Because the low-interest-rate, low-inflation environment is expected to continue for the foreseeable future, the challenge for investors and lenders of all types is to find investments that offer something more than single-digit yields. That search is driving the current trends in equity and debt financing.
Partnering with Local Owners
One of the more striking trends in equity financing is that funds with millions of dollars to deploy (supplied by pension companies, endowments, sovereign wealth funds and high net worth individuals) are partnering with strong, local owners to acquire and improve or reposition, commercial properties.
Take the example of Admiral Capital Real Estate Fund, a joint venture with USAA Real Estate Company and Admiral Capital Group (ACG). ACG was founded by NBA Hall of Famer, philanthropist and U.S. Naval Academy graduate David Robinson and managing partner Dan Bassichis.
Admiral Capital Real Estate Fund and SDM Partners, an Atlanta-based private commercial real estate investment firm, recently acquired a 160,000-square-foot, six-story, Class A office building in Atlanta’s central perimeter submarket. SDM Partners’ managing principal, Steven D. Martin, led the negotiations on the transaction. This was the first investment in the Atlanta market on behalf of the Admiral Fund. Equity capital for the acquisition was provided by Admiral Capital Real Estate Fund and an SDM Partners’ investor group, while State Bank and Trust Company contributed senior-level financing. Colliers International was hired to lease and manage the property.
Fund transactions typically range between $30 and $40 million, a level that many larger institutions would find too small, according to Dirk Mosis, executive managing director of USAA Real Estate Company and Admiral Capital. He said that the fund looks for value-add opportunities where the levered internal rate of return (IRR) is in the mid- to high-teens. It looks to hold its investments for three to five years, although the fund could go out as far as nine years, according to Mosis. With over $100 million in assets under management, the private equity fund currently owns three more office buildings in addition to the Atlanta property, two hotel properties and a performing mortgage on a non-gaming hotel in Las Vegas.
Mosis explained that the seller of the Atlanta asset was the property’s original owner for more than 20 years. The building had been designed for a corporate user and features high-end materials, structured parking, a conference center and cafe and other above-standard touches. The acquisition price was below the replacement cost.
“Ninety-nine percent of the time we have local partners,” he said. “We knew Steve [Martin, of SDM] through NAIOP, professionally. He’s smart, funny, capable and the ideal partner for us.” The partners will invest a small amount for mostly cosmetic improvements, such as expanding the fitness center, but nothing structural.
Like many real estate professionals, Mosis believes that more banks will be selling real estate owned (REO) properties and debt in 2013 and 2014. Not coincidentally, USAA Real Estate Company has invested in New York City-based Square Mile Capital Management, focusing on debt placement and recapitalizations.
Infusing Capital at the Entity Level
For some equity investors, it isn’t enough just to invest in a single development; far better, they reason, to invest in a company itself. One example: a $200 million investment by global real estate investment firm TPG Capital in Parkway Properties, Inc., a small publicly-traded REIT. The capital infusion enabled Parkway, among other things, to complete the purchase of Hearst Tower, a 972,000-square-foot office tower located in the Charlotte, N.C., Central Business District (CBD), for $250 million.
Sources: Marcus & Millichap Research Services, Real Capital Analytics and CoStar Group, Inc.
Includes sales of $5 million and greater.
* Preliminary estimate for trailing four quarters through 3Q12.
At the same time, it positions TPG Capital to reap the benefits of Parkway’s growth and rising stock price, as well as providing an investment vehicle for select office submarkets in the Southeast.
The relationship between TPG and Parkway began when TPG was interested in acquiring a large portfolio of properties in Florida, and Parkway had been recommended as a local partner to assist them. While that acquisition did not occur, the investment firm and the REIT developed a mutual respect, as they learned of each other’s operations and management philosophies.
Adam Metz, senior advisor for TPG Capital, explained that the firm’s approach is to develop “investment themes” that may run contrary to conventional wisdom and depend greatly on in-depth research. “We look for a macro theme and a situation that’s opportunistic,” he said.
For example, in early 2012, it was clear that institutional investors were mainly interested in the gateway markets. TPG’s analysis showed that many Sunbelt cities were business-friendly, offered better cap rates and returns and were high office-using employment centers experiencing growth. Were these markets not appreciated?
“Our theory was that demand looked pretty good, but what about supply?” Metz said. As it turned out, buildings were valued so far below replacement cost that it didn’t make sense to build new, “so there’s nothing on the drawing board and no one to finance it. We liked it as a theme,” noted Metz. TPG liked Parkway as well, and believed the REIT was misunderstood because it had a new CEO, received little coverage by Wall Street analysts, and the stock was trading below net asset value.
“The ingredients all came together,” said Metz. Following the investment (and the inclusion of four people from TPG on Parkway’s board), there have been no strategic changes, just a continuation of what the company had started to do in upgrading the portfolio and selling non-core assets.
Regarding Hearst Tower, Jim Heistand, president and CEO of Parkway, noted, “We knew Bank of America intended to sell, but it would have been impossible to purchase it on our own.” As it happens, Bank of America knows Parkway well, being an anchor tenant in three other Parkway properties. The purchase price was “half of what Bank of America put into it,” said Heistand. Parkway has been able to raise rents from $28 to $30 in a three-month period.
“The company has completely transformed in a year, and we are at the beginning of a meaningful growth cycle, noted Heistand. Parkway has sold 90 percent of its non-core assets and is focusing on Austin and Miami for the next two years. “We are looking at urban infill opportunities — those quality assets will get tight very quickly, enabling us to raise rents.” All markets where Parkway is active have had positive absorption, Heistand remarked.
Since the TPG investment, decision-making at Parkway has become more streamlined. Overhead costs have been reduced by 20 percent, with changes such as doubling the number of employees per square foot. During the next two years, Parkway’s goal is to expand and raise additional equity, anticipating that the involvement of TPG will help burnish the image of the company and encourage investment by other firms.
Abundant Capital on the Debt Side
There is an abundance of debt capital available from traditional sources, as well as from debt funds and once-again active CMBS sources. According to Marcus & Millichap, major lenders continue looking for quality and consistency of income stream, with stable occupancy by stronger, multiple tenants: “Consistent revenue streams translate into lender confidence,” it pointed out in a Capital Markets webcast. Lenders want debt yields of 10 to 11 percent; debt service coverage of 1.3 or better; and LTV of 60 to 70 percent.
Brian Stoffers, CEO of the Debt and Equity Finance Group at CBRE, cited renewed enthusiasm for mortgage lending by banks, thanks to strengthening community and national balance sheets. While there may not be a lot of construction lending taking place, there are more term loans with seven- to 10-year durations. “Recourse loans are common for banks, which is fine if you’re not overleveraged; otherwise, it gets very expensive,” he said.
As for life insurance companies, they are increasing allocations for next year. “Because rates are so low, they’re looking for additional yield and going further out on the risk spectrum, with mezzanine loans and higher LTVs,” he noted.
Stoffers also pointed out that there is more structured financing available for refinancing and recapitalization than there has been in years, in cases where values have been reset.
“I feel better than I did six months ago, at all levels of the capital stack, and expect 2013 to be an active year, baring no headwinds from the Middle East or Europe,” he remarked. Regarding the impact of the pending fiscal cliff, he commented, “If we figure this out, it could be an adrenalin rush to the economy.”
Beyond the Gateway Markets
Paul Ahmed, senior vice president of capital markets at Walker & Dunlop, LLC, said there is an ample amount of capital available in such markets as Miami, Tampa, Atlanta, Orlando, Charlotte and Birmingham. While multi-family is the most competitive property category, garnering 75 to 80 percent LTVs and 10-year loans at rates below four percent, industrial can command 65 to 75 percent LTVs in the low-four percent range in non-gateway cities, he noted. For industrial owners, “rates are at all time lows and you can get good short-term money. Insurance companies are offering flexible pre-pays, so you can sell in a few years,” said Ahmed.
A $200 million investment by TPG Capital in Parkway Properties, Inc., enabled Parkway, among other things, to complete the purchase of Hearst Tower, a 972,000-square-foot office tower located in the Charlotte, N.C., Central Business District (CBD).
Regarding recapitalizing an office property, he commented, “Hopefully you’re not under water. It’s great if you can get long-term financing, but bridge and short-term financing are becoming more available (both recourse and non-recourse) for three to five years.”
“For 2013, we’re still going to see more money chasing too few deals. Nobody has filled up the bucket this year — there will be plenty of liquidity for deals that make sense,” noted Ahmed.
Property owners looking for non-recourse financing at still-reasonable rates (in the range of five to six percent) might look to a company like Mesa West Capital, which provides first mortgage bridge loans on value-add real estate and holds its loans on its balance sheet. Last year, the firm transacted $1 billion in loans and expects to do the same in 2012.
These are “bread and butter” first mortgage loans, said Jeff Friedman, co-founder of the company, and proceeds generally are used to enable property owners to carry out their business plans. Loans can range from $10 to $100 million, but the company has been most active in the $30 to $40 million range. Friedman estimated that one-quarter to one-third of the company’s business now consists of recapitalizations.
“It depends on whether the basis has been reset,” he said. Typically owners in these instances are writing a check (as an equity investment), but the company can also arrange for mezzanine financing, as it did recently when the owner of a two-building complex in Denver needed 85 percent financing. Mesa West provided the bridge loan and brought in mezzanine financing for 15 percent of the capital stack.
Mesa West looks for a return of seven to eight percent from current income, not appreciation. The company likes all product categories, especially industrial in the $10 to $15 million range and sees more opportunities in office because it has been out of favor. Mesa West has made loans in Phoenix, Dallas and other non-gateway markets where the properties were well-located, high-quality and had a “fantastic basis,” he said. Loans are typically issued for three to five years.
The firm has made loans to owner- operators who have their own funds, such as JBG Companies and Savanna. It looks for an alignment of interests with borrowers, whose experience, track record and deep pockets are critical. “Borrowers simply cannot rely on market dynamics to lift rents and occupancy — you need a business plan,” advised Friedman.
(Editor’s note: For more on the capital markets, as well as the rise of debt funds and mezzanine financing, see highlights of the recent ICSC/NAIOP Capital MarketPlace Conference.)