The credit crunch means that investors have lost bargaining power but they should gain in reassurance. Claudio Lagemann reports
While the scope and impact of the sub-prime crisis on the US mortgage market are impossible to pinpoint yet, investors have started considering what the post-crisis market will look like, and what lasting changes we should expect.
From a financing perspective, we say: banks have become more cautious, and their caution matches the nascent risk sensitivity of investors. Off-balance-sheet financers who used to underwrite big projects currently lack the option to refinance through the securitisation market, and have lapsed into virtual inactivity. Institutions that handle their own loans, however, get more enquiries than before, while able to serve only on a selective basis. Even with auspicious projects they proceed much more selectively than even a few months ago. The main reason for this shift is not the risk, but rather the volume these transactions involve - they reach proportions that simply exceed the stamina of a standalone bank. For a bank to act a sole arranger of a transaction and not to call in other banks until the next stage will soon be a thing of the past, while the number of club deals will increase.
Meanwhile, market developments confirm that the real estate market is hardly undergoing a general crisis, least of all the commercial real estate market. The issue is rather one of financing and a confidence crisis caused by the high rate of loans granted to low-net-worth home buyers in the US, and by the associated high volume of loan derivatives issued. Yet the real estate markets themselves are basically intact.
The economic climate in the US and in Europe remains robust - and dynamic in Asia. This in turn stimulates tenant demand in all commercial real estate markets - office to retail and logistics. Yet in many places, the supply of quality floor space is limited because few buildings have been raised on speculation in recent years. Nothing suggests a supply bubble, and the opportunity to benefit from moderate rent increases presents itself to real estate investors then as now.
So arguably the situation in the commercial real estate markets should encourage investment, and demand remains high despite the expected slowdown in the wake of last year's record transaction volumes. According to Jones Lang LaSalle, the transaction volume in the German commercial real estate market during the first nine months of 2007 was approximately €44bn - up by 20% in 2006.
Real estate has positioned itself as an asset class in its own right in international capital markets and among investors. This applies notwithstanding recent evidence that some major deals will be shelved, and that a (perfectly plausible) correction of prices is imminent. If transaction volumes were to decline in 2008, this would rather herald a normalisation and cyclical adjustment.
The changes wreaked by the sub-prime crisis impact demand above all. In recent years, private equity and opportunity funds and comparable investors dominated this market, realising investments with an outside capital leverage of far more than 90%. As it is virtually impossible to obtain such financing now; this investor type has largely withdrawn. Consequently, the rivalry among buyers for suitable investment property abated, and with it the pressure on purchase prices.
Investors with higher equity capital leverage benefit from this shift. As they commit more equity capital, pursue conservative investment strategies, and thus represent a lower risk profile to banks, these investors continue to have access to outside capital. Other aspects include their expertise, and the focus on real estate as an asset class.
These and the structural changes characterising recent deals are closely connected. Current interest rates have eliminated the leverage effects that were possible last year. Banks no longer underwrite deals where the investor commits just a fraction of equity capital.
Banks generally seek higher and more risk-adequate margins, and will pass higher refinancing costs on. Also, financial institutions are less willing to take on market risks, least of all liquidity risks. But for how long remains to be seen. The situation will probably become clearer during the first quarter of 2008, once the full impact of the sub-prime crisis is revealed.
Future levels of outside capital financing will hinge on the quality of a given transaction. For banks, relevant criteria are the profitability of a property, the prospective cash-flow, the existing added-value potential, the quality of structure and floor-space, and the real estate expertise of the respective investor. Banks have developed a preference for loan to value ratios of 60% to about 70% for senior loans. Beyond that, even an LTV ratio of 80% seems possible for subordinated tranches, assuming risk-adequate pricing.
Borrowers now need to brace themselves for a stricter application of sanctions.
Punitive mechanisms embedded in loan agreements are more strictly enforced today, while the ratios of newly negotiated financing agreements are subject to advanced requirements.
We discern no fundamental change regarding securitisation and syndication trends. In banking, the current crisis will most likely help to bolster the role of on-balance sheet banks and on-balance sheet financing. Clearly, off-balance financing will return, yet the experience of mid-2007 will inspire greater appreciation for the traditional bank. Banks prefer clients they know very well, and whose motives, strategy, know-how and risks they are perfectly able to assess.
Despite ongoing difficulties, capital and real estate markets continue to move closer together. Real estate is a class of increasing liquidity. Large capital depositories have shown a deepening commitment to real estate recently. While some investors are abandoning the market, their real estate holdings will simply change hands.
Overall, the situation is as serious as it is beneficial. The cleansing process now underway is necessary and sensible, purging the market of excesses. There is no need to panic, neither for investors, nor for banks. Real estate investors seeking to finance attractive commitments with more conservative conditions in place will have as little trouble as the banks that underwrite such ventures.
Claudio Lagemann is global head of real estate at HSH Nordbank
