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Notes From the Credit Market's Front Lines

Peter Slatin

As the latest week of market chop ended in sudden calm and the new week quickly reverted to chop, I spoke with a few people on the front lines of the credit conflict.

A mix of deep concern and cautious optimism cuts across the professional spectrum, affecting those whose hands are directly on the money as well as those in the middle. Several themes dominated, as they are dominating deal considerations.

Of course, much of the talk centered around repricing of risk or the changing cost of debt, capital on the sidelines and the conundrum of strong operating fundamentals against weak liquidity. Refreshingly -- and contrary to some recent reports -- there was very little head-in-the-sand thinking. Instead, I found people trying to balance a sense of panic with feelings of forbearance about a market gone haywire amid late-summer somnolence.

Making Sense of the Noise

"The whole issue is," said one commercial mortgage broker -- reflecting the concerns that no doubt are on the top of the mind for anyone whose livelihood depends on a steady deal flow during a period of virtual deal-lessness -- "how long this repricing period is going to last and, when it's finished, what is the new capital market going to look like?"

That's a question no one can really answer. Maury Tognarelli, chief executive officer of Heitman, which manages some $20 billion in real estate-related investments for mostly institutional clients, projects a measured calm in his approach to market tumult. "Clearly, we are watching the volatility in the capital markets and trying to assess how that is going to impact pricing in regards to investments we're making and investments we're trying to sell," he says.

One challenge is trying to steer clear of misinformation. "There is quite a bit of noise in the market, about spreads, about the cost of capital, about a number of failures that have been highly publicized. You look at that information and try and relate it to the fundamentals in the market," Tognarelli says.

Like many observers, Tognarelli finds it difficult to reconcile current real estate fundamentals with the turmoil in the capital markets. Current growth conditions in the economy as a whole, he says, "are supportive of good real estate operating fundamentals."

For Tognarelli and his investors, though, such metrics are just one part of the investment decision. To date, he says with a hint of relief, the widening of spreads has been offset to some degree by the declining yield of 10-year Treasuries, so the "total cost of that component in the capital structure hasn't changed as of yet -- the cost of funds hasn't risen dramatically yet." However, that scenario may be short-lived, he adds: "It appears that spreads will be rising further, so there will be changes in the cost of capital at the debt structure level. That should translate into different pricing at the equity level."

So even as those fine fundamentals hold strong, uncertainty over capital costs are ruling the roost. "When you overlay those background elements in the market, how is all that going to impact my investment decisions?" he asks. That's playing out right now: "So far, it's not translating into pricing yet." (Yet, yet again.)

But he suggests that asset pricing is about to take a hit of an indeterminate scale. "When you look at apples to apples, there are fewer buyers than 12 months ago. I suspect that terms being negotiated today are more oriented to the buy side; buyers can extract more attractive terms." These changes, he believes, "are probably showing up in the pricing of lower-quality assets or in secondary and tertiary markets."

As for reaction from the investment community, Tognarelli prefers to say that investors are being "more cautious" rather than "less aggressive."

The main question, though, is how current conditions are affecting Heitman's stance toward its own investment decisions. They are and they aren't, Tognarelli says. "Regardless of market conditions, you have to assess opportunity. For us, we've not paused in any sense, although we are cautions and watching."

New Mortgage Realities

Although everyone in the game can be said to be watching, too, not everyone wants their name or their firm's name anywhere close to the market churn. That doesn't mean they won't talk about it -- they will, just not for attribution.

A mortgage broker active across the country says that "the CMBS [commercial mortgage-backed securities] market on the fixed-rate side is shut down." Sort of, that is. "There are guys doing fixed-rate deals at pretty predatory levels." However, he adds, "most deals that already are under application or in a commit are being honored" -- with some maneuvering. For new deals, though, spreads being quoted are "very wide." And no one is biting.

However, there's still what might be called the old-fashioned loan business -- that is, unsecuritized debt, typically involving insurance companies. "That market," says this mortgage broker, "is still fine. There are not any liquidity issues in that market yet." But he adds, "If you take a snapshot going forward, that's going to change."

Dig deeper, however, and he acknowledges that even that sector is "a little slower" and that lenders are being "much more selective." They also are extracting wider spreads from borrowers for smaller loan valuations. Borrowers are faced with lower loan-to-value ratios and much higher capital costs for mezzanine debt, which is now a far larger piece of the deal puzzle that buyers have to put together.

Many of the high-profile transactions -- and, of course, other building sales -- "were bought with negative debt service ratios," notes the broker. Thus, "the lender was looking at [a few prior years of growth] to justify their loan amounts."

Fears vs. Fundamentals

Jack Foster is managing director of Franklin Templeton Real Estate Advisors, which has some $4.5 billion in assets roughly evenly divided between real estate investment trust, or REIT, securities and private equity . Foster, who has been on the job for two decades, is blunt in assessing the current capital-markets fog.

"There isn't going to be much clarity until September or October" at the earliest, he says. The situation is having an impact on anyone involved in a transaction. "Right now the costs of lending are increasing, and capital-markets players are going to have fewer stamps on their dance cards."

To assess the amount of what Foster calls a "spillover" into commercial lending from the residential world -- led, of course, by the subprime-mortgage morass -- he is surveying Franklin Templeton's fund managers "on how this is playing out. The initial take is that smaller managers are less impacted. But this is not going to clear itself for some time." Still, he says, echoing a now-familiar theme: "The commercial side is not as impacted as the residential side, because of" -- can you guess? -- "strong fundamentals."

While some observers express little concern for the time it will take markets to unwind, Foster sees an impact for lenders and syndicators "who can't move loans off their books." Those loans, he notes, "are depreciating in value." That is setting the stage for "opportunistic players that surface and clear the market -- at a substantial discount."

One wrinkle that Foster sees is that "lenders are spending a lot more effort marking to market, and that is going to cause balance-sheet deterioration" for investment banks and commercial banks alike. Longer term, he says, "this will be more of a problem with your overleveraged players who geared up and bought big chunks of this stuff." He says there won't be "the same level of damage on the equity side of property, although we could see cap [capitalization] rates expanding. The bottom line is that you're looking at an increased cost of debt for strong and secure borrowers. "

Foster expects perception on both sides of the fence -- the players and the played -- as being a major factor. "Players in real estate have always been willing to consider disastrous situations," he notes. "Everyone knows the drama of overextended property. And the sentiment issue is exacerbating the problem.

"It's going to feel ugly as we get through September and October, but given that the commercial markets are fairly healthy, the impact there will be substantially less" than in the residential market. In fact, he says, "I'm enjoying this, because I look to buy things cheap."