Survey says financing drought over, but scars remain.

The drought is over in commercial real estate financing. Thanks to a steady inflow of new capital, the commercial real estate market is gaining greater liquidity - a far cry from the parched real estate landscape of just a few years ago.

That's according to a survey by Price Waterhouse's New York Metro Real Estate Industry Services Group (REISG), which questioned senior executives of 50 leading providers of capital to the commercial real estate industry (representing in excess of $110 billion of current real estate lending and investment). Among the survey's key findings:

* Commercial banks and life insurance companies plan to increase their real estate investment levels, focussing on multi-family, industrial and retail property types.

* Real estate capital financial executives are still generally pessimistic on office property, indicating that the capital shortage for the office sector is likely to continue.

* Fundamental factors such as loan-to-value, debt service coverage ratios and property quality/class will be more important to providers of debt capital in making new real estate investment decisions than factors such as investment yield and personal guarantees.

* All types of capital providers except life insurance companies saw their level of underperforming real estate assets fall in the past year.

* Debt securitization is viewed as a major force in future real estate capitalization plans and investment banks, in particular, are widely perceived as becoming much more active as providers of real estate capital, both as securitizers of commercial mortgages and as equity in opportunity funds.

* Both commercial banks and life insurance companies plan to reduce their workout staffing. However, insurance companies plan to augment their risk management and asset management areas, while commercial banks foresee reducing both categories.

* In order to manage their existing and future real estate assets more effectively, survey participants see the need to improve their technology and information management capabilities.

* Looking toward the future, there is general agreement that real estate returns will improve in all property segments, but that new commercial development opportunities (with the possible exception of multi-family housing) will be limited.

"The survey reinforces the notion that the commercial real estate capital market has learned lessons from the last downturn and is focusing on property fundamentals for the future," said Mordecai Soloff, managing partner for Price Waterhouse's New York Metro REISG.

The Price Waterhouse survey covered 50 institutions providing capital to the commercial real estate industry. By number of respondents, 30 percent were commercial banks, 30 percent were life insurance companies, 25 percent were equity sources (pension funds and REITs) and 15 percent were defined as other (mainly commercial finance companies and investment companies).

Non-Performing Assets

According to the survey, banks and insurance companies still hold the highest percentage of non-performing assets in their portfolios (23 percent of real estate assets non-performing for each). All groups of real estate capital providers saw a drop in the percentage of non-performing assets except life insurance companies, which saw their problem assets rise 11 percent.

"While banks have made substantial headway in resolving problem assets - their level of non-performing real estate credits fell 10 percent - the other 90 percent of non-performing real estate fact still remains. This is an indication that banks probably will be in the workout business for the foreseeable future," said Jeffrey Rutishauser, managing director for the NY Metro REISG practice.

Office and retail properties dominate the portfolios of institutional lenders, comprising 43 percent of banks' and 51 percent of life companies' real estate portfolios. Pension funds also have a high percentage (63 percent) of assets invested in office and retail property. These property types also have seen the largest decline in value in the past few years. Multi-family assets comprise a fairly small percentage of institutional lenders' portfolios (11 percent and 9 percent for banks and insurance companies, respectively) while representing nearly 25 percent of oommercial finance company and REIT portfolios.

Future Investment Activity

Real estate executives continue to favor multi-family assets for future investment by a wide margin, with commercial banks and life insurance companies indicating an interest in doubling their allocation of new investment capital to this property type.

According to Rutishauser, the combination of current demand/supply balance for rental apartments, coupled with debt and equity capital inflow from major players, has made this the only property category in the industry to experience rising values in recent months. Unless a wave of new construction commences, unlikely in the current environment for construction lending, this sector will continue to show economic strength and attract capital, he says.

According to the survey, capital targeted for multi-family investment has been diverted from other property sectors, most notably office buildings. Commercial banks plan to decrease their allocation to office from 26 percent today to 9 percent of new investment. Likewise, life insurance companies plan to decrease their allocation from 30 percent today to 13 percent of new investment.

Retail properties also are seen as having less capital allocation in the future. While commercial banks seem willing to keep current retail allocations at 17 percent of their real estate portfolio, life insurance companies plan to reduce future retail allocations from 21 to 15 percent, while pension funds plan a reduction from 37 to 21 percent. According to Soloff, this finding has special significance because life insurance companies and pension funds historically have been the main providers of capital for large retail investments, especially regional malls and community centers. Some concerns facing retail properties, such as consolidation of the retailing industry, rise of stand-alone stores (e.g., WalMart) and factory outlets, and direct distribution (e.g., mail order and home shopping) have caused uncertainty for many institutional investors/lenders to this segment of the industry.

The Major Players

Respondents identified investment banks as the likely most active providers of capital for the industry, via commercial mortgage securitization and as sponsors of real estate equity/opportunity funds.

Mortgage banks and pension funds also were seen as active capital sources. Banks were viewed as moderate in their participation. Life insurance companies and commercial finance companies are expected to be less active in the future. When asked to rate their own future investment activity, over two-thirds felt it would increase. Included in that response were more neutral views by banks and insurance companies who saw their own activity level split between increase and decrease.

Survey respondents were consistent in changes they would require in their real estate investment for the future - more owner equity and increased monitoring of the portfolio. "It appears that the lessons of the last downturn are still fresh in the memories of the financial executives," noted Rutishauser.

Strengthening risk management was also cited as a necessary change, especially by life insurance companies. Their plans for staff additions and reductions reflected a recovering marketplace with a significant downsizing of the workout staff, coupled with additions for origination, asset management, capital markets/securitization and risk management.

Emerging Market Trends

In commenting on emerging trends in the real estate marketplace, a number of respondents held diverging viewpoints. For example, respondents were divided on the future potential for REITs. While equity players felt REITs represent a fundamental shift in how real estate equity will be financed, banks and life insurance companies tended to view REITs as a passing phenomenon. Those viewing REITs positively cited liquidity and institutional interest as reasons for their support. Those viewing REITs more critically cited the declining quality of new REITs and over-pricing as hindering their support. Respondents strongly felt that debt securitization is a fundamental shift in the way real estate debt will be financed. Insurance companies, REITs and pension funds were the strongest believers, with commercial banks more neutral in their support.

Most respondents view the recent flurry of bulk sale transactions as temporary and cyclical. Many feel most major portfolios already have been sold and remaining "non-performing" assets have been written down or can be managed by the institution without resorting to bulk disposition. Notably, no respondent chose "maintaining customer relationships and avoid showing weakness" as a reason not to do bulk sales. For major lenders this is a basic attitude shift from a few years ago and may signal an emerging trend away from "relationship lending" in the real estate business.

Respondents felt foreign real estate capital investment to the U.S. will increase, but from different sources as before. By large margins, respondents felt Asian (non-Japan) and European (non-UK) investors will be more active, while the Japanese will be far less active. Views on British investment activity in the U.S. were divided.

In addition, the survey found renewed interest in asset and risk management. Respondents clearly felt a need to improve technological capabilities for asset management - a view held most strongly by life insurance companies and REITs. The next most vital needs were to improve policies and procedures, followed by staff additions.

The Future of the

Real Estate Industry

Overall, survey respondents expressed cautious optimism about their future prospects, but clearly the recent downturn left scars that will take a long time to heal. A general feeling exists that future lending and development will focus more on real estate basics of supply/demand rather than availability of capital. In the short-term, the general view is that space demand will continue to increase, but this will not set off any new construction boom. By type, only multi-family received any positive support for new construction in the next 2-3 years. By contrast, office and retail were seen as having little new development potential near-term. Thus, restraints on construction lending will likely persist, except for the unusual situation such as a build-to-suit.

Respondents felt securitization and pension funds will play a larger role in the future in providing real estate capital and that foreign capital for U.S. real estate will be scarce. Meanwhile, traditional lenders will continue to be hampered by regulation, with no tax or regulatory relief in sight. This sets the stage for a shift in the mix of real estate capital market share - away from banks and insurance companies - and toward pension funds, REITs and securitized mortgages.

In what may be the survey's most promising finding, the participants expressed support for the idea that future deals will require greater equity cushions and that real estate will be valued based on underlying cash flows, rather than prospective asset values. "If these executives make their real estate decisions based on that same line of thinking, we should greatly reduce the problems faced by providers of capital in the last cycle - that would be very good news for both the industry and the participants," Soloff said.