Like markets across the board, the commercial property arena is filled with mixed signals about the future of the U.S. economy. Credit deterioration, poor corporate performance, and the sundry ramifications of the telecom debacle have sent many market players to the bulkheads, holding fast to what they know and simply staying the course. But smart players are making headway, and more and more often are turning to the credit tenant lease structure for their bearings.

"Precisely because we appear to be in an economic slowdown in certain sectors of the market and in certain industries, the corporations within those industries need to find alternative methods for raising capital," said Kyle Gore, managing director of Legg Mason Wood Walker, Inc.'s real estate capital markets group. "Sale lease-backeds, financed with credit tenant loans, represent an effective off-balance-sheet strategy for raising capital away from the traditional debt and equity markets."

According to recent market research from Standard & Poor's, mortgage delinquency rates in 2001 will likely rise across all property types, with the most marked increases concentrated in the lodging and healthcare sectors. Average delinquency rates could reach 2.0% by early 2002, with projected numbers for the end of that year pushing 2.5%.

S&P levels most of the blame for these credit problems at detrimental events external to the real estate property markets, as well as an excessive pace of development activity within certain sectors. Wherever the blame may rest, the result is a buyside wary of anything hinting at distress.

"We think our market is, as it has been for the last several years, an investment-grade market," said Gore.

Retail and Telecom Woes

Two sectors where investors are most wary retail and telecom are the two sectors where there seems to be a fair amount of interest from companies looking to move assets off of balance sheets. "We're seeing a lot of interest all over the place from corporations that want people like us to do structured, off balance-sheet financing for them," continued Gore. "Clearly there are more non investment-grade companies looking to monetize their real estate assets than there is investor interest.

"We see a lot of borderline retail transactions out there. In retail, it depends on the name there are literally only a handful of single-A or higher retail credits, and there's still interest for those. If you go down toward the NAIC-2 level, it's harder to get done."

An investment-grade rating doesn't guarantee smooth sailing, however. Pricing and structure issues have hobbled Moody's Aa3-rated Walgreen's efforts to shop out $200 million in sale lease-backed notes, according to buyside sources some of whom have referred to the tight pricing Walgreen's is after as "a joke."

Hard sell or not, Walgreen's conservatism might be well warranted. S&P reports that in the slow-growth economy forecasted for 2001, retail sales will be hard-pressed to exceed a 4.0% annual growth rate - half the pace of 1999 and 2000 - with some increase in the retail mortgage delinquency rate "likely to occur."

And then there's telecom. On June 15, S&P placed Nortel Network Ltd.'s single-A rating on CreditWatch with negative implications. Just last week, the rating agency assigned its preliminary single-A rating to $138.9 million of Nortel Networks Lease Pass-Through Trust certificates, and placed it on CreditWatch with negative implications as well. The preliminary rating reflects security interests in five single-tenant, office/R&D buildings leased to Nortel Networks Inc., a wholly owned subsidiary of Nortel Networks Ltd.

Nortel, in the last sixty days, has tried to bring close to $350 million in sales lease-backed transactions to market, which would have driven a like amount of CTL financing. Concerned by Nortel's negative earnings announcement and the subsequent gapping-out of Nortel bond spreads over the past few weeks, investor interest in these deals is reportedly thin. Word on the Street has it that one of Nortel's latest deals will involve a twenty-year lease, with the issuer acquiescing to a 500 to 600 basis points spread over Treasuries and a double-digit coupon.

What's Left?

Of the five property types covered in the National Council of Real Estate Investment Fiduciaries' (NCREIF) National Property Index, the office and industrial sectors led the pack in total returns 13.85% and 13.98%, respectively; retail came in at 7.58%.

In Moody's Red-Yellow-Green Quarterly Assessment of U.S. Property Markets, the industrial sector fared well with a score of 75 for 1Q2001 well entrenched in green territory and virtually unchanged from the previous quarter. The assessment measures the sustainability of cash flows of commercial real estate in the country's top markets on a 0 to 100 point scale.

Within the industrial sector, seasoned issuer TYCO International has been hitting the market hard through Legg Mason, which recently priced its third build-to-suit CTL financing for ADT, a subsidiary of TYCO. The $51 million deal for a new ADT monitoring facility holds a TYCO lease guarantee, according to market sources.

Although office rents rose an average of 12.5% in 2000, Moody's has dropped the sector from green to yellow status, indicating a "fragile" state of supply and demand. The Quarterly Assessment pointed to climbing vacancy rates and unusually poor performance from the San Francisco, New York, and Detroit markets as factors in the general slide. Bright spots, however, are there for the picking.

Houston, Texas did not change color classifications, but its score rose from 55 to 65 on the cusp of green territory. Legg Mason recently closed its $122.5 million deal for the Fluor Corporation (See PPL 7/2) involving a 1.1 million square foot office campus in that city. Investor interest was reportedly very high.

In addition, Legg Mason recently closed a $13.65 million transaction for the Swedish firm Securitas AB involving an office facility in New Jersey for Pinkerton's, a subsidiary of Securitas.

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