This time last year marked the beginning of a dramatic shift in the availability and cost of capital. Issues once described as “technical” have
become intrinsically linked to the basic
values and demand for the underlying
real estate.
“We will likely always see our real
estate markets cycle through periods of
upturn, stability, decline and then beginning again with a new upturn in demand,”
says Rick Klepal, vice president with
CBRE/Melody. “What may be different
today is that, through increasingly sophisticated uses of leverage, these cycles
appear to have changed somewhat in
both frequency and duration. Many
believe we experienced the cresting of
one such cycle last summer and are
already beginning to see initial signs of
improvements in the capital markets.”
Klepal attributes the issues facing
today’s capital markets to an insufficient
demand for bonds created as a result of
CMBS lending, leading to a significant
decrease in liquidity. However, institutional investors are beginning to return to the
market and, though not yet at levels needed to re-establish a stable supply of capital, it is a first step in the right direction.
Smart Business spoke to Klepal about
the current state of the capital markets,
who is supplying today’s capital and what
we might expect going forward.
What is the status of today’s capital market?
The cost of capital for real estate investments has increased dramatically. In the
overall capital stack, which is frequently
made up of debt and equity, equity is considerably more expensive. Combine that
with higher minimum equity requirements and the result is a higher overall
cost of capital.
On the debt side, the investment banks
who funded, packaged and securitized
CMBS loans have reduced levels of effectiveness (down 92 percent in March
according to Real Capital Analytics). In
their place, the portfolio lenders, such as
life insurance companies, pension funds
and commercial banks, have returned to center stage as the market’s primary capital source. Commercial mortgage loans
in today’s marketplace have become
more selective and restrictive. Loan
terms, such as loan-to-value levels, debt
coverage requirements and amortization
periods, have all become more conservative. As the supply of commercial financing is significantly less than the demand
and as the perception of performance
risk has increased, the cost for financing
has gone up in terms of lenders’ spreads
over the index or cost of funds.
Fortunately, those indexes (U.S. Treasury
rates and LIBOR) have gone down
throughout the past year, helping to offset
the increases in spreads. The result is
attractive loan rates available to those
properties and borrowers that meet the
new lending criteria.
How have these conditions impacted investment sales?
It has certainly made it more challenging
for all parties to transact today. Both the
debt and equity available has seen a clear
flight to quality, and it has given a discernable advantage to investors with reliable capital. Reduced leverage has caused
upward pressure on capitalization rates
and downward pressure on property values. Investors need to hit acceptable internal rates of return, and as the cost of capital goes up, something has to give. Many
sellers have been resistant to acknowledge this change leading to a gap between
the bid and ask prices, thus reducing the
number of recent sales transactions.
Demand for quality assets remains strong
though much thinner than it was a year
ago and with fewer qualified buyers.
What is your insight of the future of these
markets?
It appears that most believe we will
have a much better perspective of the
capital market landscape by the end of
this year with measurable levels of
improvement in the first half of 2009. We
can draw further encouragement from
the popular consensus that the worst is
behind us. One truly promising outcome
is that the CMBS markets are finding it
necessary to incorporate more risk
adverse underwriting and greater levels
of transparency. This is likely to lead to
more sustainable capital. While we still
have a long way to go in this regard, a
healthy CMBS marketplace is key to a
stable commercial real estate market.
How should today’s challenges be
addressed?
While it’s certainly a challenging time to
see transactions through to closing,
imbedded in the process are opportunities for all parties. Today’s current market
makes it imperative that we rely on each
other to bring integrated services to bear.
Valuation, debt and equity financing,
asset management, leasing and investment sales all play an impactful role in
the process. Securing an adviser who can
address all your needs and provide an
integrated set of solutions to the challenges facing today’s property owner is
more important than ever.
RICK KLEPAL is vice president with CBRE/Melody. Reach him at (813) 273-8480 or [email protected].