If you thought it was tough raising finance in the UK, spare a thought for the US debt-backed investor.
“Those looking for debt now are in a terrible situation. It’s like trying to buy a flashlight in the middle of a hurricane. Wall Street is experiencing the banking equivalent of a hurricane,” says David Lichtenstein, chairman of the Lightstone Group – one of the largest private real estate companies in the US.
At best, highly geared investors have been banished to the sidelines because lending criteria have become so tight and debt so expensive since the residential subprime lending crisis hit the banks. At worst, they are being forced to sell assets because they can’t get last year’s short-term debt refinanced.
One of the most high-profile victims so far is New York real estate titan Harry Macklowe, who borrowed $5.8bn from Deutsche Bank last February to buy seven Manhattan office buildings, formerly owned by Equity Office Properties, for $7bn. That loan was due last month, but the rapid and severe credit crisis that has wiped out easy and generous debt financing left Macklowe struggling to refinance. He is now looking to sell a sought-after property he bought in 2003 – the trophy GM building in Midtown Manhattan - in order to raise cash.
“A lot of people feel sorry for him. He’s been caught in a tragic situation. The underlying assets are excellent, with excellent futures,” says Lichtenstein. Others are less sympathetic. “The Equity Office properties are worth substantially less than what Macklowe paid for them and that is true for deals of all sizes – not just the big high-profile ones,” says one investment banker.
Either way, Macklowe will not be the only investor left stranded by the virtual disappearance of the commercial mortgage-backed securities (CMBS) market. Ian Bruce Eichner, a New York developer, defaulted last month on a $760m loan from Deutsche Bank AG for his Cosmopolitan Resort & Casino on the Las Vegas Strip and Australian REIT Centro Properties Group, which owns A$18bn of US shopping centres, is struggling to refinance A$3.9bn ($3.4bn) of debt.
The problem of refinancing
“Everybody is going to feel the effects of the slowdown in rental growth rates and the economy at large – but it’s the people who face that and simultaneously have to refinance that have a big problem,” says David Tobin, a principal at boutique investment bank Mission Capital, which specialises in selling debt into the secondary market.
“If you think about Centro, Macklowe and Eichner and a handful of other similar situations, you’re talking about $10bn of defaults just in the past month. There’s a substantial amount of short-term, floating- rate debt out there,” adds Tobin.
When Macklowe bought his $7bn portfolio, there was already talk that the top of the market had been reached. Shortly afterwards, unease began to grow that lenders were making overly optimistic projections about rent growth.
Bull run comes to an end
The subsequent credit crisis and the onset of recession in the US proved the naysayers right, bringing to an end a four- to five-year bull run during which real estate outperformed both the bond and stock markets (see graph, bottom right) and culminated in $416bn of deals (excluding apartments) in 2007. “Before the credit crunch, there was a record sale happening almost every week,” says Alex Sapir, president of the Sapir Organization, a family-owned company with more than 7m sq ft of prime Manhattan offices.
This record trading was driven by REIT privatisations and subsequent property flipping in the first half. These deals – the biggest of which was the first-quarter sale of Equity Office Properties Trust to Blackstone for $31.8bn – pushed the volume of transactions up by 50% on the previous year, according to agent Cushman & Wakefield (see graph above).
But since the autumn, deals like this have been impossible to finance. The lack of available debt has destabilised not only highly leveraged investors such as Blackstone and Macklowe, but – coupled with growing concerns about the declining health of the wider economy – it has destabilised the market as a whole, putting downward pressure on prices and leaving all types of investor with little choice but to adopt a “wait and see” approach.
“Pricing uncertainty slowed the magnitude of transactional activity. No one wants to be the last to acquire assets before a rise in capitalisation rates [yields],” says John Lyons, head of agent Savills Granite in New York.
Those trades that did take place in the last four months of the year were dominated by the institutions that had previously been priced out of the market by real estate funds and private investors. According to Real Capital Analytics, institutional investors accounted for 48.6% of acquisitions between September and December – up from 18.4% for the eight months from January to August (see pie charts, p14).
But despite institutional investors’ return to the market, trading activity fell by 31% in the second half of the year as the bad news from Wall Street kept on coming.
Several lenders have now announced commercial loan losses. Most have not segregated them from residential losses, but Morgan Stanley reported in the fourth quarter that it was writing down $400m in commercial mortgage losses, and in January, Wachovia, the nation’s fourth-largest bank, said it would be taking write-downs of more than $1bn for commercial loans for the second half of last year.
Most of these losses stem not from defaults but from loans that are not only secured against properties that have dramatically fallen in value but are substantially harder to syndicate or securitise – investors no longer want to buy securities backed by packages of these mortgages.
Wachovia’s losses were particularly startling for the Manhattan investment market, where the bank had established itself as a major player during the recent boom by offering aggressive loans to big names including Tishman Speyer Properties, BlackRock Realty and Blackstone.
By 2005, it was the leading originator of commercial loans intended for the bond market and last year $24.2bn of its commercial loans were packaged as securities – $8.6bn more than its nearest rival Bank of America, according to US trade publication Commercial Mortgage Alert. It pulled back on transactions fairly early in 2007 – lending only $16m in December compared with $4bn in April – but has still found itself in difficulty.
It seems likely that more banks will have to follow its lead. Bob Ricci, one of Wachovia’s managing directors, told the New York Times that it had decided to act quickly to put its losses behind it. “Many of our competitors were pursuing a strategy of hoping that after Labor Day, after the new year, things were going to get better. But just the opposite happened,” he said.
Job cuts rattle the market
Lay-offs on Wall Street have also been rattling the real estate market. “All the investment banks have cut their commercial real estate lending staff by 30-50% and I think it’s the same situation at the commercial banks. The lending business on commercial real estate hit a wall three or four months ago and those lay-offs mean that there’s no expectation of a loosening of the lending criteria any time soon,” says Mission Capital’s Tobin.
The Federal Reserve’s decision to cut interest rates again at the end of January – lowering rates from 3.5% to 3% – has at least restored a little confidence. “We’re reaching the end of the subprime [mortgage crisis] and we’re waiting to see how the consumer credit crisis will hit the market,” says Bruce Mosler, president and chief executive of C&W. “But for the first time we have the federal government and Ben Bernanke [chairman of the Federal Reserve] working in consort to aggressively try to stave off recession and return confidence to the market. That’s a powerful combination. At the end of the day, we’re seeing pro-active government.”
The move is not expected to loosen the securitised credit markets – the investment banks are still fearful of lending in the face of continued uncertainty. But the interest banks charge their existing commercial borrowers should drop as a result of the Fed’s action.
“If you have floating debt, LIBOR has dropped by almost 40% in the past three months and your bottom line has increased significantly,” says Lightstone’s Lichtenstein, who bought a portfolio of extended-stay hotels for $8bn from Blackstone last June with a $5bn slug of floating debt. The successive rate cuts have been like “a gift from god”, he says. “It’s almost like a subsidy to landlords. And it will help banks as well. Banks are using it to become healthier and borrowers are getting a better spread.”
Liquidity on the horizon?
He adds: “People are becoming more optimistic. There was a feeling for a few months that Bernanke was in a coma, but he seems to be alive and kicking. Optimism and liquidity are slowly coming back. I would be surprised if we didn’t have a fundamentally sound third quarter.”
For now, however, the market is adjusting to a new state of play in which “cash is king” loan-to-value ratios are as low as 50% and deals above $50m are proving difficult to finance. As a result, a trend is emerging of equity joint ventures between buyers, says Lyons. Similarly, lenders are asking borrowers to approach a number of banks to syndicate finance in advance of acquisition.
This collaborative approach should increase liquidity and see a number of larger assets sold before the end of the first quarter, such as a New York office building owned by SL Green Realty at 440 Ninth Avenue near the Hudson Yards and Penn Station, which is under offer to a joint venture between Paramount Group and Sherwood Equities for $160m.
Despite this, the volume of deals is still going to be significantly down – perhaps 40% less in 2008 than the previous year. For all the talk of fire sales, there is very little product on the market.
“There has been a drastic slowdown, but there hasn’t needed to be too many fire sales,” says Sapir. “As an investor, we’ve been waiting and watching to see what kinds of deals come along. Everyone is talking about waiting for distressed assets. A few have come across my desk, but you would expect more if things were as bad as we’ve heard.”
All but the most optimistic of commentators agree that when activity does pick up, a 5-15% downward price adjustment for commercial real estate since last summer will become apparent, pushing yields out again after the substantial compression seen during the boom years (see top graph, p13).
The data is lagging behind the depreciation, says Janice Stanton, senior managing director in analytics at C&W. But, she says: “As time goes on and the economic conditions become softer, the theoretical 5-15% adjustment in prices will actually manifest as trades begin to happen.
“Some people think that we will never see it because credit will come back, but we think that the adjustment will happen. But starting in mid-2008 we will have seen most of the credit problem work through the system, so we could see recovery in the third or fourth quarter.”
However, the troubles across the pond do appear to have opened up the US market to UK and other foreign investors. Previously almost exclusively the domain of native investors, the US market is now open to overseas purchasers as the softening dollar encourages cross-border investors, who accounted for 12.5% of acquisitions across the US last year. This marked an increase of 70% to around $40bn, says C&W.
Activity was spurred on by the strong fundamentals of the central business districts of New York and other major US cities – which averaged a vacancy rate of just 9.7% at the end of 2007 and posted rental growth of 10.5%. Cash-rich German and Middle Eastern investors alone accounted for half of all office investments on a dollar value basis during the year.
There is also the small matter of an estimated $1 trillion sitting on the sidelines, waiting to come in to US real estate once the market has stabilised, says veteran New York agent Mosler. This notional figure comprises money already raised to put into the real estate market money that is currently being raised and estimates based on pension fund allocations to real estate.
Capital on the sidelines
Combined, this adds up to a $300bn equity appetite and, leveraged a conservative two to three times, the figure comes close to $1 trillion. “At the moment, that capital is on the sidelines, waiting for the market to price adjust,” he says.
The credit crunch may have brought the investment market to a near standstill but it may also prove the saviour of a market that was running away at unsustainable and dangerous levels. Most commentators say the slowdown and suffering dollar will preserve the long-term fundamentals that could draw all of this money in.
Although rental growth will suffer as the economy takes a battering, “the credit crunch means you won’t get overbuilding in this cycle”, says Stanton. “The times when the US market has really had a large correction have been when there was a downturn and overbuilding. To have one or the other is much easier to weather.”
