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Opportunities and tactics.

New financing mechanisms are sprouting up to fund well-researched and well-positioned commercial real estate developments. Some niche opportunities are out there, if you are willing to do the homework to find them.

A combination of low interest rates, depressed property values and a slowly recovering economy make today's environment good for real estate investment. But caution is needed, because the nature and risk of the investment opportunities vary widely, depending upon property type, geographic location and other factors.

In 1993, we're seeing a continuation of trends that began in 1991, as well as some new developments--all of which affect the opportunities available for real estate investment. Some highlights of current developments and conditions in the commercial real estate market warrant a closer look.

Moving toward equilibrium

Supply and demand are moving toward equilibrium, as supply continues to be restricted and demand is stable or slowly rising. Although it's dangerous to generalize about any aspect of the real estate market, additions to supply shouldn't outstrip demand any time in the near future. There's nothing new about the major constraint holding down new commercial construction--difficulty in obtaining financing.

Although we have seen an increase in financing activity recently; during the past twelve months, Heller Real Estate has provided financing for a wide range of property types including multifamily housing (both existing and to-be-built), mobile home parks, industrial and medical office parks, hotels and new single-family residential developments. Most of the traditional players, however, continue to limit their degree of exposure to commercial real estate loans or have pulled out of this sector altogether. Insurance companies are still involved in real estate to the extent that these entities will keep renewing existing loans as their commitments come due. However, many banks and S&Ls are completely out of the lending picture; banks in particular have realized that reducing their concentration in commercial real estate can lead to a rise in their stock value.

The stock market has sent a clear message to banks that they have done a poor job with commercial real estate in general. In the simplified world of stock market likes and dislikes, banks that take their losses and move out of real estate will be rewarded, while banks continuing to invest in real estate may pay the price with their stock value.

This overall lack of available financing for commercial real estate has several major implications: funding is scarce for new construction as well as for acquisition of existing properties. We've seen this situation developing over the past three years, and it will likely persist for the foreseeable future.

Demand likely to grow

While supply stays flat, demand is likely to increase, albeit slowly. And although each market and each property type will have a unique supply/demand curve, it's possible to generalize to some degree. Industry research shows that office space is beginning to experience an upsurge in demand as employment shows modest gains, especially in the service sector (2.3 percent increase at year-end 1992). Major cities in the Southeast are particularly favored for employment increases and related demand for office space: Atlanta, Nashville and Greensboro experienced the largest employment gains in 1992 (6.3 percent, 6.1 percent and 5.7 percent, respectively). Notwithstanding a movement toward better conditions in the office sector, the prospects for near-term increases in rental rates and values remain bleak with current vacancy at 20 percent. However, construction starts for office properties have continued to decline (year-end 1992 showed a 20 percent drop in the largest metro areas over the previous year, continuing a five-year trend).

Demand for retail properties has been boosted by an increase in real disposable income, particularly during the second half of 1992. The related jump in retail sales activity (8.2 percent nationally at year-end 1992) was especially strong in resort areas such as Miami, Phoenix and Tampa (23 percent, 15 percent and 14 percent, respectively). Construction starts have remained relatively stable in comparison with the steep declines seen in other property types; however, with only a 2.4 percent increase in starts nationwide during 1992, supply is still unlikely to surpass demand, although the supply/demand gap for retail properties probably won't be as dramatic here as in other property types.

Hotel completions continued to decline in 1992; completions in major U.S. cities were on average 30 percent lower during the first three years of the 1990s than the average annual completions during the 1980s. Real gross domestic product (GDP), which is the primary demand indicator for hotels, has begun to recover and push up occupancy rates and real room rates. Miami and Ft. Lauderdale both experienced occupancy rate increases of more than 13 percent, with room rates increasing 12 percent and 5 percent respectively. Thus, a modest improvement in the hotel market appears to be underway.

In the multifamily arena, demand is also likely to outpace supply. Additions of new apartments have reached the lowest level in the post-World War II era during the past seven years; 100,000 units nationwide. At the same time, demographic trends indicate that demand will at least continue unabated and may increase in some sectors. Population growth nationally will remain flat; but household formations will grow as the average size of households continues to decrease (from 2.75 persons in 1980 to 2.63 in 1990, according to the U.S. Bureau of the Census). Groups with high birth rates (notably Hispanic and Southeast Asian ethnic groups) will have an increasingly strong impact on demand for apartments in areas with high concentrations of these populations (California and the Southwest, in particular).

Some industry analysis of multifamily housing estimates that the total number of renters will continue to grow, despite the conventional wisdom that aging baby boomers will fuel a drive to single-family housing versus apartment dwellings, as this group reaches the traditional home-buying age. Even the historically small percentage of renters in the 35 to 54 age group will have a significant impact on rental housing demand, simply because the total numbers in this cohort are so large.

Furthermore, some recent studies show that a larger percentage of Americans under age 45 are selecting rental housing over homeownership. This trend is driven by several factors. The "affordability barrier" has become more difficult to overcome as job creation and income increases decline. In addition, rental housing is a preferred lifestyle for many who desire flexible housing arrangements suited to an increasingly mobile society and low maintenance requirements. The increase in single-person households (up 630,000 from 1985 to 1990, more than 1.5 times the increase in married-couple households) and single-parent households (which increased by 280,000 from 1985 to 1990) will also have a positive impact on rental housing.

The real estate industry hasn't been able to respond to this increased demand because of the factors we discussed earlier: lack of financing, especially the reluctance of conventional construction lenders to participate. This creates a niche or underserved area that is being partially filled by commercial finance companies as well as a new source of capital: Wall Street.

Real estate and Wall Street

Real estate is once again becoming "respectable" to Wall Street and certain institutional investors. Another new aspect of financing is Wall Street's involvement in real estate financing through a variety of investment vehicles, such as commercial mortgage conduits, opportunity funds and real estate investment trusts (REITs)--and this trend is likely to escalate. A major spur has been the current economic environment in which real estate investment is providing better returns (both cash-on-cash and capital appreciation potential) than many other alternative investments.

Look at real estate compared with the stock market, for example. At this writing, the market continues to climb higher but price/earnings (PE) ratios are at historic highs. Furthermore, these high PEs can't be rationalized by sunny projections of future earnings, or by strong economic growth indicators or by increasing consumer confidence. As a result, some technical analysts consider the stock market overvalued currently.

The bond market outlook is even cloudier. Although interest rates are at the lowest levels in years, some economists who follow the bond markets maintain that these are actually "normal" levels, with the highs of the 1970s and 1980s being aberrations. Maybe rates will stay where they are for a while, but in any event, they're not likely to decline significantly in the near future, leaving little potential for capital appreciation.

Real estate offers some attractive characteristics to investors who are ready to take their profits out of the stock market and move on to alternative investments. The government (through the Resolution Trust Corporation and Federal Deposit Insurance Corporation) and, more recently, banks have demonstrated the willingness to unload their real estate assets at prices below what would seem reasonable given the underlying economics and values of the properties. This obviously creates a positive situation for buyers. With higher capitalization rates and lower interest rates, investors in real estate can lock in relatively high cash-on-cash returns. For example, if an investor purchases a building that's providing a 10 percent current return and borrows 70 percent of the purchase price at 8.5 percent, the going-in return on equity will be 13.5 percent; a relatively attractive yield when compared with a money market or Treasury yield of 3 percent to 4 percent. You might be able to get a current return of 8 percent in the bond market, but if interest rates go up, you'll lose on your principal.

And there are other factors to consider besides the current return. Real estate is a traditional hedge against inflation, because historically real estate values have outpaced inflation. So there's upside potential of appreciation; however, each situation is different (for example, inflation may actually decrease the value of office properties as increases in expenses are more likely to outpace rental increases in an inflationary environment). And your current return of 13.5 percent can increase as inflation rises, because you may have the ability to increase rents--which can be enhanced through triple net leases that eliminate the drag of increased expenses on current yield.

However, it's essential to make informed decisions. If you don't have the right information (or put your money with someone who does), then you're probably taking on too much risk for the potential return.

In-depth information is key

You need to know the local real estate market well. You need to know particular properties and what may be right or wrong with them; what image they have in the marketplace; whether performance is a reflection of management or the marketplace. You need to know what's going on in the marketplace in terms of economic and employment trends--is there a military base closing down? Has a major employer moved into the area? Sitting in an ivory tower attempting to make investment decisions doesn't work in this environment.

An argument can be made that almost any year is a good year to invest in real estate, but only through exhaustive evaluation and exploration of multiple opportunities will you find the right investments. And the only way to evaluate these opportunities is to have local market knowledge and the ability to act quickly.

Favorable investments in 1993

Although we don't want to overgeneralize, we can look at several property types and draw some conclusions about how they're likely to perform in the current environment.

Multifamily Housing: This has been the "gem" of the real estate income properties for the past few years. The emphasis on apartment buildings might lead to the conclusion that these properties have received too much attention and that opportunities are scarce as capitalization rates on apartments have been decreasing recently. The gap between household formations and multifamily starts continues to widen--a trend that began in the summer of 1987 and has prevailed, except for a brief period in 1990.

In the second quarter of 1992, there were more than three times as many new household formations as multifamily housing starts. As multifamily analysts point out, this is not a market correction but rather an indication of significant shortfall in supply--a market correction would be preceded by high vacancy rates and sharply declining rents; these factors have not been in place. Vacancy rates have ranged from 8 percent to 12 percent for the past seven years and rents have remained fairly stable.

Apartment development can be an attractive investment. These properties are likely to attract a high-quality tenant base. Not only is the total market for apartments expected to grow, there will be a more upscale segment that's larger than we've seen recently (or perhaps ever). This is linked to the factors mentioned earlier; that rental housing is a preferred choice, as opposed to an economic necessity, for many renters. These renters are older--in the traditional peak earning years of their working lives--and are demanding more amenities as well as specific design features. This situation will generate rents that provide a good return on cost--and there's opportunity for institutional takeouts if a short-term profit is desired.

As with any property type, though, location plays a big role in determining value. An apartment building in Houston might very well represent a terrific opportunity, while developing a highrise building in Chicago would present difficult, if not impossible, economics.

Mobile Home Parks: This housing category is almost certain to grow and prosper during the next decade for several reasons. First, mobile homes have undergone a tremendous change in structure--some are indistinguishable from site-built homes, which has widened the appeal and acceptance of this type of housing as a low-cost alternative. Second, mobile homes are very popular among retirees, who appreciate the low maintenance as well as the low cost of their "empty nester" dwellings--and this demographic group is growing. Finally, there are significant restrictions on the supply of mobile home parks, due to zoning requirements, thereby insulating property economics from the threat of new competition. Add to these factors the additional plus of low operating costs, and mobile home parks look very good indeed.

Nonperforming Loan Pools: If an investor has the foresight to spot a good opportunity, despite what might appear to be low-quality real estate, nonperforming loans have good potential for investment. These are difficult loan situations because they're usually over-leveraged and delinquent; often the borrowers are going through bankruptcy and foreclosure. But if you buy at the right price, you can work out the account so that the borrower as well as the owner of the note will come out ahead.

We think there's going to be a lot more competition and interest in these pools in 1993. The keys to success in this business include account valuation, workout expertise and capitalizing on the benefits of a diversified pool.

Specialized Properties: Other promising areas include specialized niches that require indepth knowledge for proper evaluation, including nursing homes, other facilities for the elderly, medical offices and hotels.

Anchored retail properties are another type of specialized property that can be very profitable in the right circumstances. Criteria for evaluation would include the quality of the tenant base, the fit between the demographics of the area vis-a-vis the prospective tenants, competition from other retail outlets and the experience of the developer.

Financing mechanisms

As we've already mentioned, Wall Street is beginning to take an interest in real estate, judging from the volume of real estate-related investment vehicles. Opportunity funds, such as those offered by Goldman Sachs, Merrill Lynch and other investment banking firms, allow high-net-worth individuals and institutions to invest in real estate categories, such as those described earlier, that offer unique profit opportunities.

In addition, real estate investment trusts (REITs) have seen a big increase in activity, as shown in Figure 1. These pooled investments have the advantage of liquidity through public trading (though the pricing is highly sensitive to interest rates). Institutional investors as well as individuals are buying up the new offerings of REITs, acting on the belief that real estate markets are bottoming out.

In a low interest rate environment, REITs are becoming increasingly attractive to investors. More than just a "flight to yield" is at work in the REIT boom; investors are betting on management's ability to create value through improvements of existing properties and opportunistic purchases of new properties.

For investors who wish to invest directly in real estate, a variety of innovative financing mechanisms have evolved as well. We can use examples of recent transactions from Heller Real Estate, Chicago, to illustrate how these work.

Credit Sale/Leaseback: In conjunction with Chicago-based Mesirow Financial, Heller is offering a sale/leaseback program that can help creditworthy corporations improve ratios and free up assets by selling existing properties (the traditional virtues of the sale/leaseback) as well as fund new construction--specifically, build-to-suits.

To illustrate how the build-to-suit program would work, we can look at a case example with an investment-grade industrial company that needed to build a facility tying up assets in real estate. For the in-house development team, the key advantage is the ability to bring a project to completion and then dispose of the asset. The seller/lessee retains the use of the real estate, but passes along the risk of ownership to the Mesirow-Heller fund. Moreover, this process frees up corporate or developer funds for other purposes, including development of other real estate projects.

The Mesirow-Heller fund contributes cash equity and/or a letter of credit to enable the developer to secure 100 percent construction financing. In addition, the sale/leaseback contract enables the seller/lessee to take out third-party construction financing and pay the developer's profit; the fund may also provide full construction financing on select deals. Leases are triple net and usually set at 20 to 25 years, although 15-year leases will be considered on a case-by-case basis. Bondable leases are preferred and can result in more attractive pricing for the seller/lessee.

Most deals fall within the $3 million to $30 million range for industrial, retail or office buildings that will be occupied by tenants with investment-grade credit ratings or the equivalent.

Participating First Mortgage: Heller Real Estate's core financing product is the participating first mortgage, in which Heller provides financing and receives in return a share in the upside potential of the project. Heller's funds can be used for a variety of purposes, including acquisition of properties or nonperforming loan pools, or for refinancings of properties already held for investment. A case in point is a first mortgage commitment of $5.1 million extended for the refinancing of a mobile home park in New England.

The property is a nearly 100 percent-leased, mobile home park built between 1986 and 1992. The park, which is for seniors only, is located in a market that is 99 percent occupied. The average sales price for homes in the community currently exceeds $100,000. Amenities in the park include a pool and a 4,000-square-foot clubhouse; 90 percent of all of the homes are "double wides" that closely resemble site-built homes.

In addition to the positive demographics and physical attributes of the park, the owner's experience working with this type of property helped enhance the investment potential of this transaction--he owns two other successful mobile home parks. His extensive research and marketing knowledge led him to develop the property with the attributes seniors wanted most--in addition to the large clubhouse, he provided lifetime leases, a shuttle bus and a security gate.

Standby Commitment: Standby commitments can help developers obtain construction financing for new projects. For example, Heller recently extended a $26.5 million standby first mortgage to facilitate the construction of a 46-unit, oceanfront, luxury condominium project in Boca Raton. Without the standby commitment, the borrower would have had great difficulty obtaining construction financing, because in the current environment lenders will not consider unit sales alone as a viable exit strategy.

The property was designed specifically to appeal to the purchaser of ultra-luxury oceanfront property, with the average sales price of individual units at $1.4 million. Units range in size from 2,700 square feet to 5,500 square feet, with private elevator access; all units will have ocean views.

There is a strong market in South Florida for maintenance-free oceanfront residences; competition from other new construction will be very limited due to the lack of available land and lack of financing. Demographic analysis of the area indicates that this area will lead the nation's large communities in population growth, total income growth and creation of new jobs.

The transaction illustrates what we've discussed about specialized niche development opportunities. First, the project is located in an area with positive demographics; second, supply of new construction is likely to be nonexistent or very limited; finally, the project is targeted to attract a very specific type of buyer.

Discounted Payoff: Providing financing to effect a discounted payoff of an existing note can be a rewarding activity in 1993. As mentioned earlier, many banks and S&Ls have realized that disposing of real estate assets in many cases is a smart move--even if the selling price is below what the underlying economics of the properties would suggest as a reasonable market price. Thus, many financial institutions (and the RTC and FDIC) are open to discussing a discounted payoff in certain situations.

Heller Real Estate recently completed a discounted payoff transaction involving a one-year-old, 296-unit, institutional-quality, luxury garden apartment complex in Glendale Heights, near Chicago. The borrower negotiated a $15.6 million payoff of the $18.48 million first mortgage construction loan, and Heller provided the financing.

The $18 million construction financing had been committed in 1989, when real estate values were escalating and cap rates were in the 8 percent range; a subsequent slowdown in the economy and a surge in apartment development in suburban Chicago led to a decline in pro forma rents and occupancy levels. The result was an overleveraged asset that could not be refinanced due to an excessive debt load.

The property is located in a stable market and is of institutional quality (although under the previous financial structure it was not attractive to institutional buyers because of a heavy equity burden and lack of operating results). The borrower has a business plan in place that involves disposing of the property within two years, thus providing Heller with a viable near-term exit strategy.

Junior Equity: Junior equity (or second mortgage) loans are another tool that can be used to take advantage of attractive investment opportunities. Heller recently provided a $2.8 million participating second mortgage loan on the Reserve at Meyer Park, a to-be-built 345-unit Class A luxury apartment complex in Houston, Texas. Heller's commitment led to the approval of an open-ended construction loan that permitted the project to go through.

The project incorporates features that will be attractive to institutional buyers: slightly lower rents than competing high-end buildings in the same area, a unique park-like setting, and other aspects such as nine-foot ceilings, crown moldings and 60 percent brick construction. It is ideally situated to draw prospective tenants from major employment centers nearby. Houston's positive growth trends have led the nation's job growth during the past few years and is expected to continue.

Houston's apartment activity has increased significantly during the past two years, but this will taper off during 1993 due to a lack of construction financing. Lenders in Houston are demanding 30 percent to 35 percent equity before committing to construction financing. Thus, developers who can tap another equity source--such as Heller's junior equity loan--will be able to bring new projects to market at a time when similar projects are being restricted.

All of these points support the assumption that any year can be a good year to selectively invest in real estate niches--provided informed and timely decisions are made based on local market knowledge and needs. And certain aspects of the current environment--low interest rates, motivated sellers in certain niches and limited additions to supply--point to above-average opportunities for 1993.

Robert Dennis is senior vice president of Chicago-based Heller Real Estate Financial Services.
COPYRIGHT 1993 Mortgage Bankers Association of America
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Title Annotation:new funding programs for commercial real estate
Author:Dennis, Robert
Publication:Mortgage Banking
Date:Jul 1, 1993
Previous Article:Big opportunities for small investors.
Next Article:Wreaking real estate havoc.

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