There is a decided — and quite unexpected — glow in the real estate capital markets, according to a consensus of the major debt and equity funders operating in the United States. At a conclave in New York City recently, I witnessed near unanimity on the outlook of real estate investment.
There is a lot of capital available for investment in real estate, more than can actually be invested.
The market is up, although, it is limited in asset type, class and geography.
Investors are “chasing quality.” Finding the right spot for the capital is tricky. The “flight to quality theme” is consistent among all money sources at the moment. They want to be in the best buildings mainly in certain markets.
The geographical targets for this money are the primary metropolitan regions of New York, Los Angeles, Chicago, Washington, D.C., San Francisco Bay Area and Boston.
Some more observations: The current “darling” target product is multifamily residential (apartments); most of the attendees expect inflation to remain low for the next three years, and then rise; capitalization rates remain stable; the levels of distressed sales are now trending down throughout the nation; there is virtually no chance of a double-dip recession.
The analyses I heard in New York addressed other subjects.
Pricing for most assets is hitting about 25 percent below the historic average. This is low, but not necessarily “distressed.” Companies such as Blackstone, the largest private equity fund in America with $30 billion of equity under management, representing $100 billion in assets, are currently buying high quality assets that have debt issues.
Clearly Blackstone is taking advantage of real estate assets which it believes are mispriced today. Its strategy is to aggregate assets in specific investment pools, hold for approximately five years, and then sell to institutional buyers.
However, the low fruit has been picked off — the best assets in the best markets have mostly been transacted. Capital markets are smart. When the spread is wide enough, the investors will broaden their investments to the middle of the country.
There is diversity in the sources of capital available to commercial real estate. Foreign investors (mostly from Europe and Asia) make up about 10 percent of investment sources. Approximately 24 percent of the deals are being made by private equity funds. But it is the REITs that are the biggest investors. Through the securities market, they continue to have the best access to capital.
One example is Jones Lang LaSalle, the “unlisted” REIT has $72 billion in assets. It raises money mostly from small investors. The REIT’s strategy is to invest in “hard” real estate whose fate is not correlated to the stock market. This is what is called “blind pool” capital (money that is invested without necessarily knowing what assets it will be directed toward). Those investors are investing in current yields of 5 percent to 7 percent. Adding in dividends, investors can expect total returns of 11 percent.
My view is that this isn’t bad at all considering that these seem to be purchased assets at less than 50 percent leverage, or loan-to-value ratios.
The big change in this industry is that the internal fees, or fee loads, are way down, a result of the excesses before the recession.
For all of the dynamics and optimism on the equity side, lenders have elected not to participate. They apparently want to invest. But since there is a general belief that interest rates will go up 100 to 300 basis points over the next three years, many are simply sitting on the sidelines and holding out their money for better rates.
The concept of allowing bad loans to wither or “extend and pretend” is still present with lenders. A lot of loans still need to mature, although in general, loan levels have been shrinking through restructuring and repayment of notes.
U.S. banks are still hobbled by their “heritage” issues. Most are still only lending to people and entities that really don’t need the money. What money they are putting out seems to be concentrated in multifamily.
Since Lehman Brothers fell in 2008, there has been over $300 billion in loan defaults. Right now only about 42 percent of these notes have been “worked out.” The good news is that lenders are making progress in resolving these troubles, but everyday still brings reports of new defaults.
Regional banks are still under pressure. These banks are concentrated in the weakest secondary and tertiary metropolitan markets. Most are in no position to put out money now.
The great issue that is still looming for banks is a coming maturity of mortgages. Over the next few years, many notes are coming due. Conditions have improved: maybe half the loans are bad. It used to be 90 percent.
The focus for the short term in the capital world is to invest in existing product. Funds are mostly not available for development. There is a consensus that while investment-grade markets are not critically overbuilt, many have inventory of both housing and commercial space that needs to fill and stabilize. Other markets need to tighten up and see revenue increases before development is an option. This may be as long as three to five years.
Much of the money focus has been on the “big six” primary markets in the U.S. Cap rates had moved way down in 2010 in six major markets, especially in New York City and Washington, D.C., where most of the deals are. There is a far greater sense of risk in the secondary markets, including San Diego.
The dichotomy is that much of the rest of America has yet to rebound. And except for a broader investment foray into multifamily, the capital markets have mostly restricted their activities there. The feeling is that assets are currently not stabilized in markets, so it is hard to attract capital.
The key difference between now and the recession of the early 1990s is that then the government’s Resolution Trust Corporation was formed to assemble and liquidate assets to “clear” the markets. There has not been a similar clearing mechanism to package and rid the market of bad assets. There is a consensus that it is going to be an additional three to five years before the economy is fully dynamic again.
There is a “structural change” at work in the American economy. Demand for real estate product is changing. Even with this change, the capital providers generally believe that existing space will find demand.
They are no longer purchasing properties to flip. Real estate investment has become a long-term strategy. Hold for stabilization. Achieve reasonable — if now lower — returns. Improve the properties, both physically and financially.
And wait for the economy to really improve.