Feldman Equities

March 2002

CAPITAL MARKETS REPORT: What crisis?
The Enron mess, 9/11, the Argentine fiasco and
other factors have made people jumpy, but
most insiders say they're not terribly worried.

Commercial real estate's capital markets-debt and equity, public and private-have clearly slowed down in the past three quarters, and aren't likely to pick up for a while yet. However, most observers agree that the quiet times can't last forever. Potential providers of equity might be waiting for asking prices to come down, but the consensus is that they'll wait in vain for any significant decreases-and that they won't wait too much longer, at that. Real estate is generally seen as a stronger play than the stock market today, and there's a lot of capital itching to be placed.

Historically low interest rates are fueling demand for debt, particularly short-term floating-rate debt. However, reluctance among most players to pick up the B piece of securitized loans, and the exacting requirements of the few B-piece buyers, are keeping the CMBS market relatively quiet. Senior lenders have been more cautious lately about how much they're willing to lend; thus, the senior pieces of the largest loans are often broken up among several lenders, and mezzanine financing is gaining in importance.

All in all, supply of capital and demand for it are both high-and yet business is slow. Buyers and sellers are both playing a waiting game. The Enron collapse, 9/11, the Argentine crisis and other factors have made everyone jumpy. Still, most industry insiders agree that they're not terribly worried, long-term.

"The market has slowed a bit," concedes Michael Sherman, senior managing director of the capital advisors group of Insignia/ESG. "There's lots of money in the market, but not much product for sale and not much refinancing going on. I expect this quarter to be a little rough, and then things should turn around. Real estate won't suffer as it did in past downturns because we had almost no new spec construction during the last up-cycle. So, once leasing starts up again, there won't be much space to absorb. It's just a question of when that'll happen.

When the action starts up again, Sherman predicts, debt and equity will come from the usual cast of characters, with few new investors coming in, and few exiting.

"I don't foresee big changes in debt structures," he adds. "Debt won't get any looser, or more conservative. Right now, though, everything's slow: You only come to work because you feel guilty if you don't."

Steven A. Kohn, president of the Sonnenblick-Goldman Co., a real estate investment bank, remarks that the only trend in capital markets specific to New York City is the current loss of confidence in Downtown. Midtown, though, is one of the healthiest markets in the country, he adds, the suburbs are doing well and both debt and equity capital are plentiful.

"Lenders are worried about the short-term viability of Downtown," he admits, "but inertest rates are attractively low, with LIBOR under 2%. On the equity side, there aren't many investment offerings right now because pricing is an issue in most markets. Everyone wants to own, but owners don't want to sell."

Dan E. Gorczycki, senior vice president of Granite Partners, notes that as the bid-ask gap in pricing continues to widen, more owners are looking at refinancing as a short-term solution.

"We're just closing a deal where we got LIBOR-plus-two (3.8%) for two years, with the intention of selling in 2004," he reports. "More and more people are taking that strategy because of where LIBOR is, hoping buyers will step up more in a couple of years."

Gorczycki notes that although not much property is for sale at the moment, neither are many players chasing deals.

"Two or three years ago," he says, "the entrepreneurs were gaining momentum with their opportunity funds partners, and even insurance companies were players. Now, opportunity funds are still there, but more selectively, and so are pension funds, but the less-capitalized entrepreneurs have been shaken out. There used to be 30 to 40 bids on a property; now you'll usually see five to 10.

"We have the same client base as before, but the opportunity funds that used to buy all-cash are now saying that given where LIBOR is now, it makes sense to put at least 50% debt on a property."

Larry Feldman, president and CEO of Feldman Equities, Floral Park, NY, suggests that if the bid-ask gap does close, it won't be because sellers are relaxing their demands significantly.

"There was a big bid-ask spread in the late 1980s, pre-recession," he points out, "and then the savings-and-- loan crisis closed the gap. You won't see a collapse in prices this time, though, because we don't have the excessive building and we don't have as much leverage as we had in the '80s. Conduit lending has been more disciplined. CMBS scrutiny of the public markets has led to better discipline in the public markets. So, you won't see the foreclosures that will cause the bid-ask gap to close on the downside."

For now, though, that gap is causing Feldman to act cautiously.

"We're just sitting patiently on the sidelines with our cash," he says. "Only recently have we found some opportunities in niches that others are shying away from, in medium-- sized retail malls."

The bid-ask spread, Feldman admits, is making capital hard to place, but he adds that it can't keep investors away indefinitely. He concurs with Gorczycki that opportunity funds have large pools of capital at their disposal. Pension funds, he adds, have a continuing commitment to real estate, as real estate portfolios have been outperforming stock portfolios. Especially in REITs, hard assets have done well against the stock market.

"Right now, capitalization rates are in the 9% to 11% range, and the LIBOR-based floating rate is in the 4.5% to 5% range," he concludes. "That spread is almost an all-time high, and it's keeping a lot of money interested in real estate."

"The capital markets are full of money," says Scott A. Singer, EVP of The Singer & Bassuk Org. "They've been so for a long time, for different types of loans-short-term, long-term, construction, mezzanine-and there's no shortage of money looking to purchase properties. New York remains an attractive market for borrowers. Lenders are doing business more conservatively, due to the negative changes in the economy-higher vacancy percentages, lower market rents, lower projections of increases in future rents. So far, we've seen a measured and appropriate response to these changes, not a headlong flight from the market, which we feared after September 11th.

"We've seen no major change as to sources of capital," he says. "We might have expected Wall Street capital to have largely disappeared, but that has not been the case. Nor have institutional lenders suddenly become very conservative-at least, not across the board. We're getting calls from lenders seeking business just as we did before September 11th."

Singer notes that very large loans-- $100 million or more-are more likely nowadays to get done with more than one lender, to diversify the risk.

"That said," he adds, "we have a $180 million transaction on the table, and some lenders are offering to do it all on their own. Floating rates have gotten so low that there's more of an incentive for borrowers to look at shorter-term financing structures, even for properties that aren't in transition, than at any point in the past several years.

"The spread between fixed- and floating-rate costs has widened. People used to be focused on fixed-rate structures, but now it's become impossible not to at least consider floating-rate deals," Singer says. "Fixed interest on a stable property might be around 796; the same property could be 3.5% with a floating-rate structure that's priced over LIBOR. You save a lot, very quickly, when the spread is that big.

"That's not to say that fixed-rate deals are unattractive," he points out. "Our clients typically buy and hold, so there's less impetus to take the interest rate gamble."

"We haven't had LIBOR rates at 1.8% since the 1950s," Feldman exults. "For a troubled portfolio, floating-rate debt is a powerful tonic to prevent serious problems. I know some owners who have all floating-rate debt right now who are enjoying the high life. If you have a fixed-rate portfolio, though, in a market where rents are down and vacancies up by 10% each, you might be in trouble right now."

Because lenders are wary of current conditions, Gorczycki notes, they're lending more conservatively; as a result, the mezzanine market is gaining importance.

"It's not harder to borrow, but it's harder to get maximum dollars," he says. "An 80% loan used to be do-able; now, 70% is more comfortable to most lenders, and above that you have to go to the mezzanine market. There are a limited number of mezzanine players-maybe only 10 who could handle a large piece-and they all want an internal rate of return in the midteens at the very least. You either pay the piper, or take in an equity partner.

"A couple of new players are talking about doing mezzanine on CMBS, where it's transparent to the CMBS market," Gorczycki continues. "This is a new structure where we have a few players. One benefit to the borrower is that the mezzanine players don't have a huge pipeline of deals, so they can be creative in structure even if they can't go down in rate."

"We attribute the increase in available mezzanine debt partly to the fact that in a potentially flat market, some capital providers would rather provide debt-which promises a priority return-than equity," Kohn adds.

Paul K. Talbot, senior managing director of Newmark Capital Group, acknowledges that commercial mortgage lending will be down throughout this year, but adds that insurance companies, banks and other asset-- based institutions will still be putting out plenty of money.

"Returns are good," he asserts. Insurance companies are outbidding the conduits on the amount of proceeds they're lending on, and they'll get more into mezzanine lending in combination with their senior piece. There's a need for mezzanine money to get borrowers up into the 80s LTV.

"People on the conduit side are underwriting more conservatively, because the B piece they need to sell off is not as active these days, and the rating agencies are becoming more restrictive because of factors like the lack of an increase in rents," Talbot continues. "Conduits will be lending conservatively, even on built-in rent increases, because if the rent's above market, the tenant might go back to the landlord to negotiate."

Bob Blanz, vice president of Capital Lease Funding, agrees very few players are interested in B pieces these days, making the CMBS market generally more conservative. But he adds that this has been the case for a couple of years, and the market is no tougher than it was six months ago.

"The very senior bond tranches attract a lot of bids," he says. "But the B-piece buyers determine who gets into the pools. It's a matter of the tail wagging the dog, but this gives the market some discipline. It's a good thing for buyers, bad for issuers. On the whole, though, I say it's bad. It diminishes competition, which is never desirable economically."

"CMBS drives the debt market, and insurance companies and banks mirror CMBS spreads, which are at historical levels of narrowness for AAA or AA notes," Gorczycki adds. "Corporates have been poor performers, so a lot of people are looking at the better tranches of CMBS. The B piece spreads, however, are higher than ever, due to this flight to quality going on in the credit markets, with Enron's collapse, the Argentine crisis, and other events."

"The CMBS market remains very aggressive for smaller deals," says Singer. "It's less aggressive nowadays for large loans. Once CMBS loans get over $50 million, many investment banks hesitate to commit to anything more than the investment-grade portion. Large-loan fixed-rate B pieces aren't popular now. However, this situation creates an opportunity for pension funds and insurance companies to take down these loans at more attractive yields than they were able to get when they were competing with investment banks."

Meanwhile, Singer reports, the longterm credit tenant net lease market has become considerably less liquid.

"The securitization market has dried up from where it was a year or two ago," he says. "At one time, every investment bank that had a CMBS program had been looking for longterm credit tenant loans, but were finding it hard to find buyers for them, so that market has dwindled. Some institutions are still in the market, though, because some very attractive deals are still available."

Robert A. Sass, executive managing director of real estate investment banking at GVA Williams, argues that certain lease structures, including synthetic leases and sale-- leasebacks, get undeserved bad press, which might be one reason for the current unpopularity of long-term credit tenant loans.

"It's falsely alleged that the synthetic lease structure will cost companies money because when the short-term financing rolls off, the building has less value," he explains. "The fallacy in that theory is that if the building had been bought outright, there'd still be the same pressure on value, and if the building had been conventionally leased, you'd miss the savings to be had in a synthetic lease structure.

"Now is a particularly good time for sale-leasebacks, too, especially for credit tenants of investment grade," Sass continues. "They have such low cost of funds these days that a longterm sale-leaseback could be done at heretofore unheard-of pricing. Using floating debt, you could conservatively finance at 150 basis points over LIBOR-just over 3%. The cost of funds is a big driver. Another huge driver is the pressure on companies to use their capital wisely and maximize earnings. If you can do a sale-leaseback at a cap rate of 8% or lower, and use that capital for a 12% return, you should do that all day, right?"

GVA Williams is looking at ways to minimize the tax exposure inherent in a sale-leaseback, Sass reveals, since such deals are bound to retain popularity for some time.

"This country contains $2 trillion worth of corporate-owned real estate," he estimates, "so it's not likely we'll run out of deals. You're seeing an expansion of the public markets in sale-leasebacks and in single-tenant credit leases in general. The pricing hasn't gotten so aggressive that yields have dropped relative to other investments."

New York isn't a market known for its abundance of single-tenant credit lease opportunities, Sass admits, although he expects to see more such plays on industrial and retail properties in the metro area.

"Synthetic leases are typically used as an acquisition vehicle," he continues, "and right now we're seeing less acquisition than disposal. Still, it's a fair generalization that a synthetic lease or some other sort of structured transaction is the rule when a corporation acquires a building for its own use, rather than an outright purchase."

It's the flexibility of the sale-leaseback structure that makes it popular, Sass explains. It might not yield the highest possible price, but quite often the goal is to lock in low occupancy costs rather than to score a high sale price.

"If you don't have a high tax basis," he says, "and want to avoid a tax exposure, you'd sooner lower the sale price and lock in below-market occupancy costs. If you can do that, you're also likely to come out ahead on your stock price. Finally, it's not true that ownership gives you maximum flexibility. If you own, you'll sometimes need to sell when prices are down."

Still, Sass cautions, such lease transactions may be coming under scrutiny from the Federal government soon, since so many of Enron's recent problems stemmed from off-balance-sheet treatments.

"Nor are net leases and sale-- leasebacks as easy to do these days," Gorczycki comments. "You used to be able to do a lease for Kmart and get killer pricing, but with credit tenants like them suddenly becoming non-credits, you find fewer players willing to take a chance on these transactions, and they want bigger spreads. They used to just put a little premium on top of the corporate debt rating, but now it's a real estate deal where they want to know that the property will be immediately re-leasable if the tenant goes bankrupt."

"Despite a few negative credit events, like Kmart, the public and private capital markets are going to keep on efficiently financing net lease properties," insists Bob Blanz. "Such transactions don't have that big a presence in New York, anyway."

The best candidates for net leases these days, says Blanz, are large grocery and drug retailers that prefer freestanding properties.

"They like to operate 24 hours a day, without a shopping center's rules," he explains. "Besides, drug and grocery stores have higher sales psf if they're stand-alone."

Fincham and Patrick Dempsey, both of Lee & Associates Arizona in Phoenix, negotiated the sale for buyer and seller, Fort Worth-based Hillwood Development Corp., a Perot Co., and joint venture partner, General Electric Capital Corp.

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