Virginia R. Fleisher is a principal of Fleisher & Assoc. of Needham and is co-chair of the research and development committee of the Real Estate Finance Association.
While real estate professionals struggle to comprehend the tragedy of Sept. 11 and comfort friends and family, they also try to move ahead with business endeavors and daily routines. This column reviews current trends in the real estate debt and equity markets and notes further market changes that may occur in the future.
The events of September 11th helped push our country towards the softening that many economists were already anticipating. The media reports daily on new layoffs, financial problems for travel related industries and the growing lack of consumer confidence. This spills over into negative affects on real estate assets, from increasing vacancy rates in many markets to curtailing the flow of investment funds into the asset class. However, many economists are also pointing out that this recession will not be as severe on the real estate industry as the recession of 1991, primarily due to the lack of overbuilding in the markets. The exact impact this economic downturn will play out in the next several months.
On the debt side, there is still liquidity in the market, especially for properties with strong cash flow. Life companies are proceeding with new business but with added caution. As underwriting standards tighten and valuations drop, loan amounts are falling as well. Spreads have risen and most lenders are requiring interest floors in the 6.5 percent to 7.0 percent range. Forward rate loans are tough to find, given the pricing difficulties, as are loans secured by hotels and some retail assets. Apartments are still the top choice of property type, followed by good industrial, food and drug-anchored retail and quality office deals. In the wake of the attacks of September 11th, lenders are also looking to enhance insurance requirements. For example, business interruption insurance will likely move from a 12-month to a 24 or 36-month requirement.
On the portfolio management side, portfolio lenders are stepping up reserves on the property types projected to be hit by an economic downturn, specifically hotel and some retail assets. Default rates have not increased sharply, but may rise next year as loans mature. Some lenders may be faced with forced refinances, or problem loans if the property owners with debt maturing in 2002 have difficulty finding take out financing or buyers for their properties.
Commercial Banks
As for the commercial banks, they are also proceeding with financings for properties with strong cash flow. Banks continue to be creative in offering an array of product types to meet a borrower’s needs. However, it is now difficult for a borrower to find financing for new construction or speculative projects without significant preleasing in place and recourse from a strong sponsor. The banks, like the life companies, are shying away from hotel and some retail product and are eager to finance apartment projects.
Conduit lenders also continue to pursue deals, while looking for higher coverage on new business. The major area of concern for this business is the state of the B-piece market. The field of B-piece players appears to be shrinking, as some become concerned about potential future delinquencies. Moreover, there is uncertainty how the several tiers of servicers involved with securitized assets will actually manage problem loans during a downturn. For large loan securitizations, it is tougher to find B-piece buyers, as investors seek the diversification gained by investing in a pool of assets. However, as of September 30, 2001, the total U.S securitization activity totaled $28.4 billion, with additional issuances currently in the pipeline.
On the equity side, the tragic event of the 11th accelerated the slowdown in the sales market seen over last summer. Sellers are often not able to achieve the desired sales price and thus are turning to the debt market to find take advantage of the low interest rate environment. Buyers and equity investors are carefully analyzing deals for future problems or erosion of cash flow. The equity market is also seeing a decrease in values and rise in cap rates in some markets. However, the low interest rate environment does provide room for attractive returns for the equity investors with solid performing assets. Buyers with financial resources are closely watching for declines in value and attractive buying opportunities.
In summary, the professionals in the real estate debt and equity markets are proceeding with added caution, looking to invest in quality deals with steady cash flow. There will likely be additional challenges as well as new opportunities as 2002 approaches. A severe liquidity crunch does not seem to be ahead. However, the rapidly changing state of the economy and real estate markets require real estate professionals to monitor market shifts closely and to scrutinize new transactions and investment strategies carefully.
