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.

The Short Tunnel for Real Estate's Recovery

The overused "light at the end of the tunnel" symbolizing the arrival of the real estate recovery may just have gained some credibility as we enter the last half of 2012.  Or at the very least, the tunnel's gotten much shorter.  The guarded optimism that the downward cycle is over is being supported by some very encouraging news on a number of different fronts. While it’s still premature to proclaim the official demise of the housing crisis, encouraging trends developing over the first six months of the year may portend overall good news for the real estate industry for the last six months of the year.

A housing market described so often as distressed for the past four years is currently getting relief that is constant, sustained, and showing measurable signs it’s providing a cure.  Predictions that lenders would ramp up foreclosures at a rapid scale in 2012 as a result of a landmark settlement with states simply haven’t materialized.  Aggregate foreclosure starts, especially in non-judicial states, dropped over 18% on an annual basis.  The widespread acceptance of short sales by both lenders and borrowers have served a dual purpose in keeping borrowers off the foreclosure rolls and preventing properties from ending up as REO on lenders’ balance sheets.  Moreover, the distressed borrower of 2012 is more qualified, educated and proactive than in years’ past to take advantage of lender solicitations and government programs to modify their loans.  As a result, mortgage delinquencies are at all-time lows, and more borrowers are avoiding Notices of Default.

The non-distressed sector provides some of the best signs of a sustained recovery as well.  In short, buyers have returned.  When bargain-price homes weren’t enough to jumpstart sales, record-low interest rates enticed buyers back to the market.  In fact, selected markets have even seen the return of multiple offers on properties, and the scarcity of housing product is contributing to modest appreciation of home values in selected areas.  We are certainly experiencing this market improvement in our immediate area in the western San Fernando Valley and the Westside of Los Angeles.  In a direct parallel to the distressed borrower of 2012, the prospective homebuyer of 2012 is better prepared for the responsibility of a long-term mortgage commitment and making more prudent choices regarding what they can afford and the right type of loan program to finance the purchase.

Investors have reason to smile as well as they furnish housing for a specific niche of the market not able to take advantage of the aforementioned buying market.  Today’s rental market is booming, generating strong returns for both multi-family and single-family property investors.  The forward-thinking all-cash buyer of SFR bargains in 2010 and 2011 foresaw the environment would be more conducive to generating revenue through renting as opposed to flipping. This strategy has been extremely popular in 2012.  Moreover, the slowdown in new apartment construction during the height of the housing crisis paved the way for a shortage of available units now that has brought back demand.  Low vacancy rates and higher rents prevail.  As a welcome footnote, new building starts and permits for new construction are on the rise to feed the appetite for new rental units.

Yes, for all practical purposes, it appears that real estate’s recovery has begun.  But at best, it is a fragile recovery that can be derailed by any new bumps in the economy.  Job and GDP growth, key metrics indicating economic stability, have improved but at tepid pace.  And a rash of recent near-defaults of foreign economies poses a lurking threat to ours.  Any unexpected economic shocks caused by unemployment, poor retail performance, European recessions, or any combination of these factors will serve to undermine real estate’s stronger performance this year.  The good news is that after six months of shrinking foreclosures, lower interest rates, more buyers returning to the market, rising rents, contracting REO inventories, and new construction activity, we’re significantly through the tunnel. The positive momentum of the first two quarters in 2012 may just be enough to propel real estate through any new headwinds it could encounter for the rest of the year.