Where is all this Money?

Easy Cash Uplifting Investors
By MICHAEL STOLER
January 25, 2007

The fuel behind New York's record-setting real estate bonanza is the sizzling market for capital, and both buyers and lenders predict that cheap financing will be available for real estate investors into the foreseeable future. The availability of investment capital set fire to the real estate investment sales market last year, when transactions topped $30 billion. Considering the preliminary sales that are in contract for 2007, I would not be surprised to see the following advertisement: "For sale in New York City, office buildings, rental apartment complexes, hotels, and retail locations, priced from $100 million to $2 billion. Financing available for up to 100% of total purchase price, nonrecourse, interest only, and flexible terms."

Real estate investors are confident capital will continue to flow into New York's office market, where vacancy rates are dropping and rents are on the rise. One of the most active lenders in 2006 was Wachovia Securities. Last year, the bank was the leading lender in the $5.9 billion financing for Peter Cooper Village and Stuyvesant Town, the largest mortgage ever provided for a single property. "Capital is plenty; it also is now a freely tradable commodity," a managing director at Wachovia Securities, Robert Verrone, said. "We only originate financing for what we can sell; so long as we can sell it, we will originate it."

The director of commercial and real estate lending for the New York City division of M&T Bank, Gino Martocci, said the city's office market "compares favorably against alternative investments for banks. Lenders are competing to provide such a significant portion of deal capitalization because they too are flush with capital, have few alternative investment options, and have not seen a significant credit event in real estate in more than 10 years. The net effect is to reduce risk premiums, reduce spread, loosen structures, and increase proceeds."

One of the most active buyers and sellers of office buildings in Manhattan in 2006 was Murray Hill Properties, which, with its joint venture partners, divested 135 W. 50th St. and 450 Lexington Ave., and acquired the building at One Park Ave. and the Brill Building. This year, it is marketing for sale the office building 417 Fifth Ave. A co-founder and principal at Murray Hill, Norman Sturner, said banks — like typical investors — need to put their deposits to work. " New York City being the real estate and finance capital, the banks are comfortable with raising the levels of the capital stack with owners and operators that they had ongoing successful relations in the past. I do not believe that there is a change in the foreseeable future for Manhattan," Mr. Sturner said.

He said the availability of capital is grounded in basic economics. "I have used the analogy before: If tomorrow there were no new diamonds being mined or added to the existing inventory, the price of diamonds would skyrocket. Similarly, there is very little office space being added to the Manhattan commercial real estate inventory, and prices are increasing at extraordinary rates. Rents have begun to increase at the same rapidity to balance the higher prices being paid for assets."

Not everyone is quite so bullish. The head of real estate in North America for HSH Nordbank, James Fitzgerald, likens the current market to a religious experience. "The last shall be first and the first shall be last," he said. "Hoping and praying is never a good business strategy, but that is exactly what some lenders and investors need to do based on their current spending spree. The last ones into this game will be the first one to lose — and lose big." The head of an investment fund who prefers not to be identified said lenders are aiming to offer more capital as a way to inflate their year-end bonuses. "Real estate developers and entrepreneurs will find deals to build and to invest as long as the money flows, the more the better. As long as the debt providers get paid their bonuses at the end of each year for the volume of business they produce, with no consequences for failure of the transaction down the road, then it will take a larger event for the capital to slow down," the source said. In 2006, RBS Greenwich Capital provided more than $12.5 billion in financing throughout the country, including the properties at 350 Madison Ave. and 1441 and 1410 Broadway. The managing director at Greenwich Capital, Chuck Rosenzweig, said the market characteristics have pushed lenders toward new extremes in their practices.

"It is the first time in recent memory that you see a large number of Wall Street lenders comfortable at 90 percent leverage and even higher, as bridge equity has become a product that many firms now offer. This is all a function of liquidity in the market as firms have been able to sell that debt in the capital markets, and place the high yield paper with real estate investment funds and hedge funds," Mr. Rosenzweig said.

One area of concern for many lenders is financing for new condominiums and land loans. A number of lenders have ceased lending in this asset class; most prudent ones stopped lending up to 18 months ago, experts say. Investment capital will be plentiful on the "near-term horizon," Mr. Rosenzweig said, but not for all real estate classes. "There has been a recent pullback from any markets for condominium deals and residential land," he added.

Mr. Martocci of M&T Bank said lenders "have tightened underwriting for new construction residential for sale and condo conversion deals over the past 12 months."

Mr. Verrone of Wachovia supports this assessment. "I don't like condominium loans, and don't do them anymore," he said.

The pause in condominium financing will allow the market to absorb the thousands of residential units in the pipeline, experts say. Currently, there are few defaults in the condominium conversion and construction loans, since the lenders have set up interest reserves for the projects. If a change in valuation of the project has occurred or costs have risen to complete the project, the day of reckoning for potential default may be still be 12 and 24 months away.

Mr. Rosenzweig says the lending climate in the capital markets can change quickly. "It is fair to say that prices for assets right now are very much driven by the cheap cost of debt capital. This liquidity, and the very tight pricing that comes with it, can change due to events that are completely outside the real estate industry, like the Russian debt crisis and the collapse of long-term capital in the fall of 1998. Borrowers understand this and are borrowing very aggressively right now, especially on a fixed-rate basis," he said.

A principal at Stellar Management, one of New York's most active investors, Robert Rosania, said the demand for real estate at historically low cap rates is a factor of the copious supply of money.

"This is not rocket science: With the market fresh with nearly $60 billion of ‘institutional equity' for acquisitions, the light appears to be green. However, anyone who tells you they know precisely what will happen is a liar, because of a thing called ‘event risk,'" Mr. Rosania said.

As long as the market is fueled by high leverage and cheap financing, backed by underlying higher leverage and still cheaper collateralized debt obligations, Mr. Rosania said "the bulls will run in Pamplona."

"When an event of significant enough magnitude occurs, like a credit blow up, a housing dive, asset default, or, God forbid, a geopolitical disaster, then folks will get gored," he said.

Last month, the chairman of BRT Realty Trust, Fred Gould, appeared on my television show and said real estate has become more like the stock market. These days, he said, the concept of cash flow is a lot less important than value, and everything is based on perceived value.

Mr. Fitzgerald of HSH Nordbank, who also appeared on my TV show, said, "Buy low, sell high, trade, trade, today."

" Mr. Gould's comments make sense, but the problem is that unlike the stock market, leverage still plays a most significant role. The liquidity of freely trading shares is not a plausible exit for real estate. All cash buyers may be coming — but not yet — especially when we have so much stupid money out there in the first loss position," Mr. Fitzgerald said.

"Or is it the venture capital formula, Do 10 deals, get three right, and it makes up for the seven losers? I don't know and neither do the investors putting up the dough. Several of my friends run hedge funds and have been complaining how they missed the real estate boat and they need to get in the game. I am sure they will find someone to help them spend their money. Last in, first out; an accounting rule or a prognostication for the coming capital losers in the real estate marketplace."

The practice of mezzanine lending, in which niche lenders accept more risk than a traditional lender but charge a premium to allow an investor to finance up to 100% of a deal, continues to fuel sales. "Mezzanine lenders are prepared to take the capital stacks to 90% or more, knowing that they can take over the properties if a default occurs because most of these lenders have operating subsidiaries that can operate the properties if they cover ownership," Mr. Sturner said.

"Condominium developments and land transactions have a bit harder time finding mezzanine, as a potential decline in value could easily erode the mezzanine player's capital position," he said.

While Mr. Sturner is bullish on New York City — where he says business is improving; employment continues to grow; fixed, long-term money is inexpensive, and the future continues to look bright — I have to concur with some prominent owners and investors who are cautiously optimistic about the capital markets in 2007.

Mr. Stoler, a contributing editor to The New York Sun, is a television broadcaster and senior principal at a real estate investment fund. He can be reached at mstoler@newyorkrealestatetv.com.