By Aaron Kazam ’15
Moderator: Alex Rubin, Managing Director, Moelis & Company
Panelists:
Michael Pappagallo, President and CFO, Brixmor Property Group
Ralph Rosenberg, Global Head of Real Estate, KKR
Hilary Spann, Executive Director of Northeast Acquisitions, J.P. Morgan Asset Management
The Real Estate Capital Markets panel discussed current capital market and investor trends in light of recent economic developments. The panelists provided valuable insights from their diverse perspectives, from public to private capital markets and across product types.
Michael Pappagallo, President and CFO of Brixmor Property Group, a publicly-traded shopping center REIT, opened the panel with an overview of market and industry conditions. He said that public mid-size REITs are currently trading at net asset value and that acquisitions are hard to justify relative to the current cost of capital of public REITs. Recently, much of the shopping centers REITs acquisition activity is limited to buying out JV partners rather than new acquisitions. Pappagallo contrasted the current nature of the private and public real estate capital markets: "Private players have a competitive advantage right now because leverage points are higher and they are not as sensitive to the nuances and vagaries of the public market."
Hilary Spann, Executive Director of Northeast Acquisitions at J.P. Morgan Asset Management (JPMAM), noted an increase in non-bank sources of financing. Until 2011, her group rarely engaged in sovereign partnerships. Since then, partnerships have been the model of choice for sovereigns – with sovereign players as JV partners, lenders, or in some other form in the capital stack.
Ralph Rosenberg, Global Head of Real Estate at KKR, added "we do not see sovereign players in the secondary and tertiary markets; they are focused on gateway markets only."
Alex Rubin, Managing Director responsible for real estate investment banking at Moelis & Company, queried the panelists about the non-traded REIT market which has been able to attract a formidable amount of capital over the past few years. The panel remarked that non-traded REITs have been less discriminating and have money to deploy. Non-traded REITs are pushing bids higher in secondary markets, thereby pricing out public REITs which have a higher cost of capital. Rosenberg mentioned that KKR’s exposure in gateway cities is limited to major opportunistic repositioning. He stated, "KKR spends more time in Houston Chicago, Denver, Philadelphia, because we feel we can get paid more fairly for the risks that we’re taking on in secondary markets." KKR would rather invest in secondary markets because the yields are higher, and the financial markets barely discriminate between the primary and secondary markets, thereby creating larger return spreads above leverage. KKR seeks higher cash-on-cash returns and marginally improves asset operations to create additional value.
Rubin subsequently directed the conversation toward the debt capital markets. Pappagallo remarked that Brixmor moved away from traditional mortgage debt and CMBS debt in order to procure unsecured debt in the long-term investment grade market. Due to the frictional costs of dealing with servicers and lenders (lender lease approval, servicing handouts, SNDAs, etc.), it has proved much more efficient to issue unsecured debt. In both bank and non-bank financing, REITs are increasingly able to issue high-grade unsecured debt. Spann mentioned that JPMAM issues mostly asset-level financing, and borrows primarily from life companies, in the $150M loan range. For smaller loans in the $50M range, banks, not securitized lenders, have been preferred since banks have recently become more competitive.
Leverage levels and mandates were mentioned a number of times during the panel, prompting Rosenberg to remark that "…the comments we are making about leverage ratios are agnostic to the typical way we think about risk." Rosenberg recalled that historically, investors viewed real estate as a complement to portfolio construction. For that reason, investors gravitated toward managers who focused on one product type: core, core plus, value-add, or opportunistic. For example, some managers viewed real estate as a fixed-income instrument, as a spread over the risk-free rate, while other managers invested in core properties as an inflation hedge. Ultimately, Rosenberg stated, "conversations with pension funds focused on vocabulary that defined certain product types, but in reality we should be vocabulary-agnostic, look at each deal in terms of risk and reward, and confirm that we will be rewarded for the specific risks at hand." He added that the opportunistic fund at KKR has a mandate that caps leverage ratios, but in reality there are many situations when moving from 60% to 70% LTV would be accretive to investors’ risk-adjusted return. Rosenberg also mentioned that it is a challenge for lenders to determine the correct inflection point of rates and leverage ratios; some first-mortgage lenders will compete directly with the blended rate of a competitor’s senior and mezzanine terms, but instead they should prudently reassess their position in the capital stack as a first-mortgage lender, rather than relying on a blended rate.
Rubin asked the panelists about their outlook for 2015. Pappagallo led off with an outlook for the retail market. He cited a reasonable amount of retailer demand and Brixmor’s strategy to redevelop its portfolio with internally generated funds, rather than use equity as fuel for new acquisitions.
Spann mentioned that multifamily rents have grown tremendously, but by contrast office rents still have room to grow. "Even though cap rates are extremely low," Spann stated, "there are still opportunities to grow yields with rent growth. Some office markets are still at a 20% discount in rent to the previous cycle." Spann also mentioned that in the northeast, certain urban areas are under-retailed and there is a shortage of industrial space. Overall, JPMAM plans to remain focused on maintaining discipline in 2015, and with increased pricing in many markets, that may mean that they do fewer deals than in 2014.
Rosenberg touched on a few themes for 2015. He mentioned that Europe’s distressed market offers many opportunities to control properties in high barrier markets at high discounts to replacement cost. If European growth does not resume in the near future, rates will stay low. To illustrate the low rate environment in Europe, he mentioned that rates from German banks are below three-percent for 60% LTV loans. This presents an opportunity to create long leases with high step-ups. In the US, KKR is focused on acquiring yielding assets in secondary markets, which can be financed very efficiently with long-term debt. For properties that were bought years ago with value-add and opportunistic returns, KKR plans to be an aggressive seller. Rosenberg summarized that KKR "will be buyers and also sellers in 2015."
Turning to the audience, Rosenberg took a question about the potential for REIT privatization, a trend that proliferated in the previous real estate cycle, exemplified by Blackstone’s privatization of Equity Office Properties. REIT privatization allows for more leverage, but given the amount of capital required, Rosenberg suggested that REIT privatization will not happen to the same extent this cycle. Although KKR bought Sunrise Senior Living’s management business two years ago, NAV was not an appropriate valuation measure for such an operationally intensive company, and value was added from a management standpoint. Spann echoed that her group prefers not to acquire large real estate portfolios because of JPMAM’s cultural habit of examining each asset closely and unwillingness to acquire any assets that diminish the quality of the pool. Pappagallo added that at certain point, too much REIT leverage is dilutive to value and therefore "most REITs gravitate to a point of leverage where they get the most love and affection. Public investors might say ‘you all look the same,’ but the public side will not support a diversified core or core plus REIT, while the private market allows for flexibility in terms of product type."
Another audience member asked Pappagallo about syndicating new financing for Brixmor from international lenders. Papagallo responded that the typical book of participants in unsecured term loans and credit facilities involves many Canadian and Japanese banks at bottom rung for a small degree of exposure, but overall he sees fewer international banks in his recent financing. He explained that there is "not as broad of a constituent base as in the past. Institutions are interested in going up in the scale of quality, and Asian banks are not a common player in shopping center REIT financing."
The final audience question asked panelists about how to hedge against currency risk when investing in foreign markets. KKR typically hedges 75% of basis, and when there is a markup in the portfolio, the hedge is resized with duration in line with the portfolio’s holding period. But there are exceptions; for example, in India, it would cost 400bps to hedge currency, which is difficult to justify as a hedge because it lowers returns significantly. Rosenberg added that the "golden ticket" for currency hedging is to raise capital in the local currency. For instance, Fortress Investment Group recently raised money in Japan on-shore to take currency risk out of the equation.