End of investment cycle means tough decisions for managers

Commercial real estate lenders are getting pickier, leaving real estate money managers with the choice between buying core real estate that is overpriced or using less leverage when they buy transitional properties or those in higher-risk sectors.

That means investment managers are having trouble spending the record $230 billion of available capital commitments they have amassed from investors. High real estate prices, heightened awareness to risk and concerns about being at the tail end of a real estate cycle caused an 11.2% drop in first-quarter commercial real estate sales volume, said a May 11 report by real estate manager Jones Lang LaSalle Inc.

The hotel sector and construction across all other sectors were first hit by the lack of financing six months ago. More recently, the multifamily sector has been having more difficulty finding financing, said Monty Bennett, Dallas-based CEO of hospitality real estate investment trust Ashford Hospitality Trust.

Indeed, most non-core properties are having more difficulty finding mortgages, especially in the U.S., said Ralph F. Rosenberg, New York-based global head of KKR & Co. LP's real estate business.

“When it comes to financing traditional assets, the credit markets are more discriminating today vs. a year ago,” Mr. Rosenberg said. “This is the byproduct of lenders reducing leverage levels and increasing credit spreads in the aftermath of China devaluing (its currency) last fall.”

That's a reversal from last year, when real estate managers were flush with debt because lenders stood to make higher yields on their investments, according to data from real estate research firm Situs RERC.

In 2015, yields on new real estate mortgages for office, retail, industrial and hotel properties improved from 2006 and 2007, when real estate was at the same point in the last cycle. In October, the average debt yield — lenders' return on a loan — for office, retail, industrial and hotel properties was 10.7%, compared with 9.6% in 2007, data from real estate research firm Real Capital Analytics show.

China's devaluation of its currency has made it more difficult to get loans.

“In the last six months since China devalued its currency, which increased return expectations in risk assets, it has been more expensive to borrow in the commercial real estate markets,” Mr. Rosenberg said.

KKR has been a net seller, and Mr. Rosenberg said he expects KKR will continue to derisk its real estate portfolio in this market.

The big question in the industry is whether prices for these hard-to-finance properties will drop or whether the equity returns will come down, said Richard Mack, CEO of Mack Real Estate Group, New York. The firm started a credit business — Mack Real Estate Credit Strategies LP — about a year ago to provide loans for transitional properties in prime markets. The firm already has originated $1.2 billion of loans.

“It's a peculiar time. A lot of (real estate) equity, but not necessarily enough debt,” Mr. Mack said.

Some investors have shifted a portion of their real estate portfolio into debt strategies. Seven real estate debt funds closed on $2.9 billion in the three months ended March 31, data from London-based alternative investment research firm Preqin show.

But real estate managers are betting investors will pour more capital into real estate debt. Three of the five largest real estate funds marketed in the first quarter include debt investments: Oaktree Capital Management's $3 billion target Oaktree Real Estate Opportunities Fund VII; Hermes Real Estate"s £1.5 billion ($2.2 billion) target Hermes Real Estate Senior Debt Fund; and Cerberus Real Estate Capital Management's $1.5 billion target Cerberus Institutional Real Estate Partners IV, according to Preqin.

Even so, the lion's share of the real estate capital lining managers' coffers is for real estate equity in need of financing. The amount of real estate debt capital raised in the first quarter is dwarfed by the $18.5 billion collected by managers for real estate equity in the quarter, according to Preqin.

Banks, which have historically provided real estate financing, especially for transitional investments like non-core and construction, have been pulling back significantly.

“It's harder to get financing than six months ago,” said Josh Zegen, managing principal and co-founder of New York real estate money management firm Madison Realty Capital.

While the financing squeeze eased slightly in the last three months, “there is still a significant pullback,” Mr. Zegen said.

Madison Realty Capital has real estate debt, real estate equity and construction businesses.

Regulatory requirements have put the brakes on bank lending, he said.

Not only that, but traditional lenders' perceptions of real estate risks have changed, Mr. Zegen said.

“Appetite for real estate has not dramatically changed, but the perception has,” he said. “No one wants to be the dumb guy who puts money out at the end of the cycle.”

The concern is that the real estate cycle that began after the financial crisis “can only continue going for so long,” he said.

Hotels, land deals, construction projects and value-added real estate have been particularly hard hit, Mr. Zegen said.

Still, 82% of the real estate capital raised in the first quarter was for value-added and opportunistic funds, Preqin data show.

Banks are preferring stabilized real estate and hotter sectors such as multifamily; an empty office building would be a hard sell, Mr. Zegen said. This makes leverage more expensive for the out-of-favor types of properties, which increases cost for buyers.

Madison Realty Capital on May 11 closed its third real estate debt fund, the $695 million Madison Realty Capital Debt Fund III aimed at lending to the middle market.

“This is an opportunity to provide (buyers) more expensive debt (than banks) but it's cheaper than more equity,” Mr. Zegen said. n