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The Denouement for Low Cap Rate Commercial Real Estate InvestmentsOrHow to Explain the Current Credit Crisis and the Future Pricing for Commercial Real Estate
The word “
denouement
” is French. “
Denouement
” is defined by the Oxford English Dictionary
as
“The unraveling of the complications of a plot, or of a confused situation or mystery; the finalresolution of a play, novel, or other narrative. “ My colleagues Richard Kusack and David Kopp
thought the word was appropriate to describe the current situation in commercial real estatedue to the effects of the Credit Crisis of 2007.Although these prognostications are theoretical, we will try to provide support for theargument that cap rates for investment grade real estate will have to increase in the short run
due to the credit crisis. We are defining “short run” as the next 6
-18 months. The impact onlonger range investment valuation is speculative at this time and is highly dependent on theavailability and cost of capital in the credit markets after the next 12-18 months.
Suffice it to say, that by April 2007 the availability of “easy credit” for commercial real estate
was at its apex. Investment Banks and the CMBS securitization market were achieving recordvolume levels of financing and spreads for various product types were extremely tight (i.e., thecost of money was relatively cheap for real estate investment and its availability waswidespread). Why was this so?Most people believe that the credit crisis is solely due to the sub-prime residential lending thathas resulted in many foreclosures and pain for homeowners throughout the U.S. Our feeling isthat the sub-prime residential was a catalyst and harbinger for the eventual problems in bothcommercial real estate and corporate debt structures.The sub-prime residential lending that occurred from around 2003 till early 2007 is based on arelaxation of traditional lending underwriting for residential property. Specifically, bankersstarted to use the underwriting for homes that they used for automobile loans which resultedin loans that were too aggressively underwritten. In many cases, these loans exceeded thevalue of an already aggressive appraisal for a particular residential property. Many loans were
advertised as “125% of value loans,”
that were often adjustable rate mortgages that hadonerous escalations built into their terms. In mortgage brokerage language, a prospect merely
had to be “warm and breathing” to qualify for a home loan. Also, many of the residential loans
made were not to owner-occupants but to investors looking to cash in on the real estate boom.
 
 Now, when the housing markets have slowed down, the 125% of value loan effectively canbecome a loan that is 50% too high due to the restriction of credit. Here is the math:If a property drops 20% in value and new lending standards limit loans to 75% of the newlyappraised value, the maximum amount of debt drops from 125% to 48% of the original over-inflated loan. In certain cases, the drop in real estate values is more serious (Florida, parts of California, Nevada and Arizona). The end result is that there are many over-leveragedAmerican families due to excessive residential lending (first mortgages and home equity loans).Politicians are now grappling with how to handle this troublesome situation which is a delicatebalance between necessary help and bail-outs for people who do not deserve them.
The Macro Problem (CDOs and SIVs)
Major money center banks and investment banks (e.g., Citicorp, UBS, Merrill Lynch) made bigbets on assets that they packaged into complex and difficult to understand investment vehicles:CDOs (Collateralized Debt Obligations) and SIVs (Structured Investment Vehicles). Unlike, therelatively transparent investment vehicles collectively known as CMBS (Collateralized MortgageBacked Securities), CDOs and SIVs are not readily discernible in terms of decipheringinformation and the ability to adequately value
these assets (they are often “marked to model”rather than “marked to market” which means there may not be any meaningful market for
these assets; hence the magnitude of the Sub-Prime Credit Crisis). Be aware that it is notsimply sub prime residential mortgages that are at risk here, but mortgage insurancecompanies like AMBAC and MBIA due to the uncertain valuation of possibly trillions of dollarsof collateral that were sold and insured (or not sold) by banks and investment banks. Theproblem is not limited to real estate in that these CDOs and SIVs may contain CLOs(Collateralized Loan Obligations) that may include corporate debt that is attached to some of the major private equity buy outs done in the past several years. So, the big question is
 –
whatare these assets worth? We do know that today oil is $110 a barrel and gold is hovering around$1000 per ounce which is quite inflationary compared to prior pricing. Food is also quiteinflationary, but assets like automobiles and real estate are somew
hat deflationary. Go figure…
 
How Does All This Affect Commercial Real Estate?
First, the amount of equity required to purchase, develop or re-develop an asset is greatlyincreased from as little as 2% in 2004-2007 to a current 40-50% in 2008. In general, equityrequires a greater yield than debt, as debt (especially senior debt) has traditionally been viewed
 
as a conservative investment in the province of large investors like commercial banks, insurancecompanies and in recent years, most importantly, investment banks.Investment banks helped bail out commercial real estate in the last major down cycle of 1987to 1993. Many substantial real estate companies became REITs (Mack-Cali and Reckson cometo mind) and large commercial banks began in early 1995 to begin to be packaged into pools of loans known as CMBS (see above).Fast forward to 2008 and we see that investment banks had record originations in the first half of 2007 and then the business disappeared in the second half of 2007. This slowdown hasresulted in the beginnings of massive layoffs at Investment Banks (with Bear Stearns being thecurrent most glaring example in its demise and assumption into JP Morgan Chase.)
We have been grappling with the return that equity should require in today’
s commercial realestate environment. On the one hand, there is enormous uncertainty in the markets today,both in terms of consumption and political stability of our country. These factors add a riskpremium to equity investments in commercial real estate. Conversely, in the debt marketsthough capital is quite scarce, there is a predilection for very high quality assets. The cost of Debt for these assets is relatively low (low 5% range for multi-family to just around 7% for manycommercial real estate assets that are not overleveraged).The general rule that we have used in calculating equity returns is that equity has to berewarded for the risk and illiquidity of owning real estate. A riskless investment is generallyviewed as a Treasury note (assuming we do not bankrupt our government). The ten yearTreasury note currently yields 3.54% and senior debt is 5.25-7% for high quality assets. Equityis subordinate to senior debt and must be afforded a risk premium of 2-4% given its added riskand illiquidity. Therefore, high quality assets are going to require equity returns ranging from
7.25% (the highest quality “Class A” real estate) to 11% (B quality assets). Class C assets havebeen most hard hit as there is a tendency for investors to have a “flight to quality.” These Class
C assets have an additional 3-4% risk premium, which would indicate that equity yields forthese assets would be 14-15%. This analysis is predicated on low interest rates (i.e., a ten yeartreasury note at 3.54%). If rates go up, then equity rates would rise commensurately.Another factor that increases the cost of capital is the fact that high leveraged deals are not
possible in today’s credit environment. So, instead of equity requirements being 2
-25% of totalcosts, the situation is now that equity has to be 15-50% of the transaction costs. This higherequity requirement puts a downward pressure on commercial real estate prices because:
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