Amid heightened competition, real estate investment trusts that operate within the commercial real estate sector are employing a number of strategies - from teaming up to changing course.
Several REITs in the first quarter admitted to having difficulty making money as, mirroring the residential lending sector, loan pricing has lagged the rising federal funds interest rate. As a result, several have announced plans to partner with one another in order to benefit from more capital and a wider range of assets.
"It will come as no surprise that the commercial real estate market is as competitive as ever," said Paul McDowell, chief executive at Capital Lease Funding, during the company's first quarter earnings conference call last week.
Last year was a record origination year for the commercial real estate sector. Commercial real estate CDO issuance is up more than 100% this quarter, as a fleet of new issuers came to the market, according to Fitch Ratings. But as CRE CDO issuance booms, market participants have noted that credit protection isn't what it used to be, nor are individual deal characteristics. For example, the so-called cap rate - in the real estate market, the value of property based on its income then divided by its present estimated value - has been falling, according to lenders.
While Capital Lease posted a 131% year-over-year increase in total assets - landing at $1.4 billion - McDowell said the company is expecting lower fee and interest income this quarter than in 1Q06 because of low cap and interest rates. He predicted that low cap rate deals that have recently come to market would have to return at higher rates in order to close, evidence that the market may be beginning to shift.
"In the last few months, we've seen a significant and sustained upward movement in the 10-year Treasury note," McDowell said. "While we've seen that cap rates have been falling, they are just beginning to change and widen out in response."
Teaming up
As REITs that hold commercial real estate assets have increasingly tapped the CDO market for matched-term funding, many of these firms are finding that the barrier of entry may be higher than they thought. A company needs to accumulate at least $300 million in assets in order to make a CDO deal beneficial, JER CEO said Joseph Robert, chief executive of commercial real estate mortgage REIT JER Investors Trust, which issued its first CRE CDO last November. While market conditions led his company to complete only one transaction in the first quarter, JER is hoping to accumulate at least $500 million in assets to issue a CRE CDO toward yearend.
Instead of waiting for a more favorable market, some companies are seeking partners in order to bulk up and diversify their assets. While RAIT Investment Trust enjoyed record loan origination in the first quarter, and is on track to produce between $800 million to $1 billion this quarter, the company is looking to complement its loan originations through more aggressive CDO financing, according to Chief Executive Betsy Cohen. The company should bring a CDO to market in mid-June. "This is not CMBS financing, which is the origination of 10-year thinly priced loans and, on the other hand, it's not the origination only of bridge and mezzanine loans," Cohen said, adding that financing the "midpoint in between" is a strategy RAIT is hoping to execute through bolstering its CDO platform.
RAIT is shopping for both build and buy-side CDO expertise, she said. Cohen disclosed that the company is in talks with a group that would bring internal CDO and credit expertise. RAIT is also in "significant discussions" toward partnership with a company that also originates CDOs but does not compete with RAIT's "baseline" business, she said.
And as NorthStar Realty Finance Corp. is preparing to price its seventh CDO this month, the company last week announced the creation of a joint venture with Chain Bridge Capital that will allow NorthStar to begin accumulating senior housing and health-care assets - beginning with a $64 million portfolio acquisition. The tricky operating and regulatory atmosphere surrounding the asset class has so far influenced it to trade at a premium, said David Hamamoto, chief executive of NorthStar.
CRE still attractive
Other players are seeking to make the transition into higher yielding assets. For instance, Resource Capital Corp. is trying to shed its RMBS assets in favor of higher yielding CRE securities. The REIT is planning to lower its exposure to agency RMBS by letting its current holdings roll off. From yearend 2005 to the end of the first quarter, its agency RMBS portfolio decreased by 17%, while it upped its holdings of commercial real estate by 24%, syndicated loans by 18% and leasing assets by 164%.
The company, which has six CDOs under its belt, is planning to begin marketing next month its first CRE CDO, which will provide match-term funding to 70% of its assets. Resource Real Estate Funding CDO I will be co-lead managed by Deutsche Bank and Bear Stearns and backed by 70% commercial mortgage assets and 30% mezzanine loans. The second CRE CDO in the series it is expecting to close by year-end.
Additionally, American Mortgage Acceptance so far has closed $180 million in assets under a $250 million repurchase facility it secured with Bank of America in the first quarter, for the purpose of funding a CDO backed by first mortgage, bridge and mezzanine loans.
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