Extending the Flow of Capital to the Small Commercial Investor

Just a little over year ago, gains on the commercial real estate ("CRE") front bolstered the recovery as home prices floundered.   Industry pundits touted CRE as the white knight to lead the real estate sector out of its economic purgatory. Fast forward to the fourth quarter of 2012 and it does seem that CRE advancement may be slowing– at least for rank and file investors seeking opportunities in smaller markets or asset classes.

In 2011, Institutional investors, large private equity funds, and deep-pocket investors possessed the capital to take advantage of the higher return on commercial backed securities and acquisition of trophy properties in Class A markets.  At the time, returns on CRE deals for selected transactions could average as high as 10-12%  when compared to much lower yields from equities, treasury notes, or other traditional investment vehicles.   Lenders, extremely risk-wary of interest revenue from the residential sector, felt more comfortable in a commercial sector that enjoyed solid price appreciation and had stronger underwriting procedures in place than its residential counterpart. Lender purse strings particularly favored institutional and large investors because of the size of the prime asset class and prime location.

This “love affair” between big lenders and big investors has barred small investors from the rally. Assets with great growth potential have been cherry picked from top markets,  forcing investors to scour smaller markets for riskier assets. The upside is that investors with a higher risk tolerance are finding some tremendous opportunities off the beaten path.  Unfortunately, lenders don’t see the same potential nor share the same risk tolerance as these investors. And this represents the current dysfunction in the CRE sector and is preventing it from moving forward at a healthier pace:  lack of available capital for commercial acquisitions in new markets as well as stringent credit requirements and guarantees by borrowers.  Without available capital, the once robust expansion of CRE is beginning  to cool down and exclude a significant sector of investors from finding the  financing it needs.

Compounding the issue is the billions of dollars in commercial debt maturing in 2012 for loans originated in 2007 and bundled into securities.  Major lenders, faced with the potential of future losses on old debt and gun-shy of financing assets in riskier markets, have constrained the flow of capital necessary for new acquisitions and thus contributed to the tepid CRE performance in 2012.

There cannot be a balanced recovery in real estate unless the imbalance in CRE capital availability that disfavors small investors is corrected.  In light of current lender sentiment, small investors would be wise to explore alternative debt structuring solutions. The real cure, however, is for traditional capital sources to extend the same underwriting latitude and trust to small investors as it does to their larger siblings. Recent trends indicate a thaw could be in the works for commercial lenders to do just that:

one of the unexpected by-products of the most recent round of Federal Reserve Quantitative Easing has created a new demand  for commercial – backed mortgage securities. To bring more CMBS product to market, lenders will need a supply of new commercial mortgages to collateralize.  This means less- expensive loans, less-restrictive underwriting guidelines and a willingness to lend on commercial properties in new geographic regions.

Real Estate’s current growth will be guaranteed a more sustained upward cycle with a stronger contribution from the commercial real estate sector. That can only happen by increasing the flow of capital to a larger cross-section of investors and product type.