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 firstname.lastname@example.org.