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Last summer's joy-ride has ended but we're still cruisin'
By KERRY L. NICHOLSON
Forget for a moment the relentless onslaught of winter storms, and think back to last summer when we cruised with the top down in our souped-up, Puget Sound real estate roadster. Remember? Tank full of high octane conduit money, REIT buyers waving those full price signs, burying the needle on our job growth and rental rate gauges Oh please, dont let this joy-ride end!
Were still cruising today (albeit with the wipers on), but there was a jarring bump last fall that rattled us. Was it just a speed bump or did we go over the curb, soon to plunge into the abyss? Read on to see if we shall all make it safely to the Millennium!
Hope you didnt miss the partyConditions for obtaining financing during the first two-thirds of 1998 were as close to ideal as can be imagined. Property markets in nearly every product type and sub market were healthy, and almost unlimited capital was available at low spreads perched atop low index rates.
A proliferation of conduit loan issuers led to a lending binge. Elastic underwriting and extremely low rates partially helped to induce the refi boom that occurred. Sensing that good times were here for an extended period, construction lenders also started to get into the spirit. It was a good time.
Inevitably, the party poopers arrived. REIT analysts began by turning down the music, questioning the amount of new space being developed. REIT share prices plummeted and real estate asset prices adjusted downwards as much as 20 percent. Churlish Fed officials turned on bright lights, urging boring prophylactic practices. Finally, the cops came, in the form of dire dispatches from emerging financial markets around the world. The conduit market went quiet. The rave was over, for the time being.
Looking back, although nobody wanted the party to end, the circuit breaker of public markets kept excesses largely in check for both debt and equity, and thus few party-goers have hangovers. Even though the respective percentages of total debt and equity markets exposed to daily capital market scrutiny are still quite modest, it is enough such that we live in a new reality.
Real estate now is not just about our local market fundamentals; it is also tied to exogenous factors from Washington D.C. to Brazil. To see the future of the real estate industry, look to the capital markets, not only to check the pulse of real estate securities, but also to see the overall prognosis for the economy (read job creation).
What lies ahead for the four main real estate capital sources?
But the speed bump of last fall has had an impact. Bank spreads have increased on the order of 50 basis points, and equity requirements have stiffened (15-20 percent of project costs again). As one seasoned local banker said, We dont really have new guidelines, its just that now were living by the ones we had in place last year!
Part of the reaction is prudent risk management, part a result of looking over their shoulders at worry-wort regulators. That said, it is possible today to get spec office financed if the project makes sense; banks will just demand enough equity so that theyre not taking equity risk for debt returns.
Make loans! Although they have become bit players on the equity side, they are still a force to reckon with in the permanent market. They are aggressively looking to place more debt here, competing against conduits by emphasizing reliability, structuring flexibility (a relative concept!), ability to lock a rate, and less onerous early repayment terms. Life companies see plenty of money being available and both spreads and treasuries continuing to move in the customers direction.
Unfortunately, the prediction of many that wildcat Wall Streeters would push the new industry inexorably into excess proved well founded. As the year progressed, underwriting standards for many issuers continued to deteriorate. With rating agencies locked in a bitter battle for market share, there was little discipline to come from that quarter. When the falls severe market dislocation came, some conduits were unable to honor their funding commitments, or cavalierly re-traded their customers. This has created a marketing challenge even for those who did honor their commitments.
Bond investors, however, have heard the wake-up call, and are now willing to give better subordination levels (i.e., pay more) for securitizations put together by organizations with solid credit cultures. Many observers now believe there will start to be a brand effect, and the financially strong originators that create good product will have a following, while others will get left behind. During the falls market meltdown, entities like GE Capital, GMAC and many of the larger bank conduits honored commitments and continued doing business, while others fled the field. Consolidation will also be the watchword in 1999, as you need $3 billion/year in securitizations to afford the infrastructure.
For the capital consumer, there will be plenty of money available in 1999, and conduits will be the product of choice for those whose situation most values loan size, rate and non-recourse borrowing. Lending parameters wont be stretch to fit as you saw sometimes in 1998, but conduit lenders will be aggressive. Rates and spreads are generally expected to drift somewhat downward during the year.
Credit companies. These are large private providers of real estate capital. Because they are not regulated by the feds, these companies enjoy greater latitude in structuring real estate deals, roaming freely up and down the risk/reward continuum. They typically have huge balance sheet capacity, as they are making loans and equity investments for their own account. They are generally focused more on collateral than credit, and most loans are done with limited or no recourse.
The credit companies are typically owned by industrial-strength parents, and are opportunistic by nature. Thus, not only did the events of last fall not knock them off their game plan; the turmoil actually made them more valuable to real estate players seeing a chance to profit from the confusion. Credit companies have ambitious plans for 1999.
The speed of the financial markets recovery from last falls jolt is welcome but somewhat eerie. Was it just a speed bump or a warning of something more serious to come? Hard to tell, but what we can say is that recent capital restraint and the on-going difficulty of developing in this region will combine to keep over-building largely at bay.
The risk is probably centered more on some (for now nameless) shock that tanks demand. Many factors are jostling to push rates up or down, but the consensus is that rates will ebb slightly during the year. Similarly, spreads may have a bit more tightening ahead (but not to last years levels).
The opportunity phase of the real estate cycle is largely past now; most assets are fully priced. It is a time to focus on the basics of the business. With the exception of limited service hotels (and to a lesser extent, certain retail formats), money will be available in 1999 for good projects. Although it is difficult to tout quality of life in the middle of this wet winter, Puget Sound remains at the top of most investors lists due to this intangible, plus the fact that this is a growth-constrained market anchored by a 24-hour city.
Our real estate roadster has de-accelerated from 120 mph to 55 mph, pushing our noses against the windshield. We feel slightly bummed. But you know what? This is a safer speed, and given our traffic, its still unbelievable!
Kerry Nicholson is vice president of new business for GE Capital Real Estate.
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