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Dec 03 2009

Filling the Funding Gap

Lender flexibility and new equity will restore real estate capital markets

By Eric Schultz '11

On the morning of November 18th, the 2009 Kellogg Real Estate Conference hosted a panel discussion on the current state of capital markets. Moderating the debate was Craig Furfine, Clinical Professor of Finance at the Kellogg School of Management. The panel consisted of Karen Case, head of commercial real estate lending at The Private Bank; Bruce Cohen, CEO of Wrightwood Capital; and Jeff Johnson (Kellogg '83), CIO of Transwestern Investment Company.

Professor Furfine kicked off the session by posing the most pressing question facing the real estate industry: with real estate asset values depressed and debt financing scarce, how is this funding gap going to be addressed?

2009 Kellogg Real Estate Conference hosted a panel discussion on the current state of capital markets.
The panelists identified four players that are expected to play a pivotal role in solving the problem: lenders, real estate private equity funds, high-net-worth individuals and institutional investors.

Given the huge volume of loans maturing over the next several years, lenders are largely expected to extend or restructure loans where it makes sense to do so. Most lenders are not in the lend-to-own business and would prefer to work with borrowers rather than foreclose. As Ms. Case explained, “How you behave today will affect banks’ willingness to help or do deals later. If we think the borrower adds value, we will probably not foreclose. If the borrower is an obstructionist, then good bye.”

However, some lenders will be more flexible than others. Mr. Johnson pointed out that it will be easier to work with banks and insurance companies, which can offer more flexibility than the special servicers for Commercial Mortgage Backed Securities (CMBS). That being said, he added that special servicers are generally prudent and will extend loans if the economics support it.

The discussion then shifted to the role of real estate private equity funds. Many of these commingled funds raised record amounts of equity during the boom years and are now waiting on the sidelines with large amounts of un-invested capital ready to be deployed into the market. However, this funding source is currently restrained by unrealistic return expectations, with many fund managers waiting for prices to drop to levels supporting IRRs above 20%. “Return expectations are still too high,” noted Mr. Cohen. “Buyers haven’t gotten the memo.”

Even so, it appears that private equity funds are beginning to reign in their lofty return requirements as their investors’ patience wanes. As Mr. Cohen explained, “Eventually, investors will want their capital put to work; otherwise they will want it back or demand lower fees for their money sitting in cash.”

Both high-net-worth and institutional investors were mentioned as additional sources of equity for the industry’s recapitalization. High-net-worth investors benefit from fewer restrictions vis-à-vis private equity funds, and are currently more willing to invest. However, these investors often seek “deep value” distressed deals, which comprise a limited share of the market. Institutional investors such as pension funds and endowments, while currently inactive in the market, are expected to increase their real estate allocations as their portfolios are rebalanced—though this new funding will not likely arrive until late 2010.

The group also commented on the public REIT market, which raised nearly $30 billion of additional equity earlier in the year to pay down debt. Despite massive dilution to shareholders, REIT stocks have rebounded strongly as the market’s “liquidity discount” was removed and confidence restored. The panelists were generally bullish on the REIT market, which is in a good position to capitalize on discounted property acquisitions and perhaps resume M&A activity.

Prof. Furfine asked the panelists whether a rejuvenated CMBS market was necessary for the real estate industry to recover. Mr. Cohen responded, “The market has no capacity to refinance unless CMBS returns.” He went on to explain that CMBS lending required that firms be willing to take “aggregation risk” by warehousing securities on their balance sheet until they are sold to investors. Financial institutions are not willing to assume this risk today, but they will do so again eventually.

During the Q&A at the session’s conclusion, the panelists were asked how they approach underwriting in the current environment. Mr. Johnson explained that investors need to focus on fewer target markets, get more granular in their rent projections and be willing to accept a reasonable return. “If you can underwrite to a 15% IRR conservatively, you’ll experience more good news than bad.”

Ms. Case offered the lender perspective, pointing out that the lending community has become much more “hands on” and nuanced than in previous years. She noted that current debt underwriting incorporates a more detailed analysis of lease maturities, as well as a more global assessment of the sponsor’s liquidity. In addition, lenders are focused primarily on cash flows generated by the properties. Appraised values and replacement cost estimates hold less relevance today, and previous loan values in particular are a non-factor.

About the Author

This article was written by Eric Schultz '11.