The credit crunch that began in the middle of 2007 now permeates the commercial real estate investment market—not to mention the economy as a whole. Trying to disentangle the threads of its influence in order to understand the behavior patterns that now govern the capital markets yields important lessons on just how closely linked all aspects of real estate investment are, not only with each other but also with the forces shaping global commerce. Each strand leads back to the erosion of debt as the market’s principal instrument. That market certainly no longer behaves as it once did, and dramatic changes have taken root and are becoming the new normal. Here is a look at what these new realities are, and what they have replaced.
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Then:
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Now:
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Debt
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Equity
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To do deals now, investors need to provide their own equity in significant proportion, and sellers often need to provide financing—or assumable debt. The additional equity now required will lead to more joint ventures and fewer deals.
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Optimism
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Pessimism
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Whether investors were looking at targets in the public or private real estate markets, they were placing increasing emphasis on trading values derived from inflated future cash flow, escalating rents and a positive outlook in general. Today, each deal is scrutinized with a negative outlook on vacancy and rental rates.
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Originations
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Workouts & Extensions
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When writing mortgages was easy, lenders courted borrowers with fancy dinners. Refinancing at a profit became a dependable exit strategy. Today a growing number of borrowers are facing cashflow deficits and near-term maturities just as asset values fall perilously close to the amount of debt they carry. The teams of originators are being replaced by workout specialists, who are unlikely to be as hospitable to borrowers.
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Mortgages are tough to get and even if a lender is willing, the terms are now onerous.
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Structured & Complex
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Transparent & Simple
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In the boom, ever-rising values were easily pegged to plumped-up pro formas and financiers went wild creating new and more complex structures. Going forward will be a return to the past with plain vanilla deals with better reporting requirements. Greater transparency is key since property values are now difficult to establish as the number of trades has fallen dramatically.
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Bliss
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The Denominator Effect
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This is the buzz-phrase of the year. After finally recognizing real estate as a serious asset class and increasing allocations to it, pension and other institutional investors no longer have much if any capital to invest in property. This has made fundraising a challenge for fund managers and added a new burden: stemming the outflows as redemption queues grow. Most recently, some major institutions have started to balk at capital calls on their prior commitments.
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The Bigger the Better: Bring it On
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Small & Strategic
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Big deals, whether portfolio acquisitions, CMBS issues, REIT IPOs or privatizations characterized the bull market. Now, size matters and smaller is better. Financing anything over $50m is very difficult. Nor do investors want to make large-scale bets, opting instead for more strategic acquisitions of certain properties.
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Emerging Markets & Decoupling
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The Ungluing of Decoupling
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Investors pouring capital into emerging markets banked on the theory of decoupling—that these nascent markets were independent economies capable of withstanding weakness in developed countries. Unfortunately, that theory has not proved to be entirely accurate.
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REIT M&A
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REIT Rout
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REIT shares outperformed all the major stock indexes as leveraged investors took underperforming and even some outperforming companies private. Now, too much debt, rising vacancies and investor panic have combined to chill any buyout activity as fund managers pull cash out of the sector the result: CEO firings, dividend cuts and share-price evisceration.
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Real Estate a Favored Asset Class
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Cash is Most Desired Asset Class
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At the most macro level, real estate is no longer a favored asset class—cash is the definite preference. Investors of all types are seeking a safe haven in cash due to the volatility and uncertainties across all markets. The hope is that when the markets calm and outlook clears, commercial property will re-emerge as a favored asset class.
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