As conditions get tougher, will hot American money go in search of easier pickings elsewhere?
Property life on the other side of the pond is confronting the same anxieties as its European cousins cumbersome amounts of capital targeting the office market, worries over rising interest rates and possible falls in property values are all causing concern.
“The race is on between interest rates and recovering fundamentals,” says Steve Blank, fellow in finance at the Urban Land Institute (ULI). “If interest rates rise fast and drag up cap rates [yields], the market could see property value leakage. The dark case is for near term financing; with rents falling there could be difficulties in financing and we will see some pain.”
The US market has similar drivers to those in Europe historically low interest rates and high levels of private capital in a modest economic recovery. How it deals with them could provide lessons for the European market.
The main question for the market is whether a withdrawal of capital will prompt price falls. Optimists, such as Blank, subscribe to theory that property has been re-rated in investors’ eyes, as it is now more “cycle-tested”. “It is gratifying that all things are working,” he says. “Lenders are disciplined, there is very little speculative development all these facts make a great story. Real estate has finally matured.”
However, pessimists speculate about how much of the capital is “hot money” that will quickly leave the sector if prospects look better elsewhere. “There is an aging population with lots of hot money,” says Joseph Gyourko, professor of real estate and finance at The Wharton School, University of Pennsylvania. “Clearly, a lot of that is searching for relative yields and when [the balance] changes it will leave. This will not last forever.”
But even if hot money moves out, many observers are confident that it will be replaced. For example, German open-ended fund money is holding back while it resolves its domestic corporate governance problems, but Blank sees more interest from Japanese investors.
“Private investors might drop off, but pension funds will make up the gap there. The sector can always find people to jump,” adds Blank. One panel at the ULI conference in New York last month estimated that upping pension funds’ real estate allocations from the average 3% to 4% could result in an extra $50bn flowing into property.
So how are investors handling the market? The ULI’s Emerging Trends in Real Estate 2005 report, says the consensus supports taking advantage of sales opportunities. “The clear recommendation with this huge weight of capital is that the smart money should sell mature but not strategic assets,” says Blank.
Lynn Thurber, global chief executive of LaSalle Investment Management, is giving similar advice to clients. “We view pricing as continually strong and are being very select about markets and properties to invest in. Investors should take advantage to pull out of assets that are not strategic.”
The follow-on issue of how to re-invest the proceeds remains, but evidence suggests that high prices are not dissuading many investors on the buy side. “Investors are buying property at low yields, not expecting appreciation. Anticipated unleveraged rates of return at 7-9% speak to the fact that the market is expecting modest recovery. They recognise that they are paying full prices to get money invested. A pension fund manger investing in property can see 7% income on the first day,” Blank explains.
The more entrepreneurial end of the market is also trying to carve its own slice of the market, despite the apparent lack of logic in doing so in present conditions. “There is so much liquidity in the capital debt and equity markets and it’s not limited to real estate, it is asset classes such as hedge funds as well,” says Michael Frascitelli, president of Vornado Realty Trust. “It seems like a time to be cautious.”
He questions the prudence of making a big bet on real estate when prices are high, but points out that caution would have proved mistaken in the immediate past. “Everything you didn’t buy in the last few years you have been wrong on.”
Mitchell Hersh, president and chief executive of Mack-Cali Realty Corporation, a $4.8bn office REIT that specialises in the North Eastern markets, says it is time to gear up for the next phase of the cycle. “The universal objective is to get on with our lives now and this is strongly reflected in the business community. We have positioned our company to acquire inventories of property ‘new vintage’ property to move into the next wave of the property cycle,” he says.
One example was its deal to buy 111,482m2 of property from AT&T in June. The majority was leased back to AT&T on short-term leases, leaving the balance for refurbishment and to take advantage of any recovery. “In this environment we are looking at sellers under the radar screen where we can address their corporate issues. We are looking at vacancy in assets to get future value.” He encourages others to expand: “In my view it is a reasonable risk to expand but do it patiently.”
Financing via the CMBS markets
The presence of large volumes of capital chasing investments has been a boon to the US commercial mortgage-backed securities market (CMBS). Rating agency Moody’s has recorded activity up 25% over last year and it is expected to reach $87bn in 2004 compared with $78bn in 2003 also a record-breaking year.
“The fourth quarter will be very active,” says Jim Duca, managing director of the CMBS structured finance group at Moody’s in New York. “It is driven by low interest rates with fixed-rate CMBS issues up more than floating.”
The US market is dominated by conduit lenders those banks that originate loans for the purpose of securitising them. Growth has been backed by an increasing appetite for CMBS bonds from investors as well as new lenders in the market such as CW Capital, Eurohypo and Nomura.
This year’s results demonstrate that the market still has room for growth, but lenders seeking better margins are looking to new markets and products, which partly explains the arrival of conduit lending programmes in Europe headed by US professionals.
Those still in the US are considering new products which pool construction loans and creating new bond tranches. Pooling construction loans for securitisation has obvious problems; CMBS works best for products with a constant income flow with the sector concentrating on lending on stable, income-producing assets. A construction loan is riskier with the development producing no income until it is completed. “The sector will have to think of a legal structure to suit this,” says Duca.
Sally Gordon, vice-president and senior research analyst at Moody’s, adds: “It could be a 0% coupon bond model where the risk is back-ended.” The sector will be keen to find a solution that will open its competitive lending model to a new part of the market.
Issuers have also been trying to improve margins by capitalising on bondholders’ worries about subordination, or the risk tranches that the issues are divided into. “Certain investors have expressed concern about current levels of subordination and are willing to pay more for a super senior triple A,” says Duca. This means creating a premium class of bond at the less risky top end.
Duca says this could backfire as the market could eventually re-rate this premium tranche the same as the normal triple A class, which could cascade down causing problems with the bottom riskier end.
CMBS bonds are now starting to be packaged into CDOs, which are baskets of investment-grade securities including CMBS bonds and loans, on the back of which bonds are issued.
The US has seen CDOs comprising only CMBS bonds, which tend to be of lower rated BA and B securities. This allows better long-term financing for B buyers, which can better match their assets with liabilities or allows institutions such as insurance companies to hold loans in bonds. It is positive for the CMBS market as it increases the liquidity of the lower-grade tranches.
For the future, the market is concerned about rising interest
rates. This is already fuelling increasing levels of extension
risk as higher interest rates could slow the rate at which the loans
will be repaid. This may reduce yields for investors as their money is committed for longer than anticipated. However, extension risk buys time and prevents a default.
Duca says the levels of extension risk were “significant” in the market and were more of a problem for bonds backed by short-term loans such as two or three years. However, potential rises in interest rates could see an increase in extension risk.
