Lender wariness signals peak for REIT buyouts

NEW YORK (Reuters) - A pullback in commercial property lending has raised questions about whether a recent surge in real estate investment trust buyouts signaled a peak for private equity funds.

Acquisitions such as Blackstone Group's $23 billion purchase of Chicago-based Equity Office Properties (EOP) in February sent property prices soaring on talk of more such deals to come, particularly for office REITs.

But valuation and credit concerns have undermined lender confidence in commercial real estate, threatening private equity firms' strategy of funding takeovers by flipping properties soon after completing a deal.

A recent rise in benchmark interest rates has also threatened to slow a broader leveraged buyout boom -- which accounts over a third of all U.S. takeovers so far this year.

Increasingly critical to financing purchases like that of EOP are commercial mortgage backed securities, but growing wariness about underwriting CMBS could impact REIT buyouts.

"It will likely be felt in the multiple property flips that come with some big M&A deals, such as in EOP where assets may get traded several times," said JPMorgan Real Estate co-head Steven Schwartz.

Within weeks of closing, Blackstone sold much of EOP's portfolio to the likes of Irvine Company and Maguire Properties . Many of these sales fetched record prices, justifying the $40 billion including debt that Blackstone paid to win a bidding war with New York REIT Vornado Realty Trust .

Blackstone then recouped about $20 billion for the parts of EOP it sold, according to analysts.

"For mega-transactions there is no question that buyers of these assets look at what their options on the debt side are before entering into an agreement," said Dan Fasulo, managing director at consultant Real Capital Analytics.

And some are now struggling to finance the agreed deals.

A feverish appetite for CMBS, which grew over 20 percent to top $200 billion in U.S. issuances last year, has given real estate investors unprecedented access to cheap debt -- pushing up both levels of leverage and prices paid per square foot.

But concern over lax lending practices, as expressed by rating agencies, has dampened enthusiasm for the paper.

"When lenders get competitive they start chipping away at loan quality to win business," said Jim Duca, managing director at Moody's Investors Service, which warned on CMBS in April.

Duca said a worrying trend for CMBS issuers was a focus on cash flow that could potentially be earned from a property, instead of what it is earning now.

"Often it's a believable story," said Duca. "But the preponderance of stories banking on future cash flows has increased a lot."

BETTER CAPITALIZED BUYERS AT LOWER PRICES

Uncertain CMBS markets could leave real estate investors with little choice but to access more expensive mezzanine and equity-linked financing. This also means deals negotiated before the pullback may be squeezing investors.

According to trade publication Real Estate Alert, RFR Holdings, a New York firm that agreed to spend $850 million for EOP's Stamford, Connecticut, office portfolio, is struggling to raise the debt it expected and, facing a $40 million penalty for backing out, it may have to put more equity into the deal.

More equity could worsen economics for a deal that, at over $500 a square foot, is the most ever paid for Stamford office property, Real Estate Alert reported. RFR declined to comment.

Lisa Pendergast, managing director of CMBS at RBS Greenwich Capital, says commercial property investors may face a 6.5 percent mortgage rate, say, and a 5 percent initial yield.

"That is real negative leverage and you're not likely to jump into that trade," Pendergast said. "So you're not likely to see a lot of the acquisition activity we've seen on these trophy assets because it just doesn't pencil out any more."

Without all the eager buyers, buyout firms will be wary of paying a premium for REITs, let alone entering a bidding war.

"This doesn't mean assets won't get bought," said Schwartz of JPMorgan, which led Vornado's EOP counterbid. "It just means better-capitalized buyers will get them at lower prices."

AN INFLUX OF FAST MONEY

Underwriting standards may have slipped as hedge funds, investing record amounts of capital, snapped up CMBS issues.

"But they are fast money and they'll likely be the first to adjust when the environment changes," Schwartz said.

Hedge fund assets under management topped $1.5 trillion in the first quarter, with $60 billion of new inflows, up from $16 billion last year, according to Hedge Fund Research, Inc.

Moody's Dugan said a lot of the so-called fast money may have left when the rating agencies warned about loan quality, an observation echoed by RBS Greenwich's Pendergast.

"You definitely saw almost a cessation of origination when this all hit the fan," Pendergast said. "Clearly the market is assuming that CMBS volume, while not likely to plummet, is going to come off its ridiculously fast pace."

Yet choppy CMBS markets won't rule out REIT deals entirely. Pendergast said valuations of multifamily residences, such as apartment buildings, lag the hottest parts of the property market, so private equity buyers may still see value there.

"To the extent that deals get done, my sense is that they are more likely in the multifamily sector," she said.

Indeed, residential REIT Archstone-Smith announced last month it was being bought for about $15 billion -- although buyers Tischman Speyer and Lehman Brothers lowered their bid due to debt cost concerns.

With media reporting Blackstone is raising a $10 billion property fund, top residential REITs like AvalonBay Communities could still be compelling targets. But the real estate buyout surge, especially in office property, may have peaked.

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