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Real value key to recovery in 90's.

The ongoing contraction of real estate capital markets has redefined the strategies and style of real estate investing in the 1990's.

The question which I am asked all too often -- "Have we hit bottom yet?" -- implies that "hitting bottom" will trigger a turnaround and subsequent balance between supply and demand. This view, however, fails to embrace the fundamental changes in the way that debt and equity providers will analyze and approach real estate transactions in the future. Going forward, decisions will be driven less by speculation and more by economic reality. Stability will be restored only after capital sources believe that they understand how to value a particular project.

The gulf between bid and asking prices embodies the capital markets' evolving view of value. In a stable, dynamic market, the average difference between bid and asking prices results in a shortfall of the buyer's required yield of 50 to 75 basis points. However, in today's market, the average difference between bid and asking prices results in a required yield spread of 300 to 350 basis points.

The existing gap between bid and ask prices is a manifestation of changes in perceptions of a property's value and, consequently, the manner in which that value is quantified. The internal rate of return (IRR) analysis long used by owners and developers to raise debt and equity is no longer viable. Not only has it become an impossibility to calculate the value of the residual, but it has also become impossible to place a certain value on anything but the income stream generated by leases in place.

During the 1980's, when reviewing projections, lenders and borrowers would argue over the amount that rents would escalate when a lease expired. Now, the inclination is to ascribe minimal value to space that has leases rolling over. For example, in two advisory assignments we are handling, the investment decisions are based upon an actual cash on cash return for a 10-year period. This fundamental approach will yield these investors a value that they perceive to be independent of the exigencies of the marketplace. While this technique has traditionally been utilized to evaluate non-real estate investment vehicles, it is now luring investors who sat on the sidelines during the 1980's into real estate investments in the 1990's.

The tightening of capital still available for real estate is not temporary but rather a fundamental change in the financing process -- a process which is now governed by "real economic value" of a particular project. Gone are the days of relationship-driven financings and the qualitative evaluation of a project. Borrowers are now required to bear more risk in the form of lower loan to value ratios and recourse. The decision to fund on the part of institutions will be made only after grueling due diligence and heavily reviewed quantitative analysis.

Changes in real estate capital flows have inverse effects on different sides of the real estate investment business. For example, while lack of capital availability adversely affects current portfolio values, it also provides greater acquisition opportunities for those investors who can either purchase on an all-cash basis or are able, under the new rules, to access funding sources.

Discussed below are several developments already apparent in the real estate industry as a direct result of the new approach to valuation and capital constraints.

* Pensions funds will step into the void and begin to provide debt rather than equity. Currently, pension funds have, to a large degree, withdrawn from the acquisition side of the market because of the write downs in value their portfolios have experienced. However, the returns that can be derived from safe debt deals are attracting pension funds to the debt side of the market. Funds can have their pick of loan transactions, with low loan to value ratios, and receive a rate of between 200 to 300 basis points over comparable treasury securities.

* Many investors will only enter the market contingent upon assurances of relative liquidity. Both debt and equity REITS, already beneficiaries of the 1986 Tax Reform Act, are well positioned to serve this function as traditional sources of capital exit the market. Equity REITS, in fact, are likely to become a mainstay of construction financing in the 1990's.

* Insurance companies are concerned about (i) liquidity problems emanating from their guaranteed investment contracts and (ii) existing mortgages on properties having significant lease rollovers. These concerns will motivate insurance companies to renegotiate key terms of performing loans. For example, on behalf of a client, we successfully secured a reduction in the interest rate on an insurance company loan whose key terms were: a principal amount in excess of $40 million, a remaining term of eight years, an interest rate of 13 percent and no right to prepay. The modification allowed the borrower to prepay, with no penalty, 20 percent of the loan amount in exchange for a reduction in the interest rate to 10.5 percent. Through this transaction, the insurance company was able to receive a substantial infusion of capital through the partial prepayment, as well as complete the sale of the note, which (after the partial prepayment) conformed to the new loan to value standards dictated by current capital markets.

* While the large Japanese banking institutions win probably not fund new loan transactions, capital from Japan will still be available for debt and equity positions on low profile, non-trophy properties. Japanese leasing and trading companies will continue to act as debt providers albeit in scaled down amounts. However, without the Japanese banks to act as agent or at least the seller of participation, new protocols must be developed to syndicate loans among these trading and leasing companies. For example, currently we are engaged in a financing assignment where we are assembling ow own syndicate.) On the equity side, syndicates of wealthy Japanese individuals will be a growing source of capital. Initially, these groups will concentrate on single tenant commercial building and multi-family properties.

* Corporations were somewhat shielded from the perverse escalation of property values in the 1980's because their holdings are carried on the balance sheet at historical book value, not market value. Also affected by the tightening of capital markets, corporations will continue to recapitalize through either the financing of their real estate or sale-lease back transactions. To the extent the corporation is a high credit, these transactions will entice some of the capital currently on the sidelines.

* The ability of many owners to float the rate of the debt on their projects over a Libor-based rate has allowed most of these projects to remain "performing."
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Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Finance; real estate industry's recovery dependent on real value of property
Author:Rutter, Mitchell Brent
Publication:Real Estate Weekly
Date:May 20, 1992
Previous Article:As the economy grows, the money flows.
Next Article:Secondary markets expect record year.

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