The Deleveraging of Global Real Estate

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					                                                 The Deleveraging of
                                                 Global Real Estate




The global picture in
                                                 A    C A P I TA L - I N T E N S I V E   asset
                                                 class such as real estate depends on diverse
real estate debt
                                                 sources of financing to function effective-
                                                 ly. An abundance of cheap debt causes
varies considerably.
                                                 unsustainably high asset pricing and stim-
                                                 ulates overbuilding. Too little debt leads to
                                                 bankruptcies and under-investment in the
                                                 building stock needed to serve a modern
                                                 economy. In the last four years, commer-
                                                 cial real estate debt has moved from one
                                                 extreme to the other, which has been high-
                                                 ly detrimental to the performance of real
                                                 estate as an asset class.
                                                     Real estate is certainly not the only
                                                 industry or asset class affected by the
JACQUES            N.   GORDON                   bursting of the “credit bubble.” A global
RICHARD            KLEINMAN                      review of commercial real estate debt mar-


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
kets reveals that commercial real estate has         There is relative certainty that funda-
many peculiar features in each market.           mentals in many western countries will
Each country has its own story to tell. And      remain weak for the next two to five years.
like the aftermath of a natural disaster,        However, there is great uncertainty about
courageous tales of debt “survivors” can be      what might happen in the debt markets
found among the death and destruction of         over this same time frame. The three major
global loan portfolios.                          categories of uncertainty are: the impact of
    Despite the idiosyncratic nature of          legacy loans on the market and the degree
commercial real estate debt in different         to which this will lead to distressed sales;
countries, common patterns can be                the timing of a return to a “normal” lend-
observed. First, to mix a metaphor, the          ing environment and what those “normal”
bursting of the commercial real estate           conditions might look like; and the future
debt bubble has a very long tail. Second,        of base rates and credit spreads in both the
unsecured real estate debt is recovering         secured and the unsecured markets.
well ahead of secured, mortgage finance.             We find that transparency on historic
Third, highly structured debt creates the        lending patterns and the status of com-
most difficulties to resolve. Fourth,            mercial real estate debt portfolios vary
national governments, central banks and          greatly. Ironically, the two most transpar-
regulators are having a major impact on          ent markets, the United States and the
the future re-alignment of commercial            U.K., are the two with the biggest legacy
real estate debt markets.                        debt issues. In reviewing debt markets
                                                 around the world, we observe major struc-
                                                 tural differences. At one end are the
    GLOBAL       DEBT     MARKETS                United States and the U.K., where institu-
                                                 tional real estate lending has been support-
The resolution of legacy commercial              ed by a deep, securitized debt market
real estate debt and the return of a             that included many cross-border lenders
normally functioning commercial                  (Figure 1). Even if most commercial real
mortgage market will be two of the               estate loans were not securitized in the
biggest issues facing investors (as both         Anglo-American markets, lenders thought
a challenge and an opportunity) for              that securitization of their mortgage port-
years to come in the G-20 countries.             folios would always be a possibility. At the
Our analysis is based on a country-by-           other end is Canada, where most lending
country survey of when and how the               was, and still is, dominated by large,
debt markets might recover.                      domestic financial institutions using con-


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
servative      underwriting       standards.        protect home prices and the construction
Canadian banks did engage in securitiza-            industry during the global recession. In
tion, but they also tended to hold a major-         2010, the government announced that it
ity of the loans they originated. Each bank         will tighten up on lending to real estate to
also had a strong deposit base and capital          keep real estate prices from rising in both
reserve ratios were high. Continental               the residential and commercial sectors.
Europe and the developed Asia-Pacific                   With the notable exception of China,
countries fall somewhere between the                lending in all G-20 countries was severely
Canadian and the Anglo-American mar-                affected by the credit crisis in 2009. In
kets in terms of legacy debt risks.                 Continental Europe, the traditional domi-
Securitization levels were lower in these           nance of commercial banks started to be
regions and lending was done more cau-              challenged by the securitized market over
tiously in Asia because of the relatively           the last five years. In Asia, the commercial
recent memory of financial crises there.            banking sector is the primary source of
Lending by Chinese banks falls into a cat-          lending but loans are typically short-term
egory of its own; data on lending volumes           (three to five years) and during 2006-2008
and non-performing loans is closely guard-          underwriting became relatively aggressive.
ed. In 2009, state-owned banks were                 All this changed in the second quarter of
encouraged to lend to real estate to help           2008, as the global financial system froze



Figure 1: Market dependence on securitized debt varies
25%



20%



15%



10%



5%



  0
        United          United          France   Germany      Japan      Canada       Australia
        States         Kingdom
Source: LaSalle Investment Management




T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
up, securitization came to a halt, and bank      at the end of a fund’s life, lower rental rates
balance sheets were put in danger of col-        due to competition from properties
lapse. Going forward, the recovery of the        recently acquired at low prices by new
banking system and of the commercial real        buyers, or depressed valuations based on
estate credit markets is likely to be quite      fire-sale comparables. The risk that this
different in each country. Where a market        scenario will materialize varies by market.
lands on the “legacy debt risk” spectrum is      In many countries, regulators are giving
likely to be a key driver that determines        lenders flexibility to renegotiate loans, so
how rapidly the debt markets recover. The        our baseline expectation is that we will not
other major driver is the regulatory envi-       see a global flood of foreclosed properties
ronment and what actions governments             in 2010, if ever.
are taking with respect to both legacy and           The highest risk is in markets where
new loans.                                       significant value declines coincide with
    In many countries, credit was abun-          lenders who are not in a position to work
dantly available between 2005 and 2007,          through issues with borrowers. Foremost
leading to the creation of a cohort of loans     on this list is the United States, where steep
with high loan to values (LTVs), limited         value declines have put many loans at
amortization, low debt service coverage          LTVs not sufficient for refinancing and
ratios (DSCRs), and few restrictive              many large loans were securitized into a
covenants. The performance of these lega-        bond structure not conducive to loan
cy loans and how troubled loans are dealt        modifications or refinancing. It remains to
with will affect both the transaction mar-       be seen in the United States whether
ket and existing portfolio performance.          recent government changes to the legal
The primary risk is that these loans will        structure associated with commercial
not be able to be refinanced without sig-        mortgage-backed securities will increase
nificant additional equity investment, and       the flexibility to restructure these loans,
that this will cause a wave of foreclosures      but even if restructuring is permitted, re-
resulting in properties trading well below       financing will be a challenge. The U.K. is
current pricing for an extended period of        in a similar situation, but due to less debt
time. Investors with capital to invest may       overall, a smaller portion of loans being
find this scenario will provide opportuni-       securitized, and most significantly a
ties to acquire property at very attractive      rebound in pricing, the risk associated is
pricing. However, for investors currently        less than in the United States.
holding a portfolio of stabilized assets, it         Asian markets have some risk because
could mean poor pricing on planned sales         the short-term loans common in the


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
region mean a large portion of properties        pejorative sense, it is a viable strategy that
have debt coming due over the next one to        provides borrowers with the option to pay
three years and many have experienced            down debt and the flexibility to get within
steep value declines. However, debt risks        normal loan covenants. It also allows
are mitigated by Asian financial institu-        banks time to improve the quality of their
tions, which tended to hold rather than          loan portfolios, which affects their capital
securitize their loans and are thus more         reserve ratios and better positions them to
willing to work with borrowers, especially       sell loans into a secondary market at some
as values start to rebound. This is especial-    point in the future.
ly true in mainland China where the gov-             Figure 2 summarizes the risk associated
ernment responded to the crisis by encour-       with legacy loans in major markets (Hong
aging new lending. Singapore and Hong            Kong, Singapore and China are not shown
Kong have seen less government interven-         on the chart due to lack of data availabili-
tion and refinancing risks are higher com-       ty. The state-supported lending environ-
pared to China. However, the risk in these       ment in China is creating the highest lev-
developed Asian markets is gradually eas-        els of debt-related risks in Asia, even
ing as capital value declines are slowing; in    though a degree of tightening is now
some cases, prices have rebounded, mak-          under way). Risk is shown as a function of
ing banks more confident to roll over            value declines and commercial real estate
loans. In France, Japan, Australia, and          debt as a share of GDP, which is a proxy
Germany most loans are held by financial         for a country’s dependence on debt as a
institutions that are reluctant to enforce       means of financing commercial real estate.
their rights in the event of a technical
default and push a borrower into foreclo-
sure. Instead, they typically allow the bor-                  THE    FUTURE

rower to refinance at a higher interest rate,        LENDING        ENVIRONMENT

require an infusion of equity and impose a
“cash sweep” on all rental income. This          During 2010 to 2012, we expect a meas-
type of forced “refinancing” improves the        ured return to a lending environment
banks’ balance sheets and creates fees. It       similar to the first half of the decade
also keeps the borrowers’ hopes alive that       before real estate lending became
they can re-establish a firm equity position     extremely aggressive. During 2002 to
in the property, maybe not today, but at         2004 spreads were typically 100 to 150
some point in the future. While the phrase       bps over the base rate and LTVs were
“pretend and extend” is often used in a          limited to 60 percent to 75 percent,


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
 Figure 2: Legacy debt risks are higher where plentiful debt coincides with value loss

-50%


                                                                         United
                                                                        Kingdom                          United
                                                                                                         States
 Peak to Trough Value Decline




                                                              Japan
                                     France

                                                  Germany
                                                                                                          High risk

                                                                       Australia


                                      Canada




                                       Low risk                                                Moderate risk
-10%


                                0%                    Real Estate Debt as % of GDP                                   25%

 Note: Real estate debt from government and private sources. GDP is 2009 nominal GDP estimate from Global Insight.
 Source: LaSalle Investment Management




depending on the market. This new                                   writing is used. The first three U.S. CMBS
“normal” will also mean much lower                                  deals in over a year were launched toward
lending volume than we saw during the                               the end of 2009. As securitization begins
2006 to 2008 peak. This lending envi-                               again, bonds backed by commercial mort-
ronment will be based on in-place                                   gages will have more subordination, and
income, limits to total loan size, and a                            originators will hold on to more risk asso-
significant spread premium charged for                              ciated with the loans. The appeal of these
interest-only loans.                                                lower risk securities to investors will return
    In the United States, we expect the                             as the economy picks up and as spreads on
debt securitization markets to open up                              alternative investment fixed-income
again for new issuance very slowly. The                             instruments move in. In the U.K. and
recent re-opening of the unsecured lend-                            Continental Europe, lenders are not likely
ing market for REITs provides evidence of                           to drastically reduce their exposure to the
the credit market’s willingness to forgive                          sector, but will lend at a slower pace with
and forget, provided that stringent under-                          lower LTV levels and higher fees.


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
    The markets that will take the longest        mortgages or public sector loans, as stipu-
to return to normal conditions are those in       lated in the Pfandbrief Act.
which the entire structure of commercial              In Asia, the timing of normalization of
real estate lending needs to be re-examined       financial conditions will vary. Hong Kong,
and re-created. One example is the United         Singapore and Australia are already start-
States, where in recent years a significant       ing to see improvements. In the first quar-
share of the debt has been securitized. For       ter of 2010, there are now many more
securitization to resume, CMBS spreads            active lenders offering slightly higher LTVs
need to narrow and investors need to trust        than during the peak of the credit crunch
that the ratings on the debt accurately           (4Q08 to 1Q09). In Japan, legacy loan
reflect the risk associated with the deal.        issues are constraining the availability of
Another market that will take longer to           credit. However, Japan’s Central Bank is
return to normal is France, where financial       encouraging lenders to make real estate
institutions will remain cautious because         financing available, which has increased
their capital will be dedicated to securing       the loan volume from balance sheet
loan extensions and supporting their exist-       lenders. The CMBS market is still closed
ing real estate clients.                          and is not expected to be a major source of
    Markets such as the U.K. are seeing           debt capital for many years to come. In
some improvement in lending, with an              contrast to almost every other market,
increasing number of active lenders and           China has not been severely affected by the
rising loan amounts. Loan availability,           credit crisis. Bank lending has always been
however, is still limited, with rates relative-   closely monitored by the state regulators.
ly expensive, and lending levels are unlike-      The tightening of the debt market during
ly to increase significantly in the near-         2006 to 2008 was mostly a tool by the
term. Financial institutions in Germany           government to curb the overheating prop-
are increasing loan availability to the           erty market. Earlier in 2009, the govern-
domestic market, and are also starting to         ment encouraged domestic banks to lend,
provide loans in other countries, support-        resulting in a sharp surge of loan growth.
ing the debt markets in Continental               Non-performing loans in China are often
Europe and even participating in some             held by banks for long periods and rarely
U.S. deals. This lending environment is           lead to foreclosures. However, govern-
possible due to German institutions’ access       ment-ordered tightening of real estate
to longer term funding via Pfandbriefs,           lending in 2010 will raise refinancing risks
which are covered bond vehicles collateral-       for loans coming due. Figure 3 shows
ized by long-term assets such as property         LaSalle’s estimates and forecasts of debt


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
Figure 3: Lending conditions by country
                   High
  Availability of Property Debt
           Moderate




                                     Normal
                   Low




                           2006            2007       2008   2009         2010          2011        2012        2013

                                  United          United     Canada          Germany           Japan            China
                                  States          Kingdom                    & France

Source: LaSalle Investment Management




availability in major markets over time.                              have launched incentives to facilitate lend-
Debt availability was based on our finance                            ing, thus far they are not generating much
team’s assessment of the ease of obtaining a                          activity. Both the Bank of England and the
loan, the amount of lending, and the terms                            U.S. Federal Reserve have quantitative eas-
attached to a typical loan.                                           ing programs aimed at providing financial
                                                                      institutions ready access to capital. The
                                                                      largest banks in both countries have issued
                                  THE      REGULATORY                 new equity to strengthen their balance
                                   ENVIRONMENT                        sheets. Smaller, regional banks are still
                                                                      capital-constrained and lending for com-
Changes in the regulation of financial                                mercial real estate still remains far below
institutions will also play a major role in                           historic, pre-credit bubble levels. Lending
the recovery of the credit markets for com-                           terms are now much more stringent than
mercial real estate. In the United States,                            even the pre-credit bubble era, and many
Japan and Europe, regulatory agencies and                             borrowers are turned down when they
central banks have taken the view that new                            apply for large, secured loans.
lending is critical to addressing overall sys-                            The gradual repair of bank balance
temic issues in the economy. While they                               sheets is a necessary first step on the way to


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
normalized lending practices. We view the        sell today. This process will probably lead
government incentives for commercial real        to RBS holding more assets and working
estate lending so far as a collection of         with borrowers, thus avoiding a flood of
short-term fixes that are not enough to          forced sales.
fully support the real estate lending mar-           An example of a less direct program is
ket. Looking ahead, regulators will be           Japan’s Real Estate Market Stabilization
focused on insuring that new lending is          Fund. This fund is designed to support
safer and treated more conservatively on         JREIT debt financing in order to avoid
bank balance sheets than it has been in the      JREITs becoming forced sellers and setting
past. There is a possibility regulatory          off an asset deflationary spiral. The fund
actions may limit lending and delay a            will be dedicated to helping refinance the
return to a “new” normal. In Europe, this        circa JPY 330 billions of bonds that will
will be heavily influenced by the tougher        reach maturity by March 2012. Lending
Basel II rules, which will be set by the end     criteria are stringent regarding both the
of 2010 and take effect by the end of 2012       financial strength of the eligible JREIT
or when the economic recovery is assured.        and the use of the capital. This action has
    There are also examples of direct pro-       helped restore confidence in JREIT bal-
grams that are designed to help the market       ance sheets, but has not increased lending
for legacy loans. In the U.K. the govern-        to the private equity sector.
ment has set up the Asset Protection
Scheme (APS). This is a five-year program
guaranteeing losses on assets selected by                IMPLICATIONS             FOR

the participating banks—now just the                    EQUITY        INVESTORS

Royal Bank of Scotland (RBS), after the
Lloyds Group found a cheaper solution            For equity investors, a functioning debt
following successfully raising additional        market is critical to a liquid real estate mar-
equity. RBS will take the first loss, at         ket. The longer it takes for debt markets to
around 10 percent, on all assets protected       stabilize, the greater the likelihood a lack of
by the APS, and the government will cover        debt will collide with a surplus of proper-
the remaining 90 percent. Under these            ties being forced onto the transaction mar-
arrangements, assets are likely to remain        ket. If this occurs, we would see a repeat of
managed by RBS rather than transferred           the 1990s, where transactions occurred at
to the government. The intention is that         a fraction of their fair market value. While
RBS will improve the assets’ value during        we do not expect this scenario to unfold in
these five years, instead of being forced to     any country, the risk of this situation is


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
greatest in the United States, where high             In contrast, Canada and China are
risks are associated with legacy loans and        experiencing little hangover from the bub-
strong incentives are needed to facilitate        ble; the ripple effects that might create
new lending.                                      interesting buying opportunities are few.
    The on-going multi-year challenge of          We see more opportunities opening up in
legacy loans will create a steady supply of       the United States, the U.K., Australia and
foreclosed properties to be marketed over         Germany, where lenders are willing to
an extended period of time (three to five         bring in fresh equity to re-stabilize loans
years). The steady erosion of net operating       and to keep underlying properties func-
income, as leases roll, will accelerate the       tioning at the highest level allowed by the
process. The largest of these transactions        market.
are not likely to be at steep discounts to            Globally the reversion to the “new nor-
fair value, but they will present opportuni-      mal” will mean significantly higher bor-
ties to acquire high-quality properties at        rowing costs compared to the 2006-2008
attractive prices. Many banks are unwilling       period and more restrictive covenants. We
to take huge losses on their commercial           believe this will enable a more disciplined
loan books and force properties into fore-        real estate market and for the foreseeable
closure. Their resolve to “wait it out”           future will limit the risk of another prop-
means that investors will have to reach           erty bubble developing. The final note of
deeply into their banking relationships to        warning is that if debt conditions improve
get a controlling interest in defaulting          much more rapidly than we expect,
loans. In Europe and the U.K., for exam-          investors will have to watch for signs of an
ple, equity investors may be invited to help      “echo” bubble. In fact, Asia, the most rap-
banks with their problem loans through            idly improving region, is already seeing
joint ventures. However, banks are moving         some signs of a potential asset bubble
very cautiously and are suspicious of vul-        emerging in the residential sector in the
ture buyers who are looking to make huge          Greater China markets.
profits by buying non-performing loans at
steep discounts to par values. In the
United States, loan portfolios are being                      CONCLUSION

auctioned off by the FDIC as part of the
disposal of assets of failed financial institu-   The innovation of mortgage securitiza-
tions. However, the loan quality is highly        tion (created to deal with the loans of
variable and is dominated by smaller, con-        failed banks in the 1990s) eventually de-
struction loans.                                  stabilized the long-term health of the debt


T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0
markets in many parts of the world.
Portfolio lenders were caught up in the
same “credit bubble” because they had to
compete with the securitization market or
stop making loans. The bursting of the
credit bubble brings back needed disci-
pline to the asset class. The re-emergence
of unsecured lending to listed property
companies in Australia, Europe and the
United States shows that the credit mar-
kets are ready to begin lending to real
estate again. In the second half of 2009
and the first half of 2010, underwriters are
more comfortable operating in the unse-
cured market, because the corporate bond
market is much stronger than the ABS
(asset backed securities) market. This
means that large, listed real estate compa-
nies have an advantage in the debt markets
over private equity funds. We view this as
a temporary situation and that the debt
costs of borrowing in the secured, mort-
gage market will eventually equilibrate
with the listed corporate debt market with-
in one to two years.




T H E W H A RT O N R E A L E S TAT E R E V I E W, V O L . X I V, N O . 1 , S P R I N G 2 0 1 0

				
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