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Despite Correction, Financing Remains Available For Sound Investments
After the Blackstone Group purchased the Equity Office portfolio for $39 billion, and 6 months later sold nearly 50 percent of the portfolio for 70 percent of the initial investment the real estate industry realized that capital market risk was not adequately priced. Most professionals predicted a correction in the capital markets was due for the hot and aggressive 2004 to mid-2007 real estate markets because it was not sustainable for lenders to continue underwriting high rent growth, low cap rates, and low occupancy rates along with loose underwriting standards. However, the correction that has taken place has been far deeper than anticipated.
There is significantly less capital available due to the collapse of CMBS. This lack of supply leads to more expensive debt. More expensive debt commands higher cap rates from buyers in order for deals to meet investor returns. Unfortunately, there is a major disconnect of property values between sellers and buyers causing a significant slowdown in property sales. Until buyers, sellers, borrowers, and lenders compromise on their expectations of rates and terms it is unlikely transaction sales and loan origination volumes will return to historical norms.
Second quarter 2008 loan originations were down 63 percent compared to the same period last year. Loan originations for banks decreased 29 percent, life companies decreased 27 percent, and CMBS, which financed 70 percent of all loans in 2007, has declined a staggering 98 percent. The only bright spot is the government-sponsored enterprise, Fannie Mae, which has increased origination volume by 66 percent primarily for multi-family loans.
Despite the gloomy statistics of 2008, there is still financing available, although at much more conservative levels through banks and life insurance companies. Typical financing for a 10-year fixed rate loan on a stabilized property is based on 65 percent loan-to-value, 1.20 DSC, no interest-only, higher underwritten tenant improvements, minimal rent growth, and possibly an element of recourse. Most loans in excess of $50 million are financed through international capital sources or participated loan pools through several American banks.
Financing deals with real estate owners that have a strong balance sheet, high liquidity, and a low leveraged portfolio is still executable in 60 days. The ideal transaction characteristics are low leverage, credit tenants, strong occupancy, reputable sponsorship and healthy debt service coverage. Cohen Financial has placed a significant number of these loans with exclusive correspondent life insurance companies at interest rates below 6.5 percent, which are still well below historic rates.
As we approach the end of the year and look towards 2009, the capital markets will most likely remain conservative in underwriting, spreads will continue to rise, with only lower leverage available. Banks and life insurance capital levels will remain similar to 2008. For the capital markets to return to equilibrium CMBS will need to be reinvented or a suitable replacement financing vehicle will need to be devised. Until there is more liquidity in the market or until buyers, sellers, and lenders reach a compromise, the real estate markets will remain bleak. During these challenging times Cohen Financial's proven experience and extensive relationships can assist you with any financing needs.
This edition of Capital Markets Perspective was researched and written by Mandy Pakes, Capital Markets Senior Analyst in San Francisco, California.
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