Corporate Finance Trends by W. Joseph Caton

by 25 Nov 2009

Mapping Out the Next Real Estate Investment Cycle

 
Investors are cheering the tightening of credit spreads – a move that can bring real estate debt investment back in vogue.
 
--BY W. JOSEPH CATON
 
 
Since experiencing an unprecedented run up that began late summer of 2008, a critical measurement of stability in the credit markets has been showing signs of strength in recent weeks.  Spreads, or the difference between how much payment lenders demand as interest above yields on benchmark instruments like LIBOR and U.S. treasury bonds, have been on a declining trend.  Overall, declining spreads is good news for any credit and interest rate driven business such as real estate finance and the fixed-income portfolios they represent.
 
To begin with, real estate debt investment activity has typically mirrored what happens in the corporate finance arena, and generally lags such activity by anywhere from six to nine months.  For instance, before any semblance of trouble reached the mortgage-backed securities and real estate lending sectors, some private equity firms first began to experience difficulty in raising funds for highly publicized leveraged buyouts.  These deals dominated the news headlines and the pages of corporate finance trade journals during the capital markets liquidity peak.  And these transactions were among the very high flying ones that ran into trouble despite their well-known brand names.
 
Follow the leader
The first hint of trouble occurred in the summer of 2007, when leveraged buyout private equity specialists began to abandon some deals such as the original $5.5 billion ServiceMaster buyout attempt by Clayton, Dubilier & Rice, Inc.  And later, the resale of the Chrysler brand from then Germany’s DaimlerChrysler Corporation to Cerberus Capital Management was delayed and renegotiated more than once.  The reason?  The buyers were having difficulty raising the required debt.
 
Shortly thereafter, the credit markets began to freeze up, resulting in the ensuing credit crunch that enveloped both the debt markets and Wall Street itself.  The real estate finance business then experienced its version of the credit meltdown beginning in the first quarter of 2008; almost exactly eight months after the corporate finance market went into its freefall.
 
But while the corporate finance space has continued to see fallout from defaults and bankruptcy filings, the creative financing minds of Wall Street have been busy at work. For one thing, many companies (including the U.S. automakers) have embarked on a debt-exchange binge in recent months that have served to dampen the blow of a rising tide of corporate defaults and bankruptcies.  Analysts at Standard & Poor’s have recently taken note of just how much this trend is proliferating across multiple business sectors, including real estate finance and investment ventures.  In its regular client report on credit markets activities, Standard & Poor’s noted that spreads had tightened across every industry measure, including the dicey banking sector.  This represents a ray of hope for resolving an increasing number of distress debt issues, including mortgages.  It is also reason for optimism among both fixed income investors and borrowers such as real estate owners.
 
Lending rates and debt investment yields, as measured by the Standard & Poor’s Composite Credit Spread Index, has been tightening since the beginning of the year.  At mid October, the investment-grade composite credit spread tightened to 235 basis points, compared to 531 basis points at the beginning of the year.  The speculative grade composite spread tightened to 740 basis points from 1,628 at the beginning of the year.  Even though these are relatively wide spreads on a historical basis, they are a far cry from the unsustainable wide margins recorded in December 2008, when speculative-grade spreads had exploded to almost 1,800 basis points, and investment-grade spreads were over 1,200 basis points.
 
 
At the very least, current spreads indicate that investors are being paid more of a premium for taking on additional risk and are somewhat satisfied with it.  This development reverses what many market observers say was the root cause of the initial credit market meltdown in the first place – investors not being compensated enough for the level of risk they were forced to shoulder.
 
High-yield real estate
So what do these emerging credit market trends mean for the real estate finance business, which is at best just muddling along, and still widely expected to move into further decline?  One important thing is that real estate investment firms and fund managers struggling with sub-performing assets are now finding a deeper well of investment partners willing to enter into creative risk sharing transactions.  It is a deeper well than just a few months ago, when buyers were expecting a real estate Armageddon to unfold.  That is no longer the case, although some still do.
 
But there is a resurging appetite for real estate-backed deals today – particularly high-yielding notes – even though the trading market remains quite dicey.  A significant amount of capital remains on the sidelines awaiting opportunities, even though many investors remain cautious.  Thus, few owners of either real estate assets or loans are willing to sell into this environment.  At the very least, they are aware that lenders and loan investors will demand higher risk premiums in order to either make property or loan trades happen under current market conditions.
 
This standoff in the loan and asset trading business has created opportunities for some lenders and investors.  Lending is turning out to be the alternative strategy to buying legacy notes and other securities.
 
For instance, New York-based W Financial Group, a direct lender recently provided a $5.7 million loan to a borrower for the purchase of a defaulted first mortgage from an investment bank.  The loan was for a prime commercial property in West Chelsea, New York City. According to Gregg Winter, the firm’s principal manager, “The borrowers in this case are seasoned opportunistic real estate investors, who saw the value of this deal even in the current tumultuous market environment.”
 
Winter offered another recent transaction as an example of how this type of creative deal structuring is emerging as an alternative investment strategy.  W Financial provided acquisition financing to a borrower for purchase of a defaulted note from a Florida bank. The note was secured by eleven unsold condominiums located in a large project in Vero Beach, Fla. He says that the eleven units were the last of a 700-unit project and that the developer owned those remaining unsold units.  Winter’s client purchased the defaulted note at a discount, and as a high-yield investment.
 
So, the real estate finance and investment cycle is once again following the early trends of the corporate finance marketplace.  As borrowers and property owners run into the challenges of declining rents, falling values, and possible loan maturity defaults, creative lending is riding to the rescue.  Capital rescue missions are an emerging trend, and are seen in the number of lenders that are prepared to lend for the purchase and rescue of distress notes and properties.
 
Madison Realty Capital, a debt investment firm is actively pursuing opportunities to lend to qualified borrowers for the purchase of distressed and defaulted notes as well.  And as many investors clamor to buy distressed notes, the New York-headquartered asset-based lender intends to take advantage of such opportunities.  As a sign of just how wide open this market is, Madison Realty Capital even hones in on the property type it is most keen to rescue – value-added multifamily properties.
 
We are actively acquiring performing and non-performing senior debt on multifamily properties from banks looking to sell,” says Roy A. Schoenfeld, vice president at Madison Realty Capital.  “We are also actively seeking to finance note purchases collateralized by multifamily properties.”
 
Bond buyers rule
Yet another trend is emerging as further evidence real estate debt is coming back in vogue.  Life is returning to the high-yield corporate finance marketplace, and spilling over into real estate debt.  One does not have to look too far for evidence of this.  The first half of 2009 produced a walloping rally in the high-yield market.  And analysts at JPMorgan Chase and Standard & Poor’s noted recently that new issuance in the high-yield bond market has been increasing at a steady clip.
 
For instance, JPMorgan Chase asset management reported that the second quarter was a strong one for high-yield U.S. corporate bonds, both in terms of issuance and pricing.  The fixed-income asset management arm of the bank says that the May to June period was its most active for high-yield bonds, with a total of $26.5 billion in new notes issuance to market, since $29.3 billion was issued in November of 2006.
 
"Another sign of improvement can be seen in the high-yield primary bond market," says Diane Vazza, head of Standard & Poor's Global Fixed Income Research Group.  Speaking about new issuance that Standard & Poor’s rates and tracks, Vazza says, "New issuance surged $18.1 billion in May, the best month since June 2007.  However, the large headline number does not represent a substantial increase in new demand for credit or an increase in the supply of new money, because a bulk of the recent issuance has been used to refinance bonds and loans."
 
To be sure, as interest returns to the junk bond market – and it clearly has – struggling real estate investment ventures will benefit from investors’ appetite for such high yield fixed-income products.  Property owners who are willing to enter into partnerships or issue high-yield debt can move to the forefront of this marketplace with high quality assets.  But these borrowers or debt issuers will need to have a critical component in place in order to capitalize on current market conditions – a viable asset management program.
 
Absent a good program with professionals who can work out loans and line up partners to rescue failing projects, the issuance of high-yield debt or taking on partners can be detrimental.  By all means the road to a comeback in the real estate finance and investment business runs through a viable asset management program.  These professionals are in high demand, and according to some industry observers they are in shorter and shorter supply.
 
There is one area of the market, however, where signs of life have yet to emerge – the leveraged loan market.  Property owners and investors whose business model relies on high leverage loans will have to remain sidelined until lenders and loan investors can warm up again to high leverage lending in either the corporate finance or real estate investment markets.
 
Joe Caton is a training and development consultant for real estate finance and investment professionals.  Caton can be reached at jcaton@hartfordone.com

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