveness of underwriting deals that have interest-only terms,” says Sublett.

One change with this market: traditionally, when capital gets harder to come by lenders usually don’t chase deals. During this cycle, though, it’s a lender’s market, says Sublett.

“More lenders are apt to say, ‘that’s my best and final deal,’ and let it lay, simply because there is less money available,” says Sublett.

“What’s amazing is how rapidly the market changed,” adds Smith. “And it is not just the capital markets. The traditional banks changed as well.”

CMBS players like RBC Capital Markets, KeyBank and others are still heavily in the market. They have money to lend and are actively quoting deals. New transactions have slowed to a trickle for CMBS. Domestic CMBS is projected to decrease its activity from about $230 billion in 2007 to about $115 billion in 2008, according to Sublett. KeyBank, which originated $3 billion in CMBS loans in 2007, is projecting $2.2 billion in CMBS activity in 2008. Like Key Bank, RBC Capital Markets has had a strong percentage of its CMBS pools in retail and continues to lend. RBC’s Smith predicts half the volume for CMBS for 2008 than in 2007.

“The issue is more the borrower looking at the results and seeing how much more he could get 6 months ago, and there’s just more hesitation,” says Smith. “Borrowers may be thinking that things are going to come back, but there is an overall slowdown in the market. I have been in the industry 25 years, and I think it is a return to normal.”

DeMarco

CMBS will return stronger when the end user — the securities buyer — understands that commercial real estate is different from residential real estate.

“For CMBS to come back, the buyers of the bonds have to understand that the fundamentals of the commercial real estate assets securing these loans are still excellent,” says Lynn DeMarco, managing director of Staubach Capital Markets’ East Coast Investment Team. “The default rates for commercial real estate mortgages are under a half a percentage point. We also haven’t had the rampant overbuilding that we had in the late 1980s and early 1990s. It will take time.”

Back To Basics

The traditional lending side of banks is another story. Traditional bank lenders are expanding their business and seeing lots of activity. KeyBank’s on-balance sheet (traditional) lending groups (to REIT and private entities), for instance, saw increased activity at the end of 2007 and expect volume to increase further in 2008. This is due in large part to institutional borrowers such as REITs seeking on-balance sheet loans in lieu of CMBS or other structured finance.

“More than ever, borrowers are scrambling to see who is really lending,” says Smith. “To some degree there is sticker shock in the spreads. When you are used to getting 100 to 125 basis points over Treasuries, and now you are seeing well over 100 basis points [1 percent] more than that, you are going to look around more. As they look around more, borrowers are realizing that the market has shifted. In order to make a transaction work, you have to look at providing more equity in the deal and adjust your returns accordingly.”

“There are just not a lot of takers on CMBS deals at the spreads that are being quoted,” says Sublett. “People are still trying to adjust to the sticker shock in terms of pricing and the new underwriting guidelines. If they have a choice, they are sitting on the sidelines waiting for stabilization. The reduction in CMBS will be offset by the growth in the traditional banking side.”

For many buyers, the bank is currently the way to go.

Haddigan

“The deals we are doing are largely bank deals,” says Bernard Haddigan, senior vice president and managing director of Marcus & Millichap’s National Retail Group. “Lenders who are out there are taking cautious positions. We are not seeing financing north of 65 to 70 percent. They’re making very safe bets. Over the past few years, we saw acceleration of high leveraged, interest-only situations.”

“We are assuming, for the most part, an on-book execution with local, regional, and foreign banks and insurance companies,” says Russell Schildkraut, principal with New York City-based mortgage bank Ackman-Ziff. “Most banks seem business as usual.”

Within the retail sector, lenders are still preferential to grocery-anchored retail, due to the stability of those assets. Even with the rise in traditional bank activity, both Smith and Sublett say that the underwriting parameters on traditional bank loans have tightened as well.

“Even if banks are going to do a short term loan, they’ve got to look at who is going to take them out of the deal,” says Smith. “Most of the takeouts have traditionally been life companies and capital markets lenders. They’re forced to underwrite their deals more conservatively.”

Schildkraut believes traditional bank loans haven’t changed that much over the last year, but that banks are looking closely at the strength of the borrower and the quality of the asset. He also says that the banking market is not as efficient in terms as the CMBS market is, so mortgage bankers like him have to shop deals longer before finding the right fit between lender and borrower.

“For the lowest cost of capital, you have to go to 40 or 50 lenders and you may end up with 15 quotes, which may be all over the place,” says Schildkraut. “Banks are going to lend on their terms.”

One of the concerns for the future is the hesitation on the part of borrowers to commit to loans.

“There are a lot of floating rate loans out there that are coming due,” Smith says. “They need long term fixed-rate financing to take them out. This could cause a huge impact to owners of property if they face loans that they can’t pay off. They may have to relinquish some equity to keep deals going or find new equity investors. I think it will be the second quarter of 2008 before you start to see some volume increase.”

Deal Volume

According to brokers, the slowdown in lending has affected deal volume, i.e., the number of centers changing hands. While some buyers may have held back from making purchases, some sellers of B and C properties and properties where the permanent financing has not been secured are taking centers to market.

“The biggest effect has been on B and C properties,” says Knoll. “The backup debt markets for these types of properties are bank loans and life companies. Both groups have become very cautious about what they are willing to lend on, so when it comes to B-minus or C properties, it is almost impossible to get debt on them.”

In some cases, where buyers have not secured permanent financing and are running up against a deadline to do so, there could be some cap rate erosion as they rush to sell the center.

All cash buyers have an opportunity in this debt-scarce climate.

“All cash buyers do have opportunities in B and C properties because pricing is changing,” says Knoll. “When CMBS comes back, there will be different pricing for B and C properties, and it won’t be nearly as aggressive as it was.”

For now, opportunistic buyers have already lined up their own lines of credit and lenders. Like in the late 1990s, the industry may see some companies forming joint ventures with pension funds and other institutions to form pools of capital to acquire centers.

Haddigan sees the market in terms of have and have-nots. If you have a Class A property in a primary market location, there won’t be any impact. Owners of B, C and D properties, which make up more than 90 percent of the transactional market, are the ones hurting.

“There is less buyer activity and there are fewer offers per transaction,” says Haddigan. “We will see some correction in 2008. There are a lot more complications with the deals we’re seeing; they are not closing as easily as they have in the past.”

In addition to B and C properties, the market for Class A retail properties continues to be strong, report both Haddigan and Knoll. On Class A properties, Knoll sees most buyers coming to the table with debt financing from life companies and pension funds, if they are not coming with all cash.

“Many buyers already have strong relationships in place with their banks, and they are drawing on those to get the deals done,” says Knoll.

Haddigan is also seeing something that hasn’t been around in the industry for years — the seller carrying financing for the buyer.

Because CMBS drove a number of deals by making financing affordable and cash flow plentiful, even on leveraged properties, that piece is now missing from the market.

Haddigan points to a Wal-Mart Supercenter in the Midwest that Marcus & Millichap sold in December 2006 for $105 million where the buyer placed a 90 percent interest-only loan on the property at 6 percent interest. Even with the property leveraged to the hilt, the buyer was able to have a decent cash flow. Today, however, Haddigan says that the project would sell for $72 to $75 million and the financing terms would never happen.

“The high leveraged financing available over the last few years drove a lot of value,” says Haddigan. “With that gone, it’s back to a normal market. CMBS drove a lot of transactions.”

For 2008, Marcus & Millichap is predicting its transaction volume will be 15 to 20 percent less than 2007. The company’s proposal volume — the amount of pitching that it is doing to get listings — is up, an indication that a number of owners are thinking of selling. Haddigan believes that the large owners, like REITs, will be net sellers during the year.

If you look at the history of retail investment sales, says Haddigan, the market is still healthy. In 1997, he points out, there were 3,500 transactions valued between $500,000 and $15 million. In 2006, there were more than 14,000 closings within that range.

“Even though we will slow down from last year, on a historical basis, the numbers are still more active than they were 10 years ago,” says Haddigan.

“Everyone is looking forward to having a good 2008,” adds DeMarco. “Buyers are hoping that the life companies will loosen some of their criteria and be a little bit more generous. They have continued to be very selective, even though there is a huge void of available capital left by the CMBS market.”