Commercial Real Estate Finance

Posts Tagged ‘yield’

We have talked ad nauseum about how the CMBS market appears to be back.  Well, right alongside private investors,  their institutional counterparts are lining up behind them….hungry for commercial real estate. In a recent report by Real Estate Research Corp. institutional investors seem to favor real estate as an asset class over their competition, mainly stocks and bonds.

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You Snooze, You Lose

If the corporate bond market is any indication of what is to come for real estate debt, it’s clear that non-bank lenders will make an attractive risk adjusted yield this cycle.  The window for putting that money out, however, could be short-lived.  Many in the corporate bond market feel that both extremely high yield and extremely good credit bonds are overpriced.  Since the end of 2008, corporate bonds at both ends of the credit rating spectrum have made a huge rally.  It’s the better quality credit junk bonds (the bonds in the middle of the credit spectrum) that look attractive still.  These bonds still have a decent yield for their default risk.

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Before the credit crisis of ’08-’09, few members of the general American public knew what a credit default swap was.  The financial instrument has gotten so much media attention by now that even my grandmother knows the mechanics of CDS.  In fact, she’d probably be far more adept at trading the product than the traders at AIG.  Like most cutting edge financial products, when CDS is used speculatively it can blow up in your face.  But when used properly as a tool to trade credit risk, it’s an ingenious invention.  Is there a way we can take the concept of CDS and apply it to private real estate transactions to encourage lenders to start lending again?

The most common explanation of CDS you’ll hear in the media is that it is a sort of “insurance policy” against a debt instrument.  Take a simple example: GE comes out with a new bond issuance.  CalPERS is interested in purchasing the bond because they like the yield profile.  As a conservative investor, however, they want to hedge some of the credit risk they are taking in buying the bond, so they buy a CDS contract.  According to the contract, CalPERS agrees to pay a premium to a counter party (they could care less who that counter party is) as long as GE does not default on their bond.  In return, the counter party agrees to make CalPERS whole should GE default on the bond.

When a commercial bank makes a loan to a real estate project, they are earning a yield in return for taking on some credit risk, similar to when CalPERS buys a GE bond.  Today, commercial banks are unwilling to take any sort of credit risk on real estate projects, regardless of the yield, which has constrained the availability of financing.  If bankers could somehow buy protection from a third party the way CalPERS does via a CDS contract, they may be more inclined to start making more real estate loans. 

In today’s commercial real estate market, the most similar product to CDS that we have is the private credit enhancer.  By co-signing with the borrower, the credit enhancer is essentially giving credit protection and earning a return for taking that risk.  However, this is different from CDS in that the borrower, not the lender, has to pay the credit enhancer a premium for covering the credit risk.  Because the bank is relying on the borrower to pay the credit enhancer in real estate deals, the universe of deals that come with credit protection is limited.  If, however, banks took the initiative to market deals that they would like to lend on to buyers of credit risk, they would get many more deals done in today’s environment.  Obviously, we could never have a highly liquid market for credit protection in private real estate transactions.  But a small, unsophisticated market for passing along credit risk is better than none.

Editor’s Note: As the second installment in a three week blog series, Questionable Brokers will  posit questions regarding Types of Capital. Last week, the first part of the series examined questions regarding Real Estate Metrics. Next Week week we will wrap up the series with questions Deal Structure. These are real questions from real real estate brokers. Enjoy!

Q: What is the difference between mezzanine debt and preferred equity?

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Editor’s Note: With Valentine’s Day coming up this weekend (order your flowers ASAP!), we figured, why not start off the week with a Cupid-esque topic? We can’t wait to hear your feedback on this one….

When a joint venture partnership occurs in real estate, the term “getting into bed” is often tossed around. And despite the fact that real estate is an industry dominated by men (and therefore subject to more coarse, perverted analogies), this phrase is somewhat appropriate. When you sleep with someone, you want to make sure you are protected (from exactly what, I will leave to the reader’s imagination), right?  Well the same goes for your equity partner in a real estate transaction.  Yet, while all real estate transaction involve some form of due diligence, JV equity partnerships involve an entirely different level of due diligence.

Rather than scoping out the salient facts of the deal, examining the borrowers track record, and crossing all the “t’s” and dotting all the “i’s” of a particular transaction (like a bank might do), an equity partner has to get extremely comfortable with the sponsor’s style and personality in addition to the aforementioned due diligence.  For this reason vetting a JV equity partner has become a lot more like eHarmony than a one night stand. Read the rest of this entry »