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DO ELECTION, TERROR, RATE HIKES FAZE CAPITAL? ‘NAH,’ SAY MANY

BY DONNA MITCHELL

Things are rosy right now for the retail real estate finance industry, as low interest rates and a high demand for properties fuel a steady flow of commercial mortgage business, commercial-mortgage-backed securities and other forms of real estate finance. But will the November elections, threats of terrorism and rising interest rates spoil the party before the year is out?

Some investors are particularly jittery about the possibility of another terrorist attack, especially since the Department of Homeland Security warned in early August that it had information that al-Qaeda had been scouting out some high-profile financial buildings in New York City; Washington, D.C.; and Newark, N.J., as targets.

Following such a strike, panicked borrowers could rush to try to get their deals done, while equally panicked lenders might be unwilling to get anything done at all, says Kin Powell, principal of Enterprise Financial Services, an Atlanta-based investment advisor to REITs.

“The controlling force will be investors, racing to buy Treasury obligations,” he said, noting that in times of economic uncertainty, government bonds have traditionally been the only investment option for the risk-averse, other than gold.

But though the capital markets did stop making and securitizing loans after the Sept. 11, 2001, attacks, that lasted only about a week and then things got going again, points out Kieran P. Quinn, president and CEO of Column Financial, an Atlanta-based commercial real estate lender.

Even a direct attack on a financial center would have a limited impact, says Quinn, because state-of-the-art technology allows the continued exchanging of critical information, and virtually every company has established systems of backup offices.

Furthermore, says Powell, investors believe that the government will continue to function after any attack on the financial establishment, backing Treasuries and maintaining law and order.

Of course, there is the open question of who will be leading that government come November. What if, as some predict, Democrat John Kerry is victorious and begins taxing businesses heavily to pay for social initiatives, such as nationalized health care?

“There is no question,” says Powell. “Anytime a business thinks someone will take their money, the first thing they do is stop investing” in such things as technology, plants, hiring.

Quinn is more sanguine, arguing that capital markets are not going to be upset by either election result. It barely matters whether Kerry or President George Bush wins, he says, because either one will need to focus on economic growth to solve such long-term puzzles as the looming Social Security shortfalls, the deficit and the fiscally strapped condition of state governments.

What’s more, according to Gregory J. Spevok, managing director of Chicago-based LaSalle Bank Real Estate Capital Markets, Kerry is a centrist with plenty of experience dealing with large companies. The prospect of his running the country is not likely to disrupt real estate finance, Spevok says.

Despite the market’s inherent resistance to tax increases, there could actually be a bright side to them, says Scott Zucker, a managing director at CDC Mortgage Capital, a New York City-based commercial mortgage lender. If Kerry were to raise capital gains taxes, for instance, that could discourage people from selling assets that have increased in value, and this would mean more business for the 1031 exchange market, he says. A 1031 exchange deal allows property owners to defer capital gains taxes on a sale if they buy a replacement property of equal value.

Or owners could decide to refinance mortgages rather than sell properties and face heavy capital gains taxes, and that would mean more business for lenders.

The capital markets don’t have much to fear from interest rates, either, Quinn says. Treasuries, which have come down significantly since June, are expected to remain low for the rest of the year as the market anticipates slow and steady growth, he says. In mid-June the 10-year Treasury was at 4.87 percent, but by Aug. 4 it had declined 44 basis points to 4.43 percent.

Not even the Federal Reserve Board’s raising the federal funds rate a quarter point to 1.5 percent the second week of August can change that, apparently.

“The capital markets are all driven by anticipation,” said James DuMars, managing director and senior vice president of Minneapolis-based Northmarq Capital’s Arizona division. “The Federal Reserve only controls the overnight lending rate, not the long-term U.S. Treasury yields, which trade on the free market. If investors choose alternative investments, then the market will reflect it, regardless of what Chairman Alan Greenspan does.”

The one area in which there could be shrinkage by year-end is profit growth, largely because several big-name institutions have crowded into the retail real estate finance field, says Clay Sublett, CMBS director at Cleveland-based Key Bank Real Estate Capital. In the first quarter, Calabasas, Calif.-based Countrywide Financial, the largest U.S. residential mortgage lender, and New York City-based investment bank Barclays Capital both launched commercial real estate finance businesses. They are among the entrants to the real estate capital markets of recent years.

Overall deal volume is increasing, but profit does not always keep pace, says Sublett, which could mean that some of the newer players, particularly in the CMBS market, are in for a rough landing by the time the year is up. “There is a 24-month time period before you can know if you are obtaining market share and are making a profit margin,” says Sublett.

It took less than 24 months for Seattle-based Washington Mutual to decide CMBS was not its cup of tea. In late July the commercial bank dropped the CMBS business it had launched the previous July. In the course of its short stay in the market, the bank originated $650 million in CMBS loans and securitized about $500 million, says Washington Mutual spokesman Alan Gulick.

“While the CMBS program met our first-year expectations, we concluded we could not scale up significant origination volumes and grow the business’s profitability to the level we desire,” Gulick said. Still, he says, the bank remains bullish about commercial real estate lending.

Investment capital continues to abound, but the supply of real estate deals is limited, say several professionals. That is encouraging flexibility in underwriting, among other things.

“We don’t see lenders making loans that are bad, but they are getting more creative,” said DuMars. “They are willing to listen to a story and structure a deal that a couple of years ago the buyer would have had to take to a bridge lender or wait until the project was considered ready for the permanent-loan market.”

Spreads, or the difference between yields on the 10-year Treasury and commercial mortgage loans, are narrow.

“We’re seeing spreads of sub-100 basis points on low-leveraged deals, and 80 to 100 basis points for conservative deals,” said DuMars. “There is a feeding frenzy for that product.”

The market’s thirst for real estate assets and its tolerance for risk prompted some commercial-mortgage lenders, such as CDC Mortgage, to venture into fixed-rate financing and mezzanine lending this year. That has sharply increased the company’s fixed-loan volumes. At the end of 2003, when CDC focused mainly on short-term floating-rate loans, the company generated about $1.1 billion in loans. This year, the company expects to double its volume to complete between $2 billion and $2.5 billion in loans.

“There is no reason in particular why this cannot continue,” says Zucker. “It seems like there is a lot more room to tighten spreads and standards.”

The same imbalance between a high supply of capital and a low availability of deals goes for CMBS.

“In an effort to deploy more capital, life insurance companies are also investing in CMBS,” DuMars said, “which has also contributed to downward pressure on spreads and increased competition among lenders to get their money placed.”

Consequently, CMBS professionals expect to enjoy a record year for business, with between $115 billion and $125 billion in deals done, up from $109 billion completed in 2003. The market has already completed about $63 billion in the first six months of this year, according to Darrel Wheeler, a managing director of CMBS research at New York City-based Citigroup Global Markets.

“A lot of things are going right for this market now,” said Wheeler.

Narrow swap spreads, which have hovered at about 50 basis points since June, help account for that robust deal flow. This makes the securities market, and CMBS financing, more competitive than loans from lenders who do not securitize them later. As long as this continues, and the volume of subordinate loans needed to add protective layers to large CMBS deals remains low, then property holders should be able to get loan quotes of about 80 to 120 basis points above Treasuries, says Wheeler.

The underlying mortgages in CMBS deals underscore the strength of the market. Delinquency rates fell from 1.6 percent at the end of June to 1.4 percent at the end of July, the “largest decrease in delinquency rates we’ve ever seen,” said Wheeler.

Retail property commercial mortgages, in particular, saw a decrease from an already small 1.05 percent at the end of June to 1 percent at the end of July. That is important to overall CMBS health, because retail commercial mortgages account for about 33 percent of the industry, says Wheeler.

Whatever happens in the broad economy or in national politics, the capital markets seem to be headed to a strong finish for 2004. Those who must fret about elections, terrorism and other disruptions should consider past patterns, at least.

Said Spevok, “More real estate financing has always occurred in the second half of the year than the first.”