Threats and Opportunities in Debt Investing

Tom Fink of Trepp / on the robust lending market

PrivcapRE: Interest rates are expected to rise. When and by how much do you anticipate they will move? What will the impact be on the commercial real estate market? Fink: Given the flood of capital, I don’t see them moving significantly for a number of years. There is plenty of capital in the market. I was talking to someone the other day who said even in the CMBS conduit market it’s very competitive. Through the downcycle, commercial real estate held up OK. Yes, there were a lot of issues around CRE, a lot of losses. If you look at what banks and CMBS lost, it was loans based on future expectations. Like single-family development loans and CMBS pro-forma underwriting. That kind of reposition lending is riskier. A lot of the losses were being driven by turnaround or development loans. PrivcapRE: Can you characterize the state of the CRE lending market today? How does it compare to one year ago? And how do you expect it to change in the coming year? Fink: It’s robust. A year ago, we had new categories of investors starting to come into the market. They are running at full pace now. Groups like insurance companies and pension funds continue to increase their exposure to real estate debt. I don’t see it changing in the next 12 months; there is still going to be a large amount of capital. If anything, it’s going to remain a competitive environment for lending. Now is as good a time as any to raise capital. But if you have a poor market or challenged project, it’s still going to be hard to raise capital. It’s the same as a year ago and it will be the same in a year. Lenders are striving to only do quality projects. Are projects more aggressively underwritten than a year ago? Yes, they are. Are we back to 2006 2007 levels? No, we are not. PrivcapRE: How great is the refinancing opportunity that is expected between 2015 and 2017? Has it been overplayed, or have lenders already missed it? Fink: There is still opportunity, but there isn’t going to be as much distressed debt as some people expect. A lot of those loans have already been through the wringer. The really bad properties and loans are already making their way through the system. A lot of lenders have been aggressive in terms of working with existing borrowers to refinance debt. There is still more debt coming due, but markets do have mechanisms to deal with loans that aren’t able to be refinanced on same terms. PrivcapRE: Do you expect loan delinquency rates to continue improving? Fink: They will because borrowers have not been able to over-lever. One thing we noticed is that property values have continued to increase, which has helped owners to delever. There will still be properties that go bad. There will still be opportunities, and distressed debt and turnaround situations, but I don’t see any reason for the delinquency rate to go up. PrivcapRE: Do you expect CMBS issuance to hit pre-crisis levels? Do you think it will reach $150 billion? Fink: We might get close to it in 2016, but there was a lot that was going on to pump that number up [the last time we reached it]. There were a couple of transactions where there were two refinancings in the space of a year, with interest rates so low. I would be hard-pressed to say we would reach $150 billion any time soon. That said, I never believed property values would come back this strongly. PrivcapRE: Where are the best opportunities for yield, in terms of investing in the capital stack? Are there particular geographies or sectors that look attractive? Fink: In terms of investing in real estate projects, do you want to be a first lender, mezzanine lender, or equity holder? The best returns are probably in the mezzanine space, compared to what’s available in the first mortgage market and equity. There are a lot of people trying to move into that space. People are starting to pitch redevelopment deals and turnaround situations; the returns are getting larger, but there are a lot of people who are active in that space. The best projects probably have capital available to them. What are the pressure points that are going to underperform? Where the market is most challenged is in smaller properties in smaller markets.

Bill Lindsay of PCCP / on rising interest rates

PrivcapRE: How fast and how far do you expect interest rates to move? And what impact will that have on commercial real estate lending? Lindsay: If you believe in reversion to the mean, we’ve got a way to go on fixed and floating rates to get them back to their historical norms. And those moves would be fairly substantial. When you ask people their expectations on how fast interest rates will move, it depends on who said what last from the Federal Reserve. The latest communications from Janet Yellen were not as concerning as previous ones. But, unfortunately, the interest rate market is largely political. I expect slow interest rate increases over the medium term. There should be plenty of time for real estate investors to react. The only caveat is that external factors could change everything. If something happens in the Ukraine that we don’t expect, then who knows? There are two factors offsetting each other in the commercial real estate market right now. Every CRE investor, whether a lender or an owner, is focused on interest rates because they’re correlated with capitalization rates. There’s a bit of nervousness all around because as rates and the cost of capital go up, real estate pricing will be affected. But there are countervailing factors in the market like increased liquidity, leading to activity from non-bank lenders. The U.S. banking system is looking strong; banks are relatively sober in their underwriting and not taking much credit risk. There is strong availability of debt capital, and generally speaking, the macro trends in investment are favoring alternative assets. In general, we are seeing more capital coming into the asset class. PrivcapRE: Do you expect CMBS issuance to hit pre-crisis levels? Do you think it will reach $150 billion any time soon? Lindsay: Reaching $150 billion isn’t a problem. The U.S. mortgage market is about $3 trillion, which includes construction loans made by banks. The average loan is outstanding, say seven years, then you have about $450 billion a year rolling over. Could CMBS be a quarter of that? I don’t see any reason why it couldn’t. As real estate values rise, you can originate more CMBS, so increasing real estate values will allow CMBS, as well as every other lending category, to move up in total dollar volume. Will CMBS get to 2007 levels? That’s more of a question of what is happening in the bond market than real estate. People will tell you that the appetite for CMBS bonds depends on what else is happening in the bond market, because those guys are the buyers. If the bond markets are healthy, I don’t see any reason why we couldn’t get back to that level. PrivcapRE: There has been an increase in the number of lenders in the market. Are there too many? Lindsay: There’s more competition now than a year ago, but demand still outstrips supply and will continue to do so. Almost everybody is trying to raise a commercial real estate debt fund. At the end of the day, we only see the same group of lenders originating, and everyone else seems to be buying parts of other people’s loans. PrivcapRE: Has the wave of debt maturities expected between 2015 and 2017 been exaggerated? Or is there still an opportunity for lenders? Lindsay: It’s a huge opportunity. Most people think that all of the distress in the U.S. real estate system has been taken care of, and that’s not true. There was about $420 billion in distress tracked by Real Capital Analytics, and by the end of 2013, about $260 billion of that had been solved. We believe there was much more distress in the system than the statistics revealed. We still see deals where the bank is trying to resolve something with a borrower from 2009. Lawsuits take a long time to wind their way through the system; there are still big transactions in litigation; there are transactions where past borrowers have been working with banks to recapitalize for years, and low interest rates have made it easy for both sides to take their time. Those loans are going to mature at some point, and somebody will have to take a loss.

Jim Corl of Siguler Guff / on the distressed debt opportunity

PrivcapRE: To what extent are there distressed debt opportunities in the U.S.? Some in the market believe most of the distressed commercial real estate debt has already worked its way through the system. Corl: The people who think the distressed debt has worked its way through the system are those who have been distressed, still are distressed or caused the distress in this past cycle and would therefore like to minimize it. The facts are that in each of the next four years, there will be over $300 billion of commercial real estate debt maturities. These loans were underwritten during the boom phase, when lenders were more aggressive in their terms and very lax in their underwriting and they were lending against very highly valued assets. Most of those loans are still unable to be refinanced, because the value of the property remains lower than the loans against it. Someone is going to have to take the pain—the equityholder, or the equity holder and the debt holder. Probably both are going to wind up having to take a write-down. And that’s where our capital steps in. It’s not broad-based, macro, top-down distress; it’s asset by asset, deal by deal, loan by loan. We are working with local operating partners who drive by zombie assets every day. They know the borrower, the lender, the tenants, the condition on the ground, and they recognize the opportunity to recapitalize the asset and return it to its operating health. There is a big uplift in value that is derived from that. PrivcapRE: Do you think there are too many lenders coming into this space to compete for distressed debt deals? Corl: Lenders are lenders, so what you find is that in situations where there is recurring cash flow, where there are leases in place, where there is a fully functional building, they are going to bend over backwards to refinance that asset. But when you have a zombie building, the lenders are few and far between. Most of them don’t want any part of an empty warehouse or a 40-percent-leased office tower. There is a lot of equity out there for the fully leased, stabilized, high-quality property. But for the high-quality property that has stumbled because someone overlevered it, there isn’t debt capital for those deals. PrivcapRE: How would you characterize the state of the lending market compared to a year ago, and how do you think it will change in the coming year? Corl: The lending market goes through the same cycle as the equity side of the equation, gradually. On the debt side, it’s a process of greed gradually replacing fear as the dominant psychological disposition of the actors in the marketplace. There is still a lot of fear out there. But I’d say increasingly the lending markets are getting more competitive. They are nowhere near where they were in the prior decade at this point in the economic cycle. The CMBS market tends to be on the leading edge of aggressiveness, and we are starting to see lending practices becoming a little more aggressive, a little less tight than they were. PrivcapRE: Which part of the capital stack do you believe will offer the best yields in the coming years? Corl: That is shifting around all the time. It’s tough to say. Generally speaking, real estate is a very capital-intensive asset class. What you often find is that the debt market conditions inform the value of the equity; they tell markets how to value things. My view is that debt leads the way, so there is less value in the debt markets today than there are in some niches of the equity markets. Also, if you believe that the economy is in an uptick, there is more opportunity on the equity side of things than on the debt side.