By Konrad Putzier
Amid record sales and blockbuster IPOs, one of the bigger stories of 2013 has hardly been noticed: commercial real estate financing may be at the beginning of a far-reaching transformation.
Under pressure from Dodd-Frank rules, banks have been reluctant to hand out mortgages.
Meanwhile, REITs, hedge funds, private equity and even crowdfunding firms have jumped in, signaling an industry-wide shift away from traditional bank loans towards alternative sources of funding.
“Ten years ago, debt used to be the aphrodisiac of the commercial real estate industry,” developer Harry Macklowe recently said at Massey Knakal’s Multifamily Summit. “But over the past five years, lending policies have changed dramatically.”
Starved of loans, Macklowe said he now finances the majority of his big projects with equity. He said the private capital market is supplying “a considerable part” of that equity.
Unlike Macklowe, Michael Stern said he has no difficulty getting loans. But the CEO of JDS Development told Real Estate Weekly that he has noticed private equity firms becoming more active.
“If the deal size gets larger, we now typically bring in a private equity partner. In the past cycle we wouldn’t have to do that,” Stern said.
JDS recently purchased a development site on 1st Avenue with the help of hedge fund, Baupost Group.
Statistically, bank lending still has a dominant hold on real estate financing. But that hold is showing signs of eroding. While bank lending is slowly recovering from its low in 2009, it is doing so at a much slower pace than other forms of financing.
In the third quarter of 2013, commercial banks across the U.S. originated $257 billion worth of commercial/multifamily mortgages, according to data from the Mortgage Bankers Association. That marks a post-crisis record and a 22 percent growth year-to-date, but still pales in comparison to the quarterly origination average of $445 billion from 2005 to 2007.
Meanwhile, the total value of assets under management by private equity real estate funds in the U.S. reached an all-time high of $335 billion in December 2012, according to data from Preqin — a 51-percent increase over the pre-crisis peak.
These figures indicate that private equity has taken over a substantial share of the financing banks are no longer willing to do.
And private capital is not merely replacing bank loans with equity — as in the case of Macklowe Properties. It is also taking bigger slices of the mortgage business itself away from banks.
A Preqin study from September showed that private real estate debt funds are currently targeting to raise the highest semi-annual volume of new capital on record.
“The smartest guys in the business I know are now in the debt world,” Steven Witkoff recently said at an Eisner Amper Breakfast Forum. “They are getting high rates because banks can’t lend. These guys are simply saying: ‘I have capital, and I am going to act as a lender of last resort’.”
The statistical growth of mezzanine lending and CMBS originations in commercial real estate are part of this changing lending landscape.
Perhaps the most conspicuous sign of the rise of alternative capital sources at the expense of banks in real estate financing is the unprecedented growth of REITs. These funds generally get the bulk of their capital by selling shares to investors — as opposed to getting bank loans.
According to NAREIT data, U.S. REITS are well on track to raise record amounts of capital in 2013 — almost two thirds through share sales. It is telling that Malkin Holdings chose to take the Empire State Building public, rather than sell it to (presumably loan-financed) bidders.
There is little doubt that bank loans have lost some of their market dominance to alternative sources of capital. The big question is whether this is a temporary phenomenon or a permanent shift.
There are signs that bank loans might once again become as dominant as they were in the past. For one, private capital has flocked into real estate in part because of record-low interest rates. These have decreased returns on other investments ,such as bonds or loans, making real estate comparatively more profitable. Some of this flow will likely stop once the Federal Reserve tightens its monetary policy and interest rates once again rise.
Moreover, as Jamie Woodwell of the Mortgage Bankers Association argues, banks have been reluctant to lend in part because they are still suffering from the aftermath of the financial crisis. Once they are on a stronger financial footing, they may well become more aggressive lenders.
Dan Fasulo, of Real Capital Analytics, also argues that the dominance of banks and insurance companies in real estate financing “is not going to change”.
But while cyclical forces play a role, changing legislation points to a more permanent shift away from traditional bank lending.
David Kessler, Cohn Reznick’s national director for the commercial real estate industry, and Michael Hartman, managing director at Reznick Capital Markets Securities, argue that there will be a continued “diversification” away from bank lending in commercial real estate.
Driving this change, Kessler and Hartman say, is the Dodd-Frank Act — passed in 2010 to prevent the type of reckless lending that led to the financial crisis of 2008.
By placing stricter capital requirements on banks, the Act makes it more difficult for them to finance risky projects. Hedge funds and private equity firms, in contrast, are far less affected by Dodd-Frank rules. This gives them a competitive advantage.
By entering high-risk and high-yield investments in a growing commercial real estate market, these funds can offer their investors higher returns than banks for the time being, allowing them to raise more capital and increase their market share.
Changing legislation has also encouraged the growth of crowdfunding, another potential rival for bank lending. On September 23, the Securities and Exchange Commission loosened restrictions on crowdfunding, allowing firms to advertise investment opportunities to accredited investors in the U.S.
Most analysts say it is too early to judge whether crowdfunding can shake up commercial real estate financing, but the concept offers several key advantages.
Most importantly, it reduces transaction costs by connecting investors and developers directly, and allows small-time savers to invest in big development projects.
The startup iFunding, which crowdfunds real estate projects, recently raised $8 million for a condo tower in downtown Manhattan, according to industry sources. Most of its investors dish out between $25,000 and $30,000.
Prodigy Network, another crowdfunding firm with a focus on commercial real estate, raised $24.5 million from foreign investors for the purchase of 84 William Street and is currently hoping to raise $66 million for the purchase of 17 John Street.
“The internet and the new SEC rules will change the way real estate is financed,” said Prodigy Network’s CEO Rodrigo Nino. “It’s going to rock the world.”
In a field as complex and fluid as commercial real estate financing, it is impossible to know if the growth of private equity and crowdfunding will be a game changer or a blip.
But if it continues, this diversification of real-estate financing would mean that financing for risky projects will continue to be available despite Dodd-Frank — albeit from different sources and possibly at a higher cost.
And as real estate financing enters a new era, it is also starting to resemble the good old days.