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Real Estate Alert

october 2011


William G. Murray, Jr.
Real Estate Group Chair



Three Years After the Meltdown:
A Snapshot of Real Estate Capital in 2011


The below article was authored by the Global Chair of Orrick's
Real Estate Group, William G. Murray. It was recently published by the Bureau of National Affairs, Inc. in its Real Estate Law & Industry Report.

Feel free to read the article below or click here to read the article as published by BNA.

For further information about Orrick's Real Estate group, please click here.  

William G. Murray, Jr.
(all rights reserved)

In the cold winter of the real estate recession of the late 1980s and the early 1990s an economic spring was created by a combination of the RTC’s efforts to manage and liquidate the troubled assets of U.S. financial institutions (primarily assets of the savings & loan industry), the availability of Wall Street capital to real estate through the vehicle of commercial mortgage backed securities and the resurgence of REIT formations. The combination of these vehicles along with the sustained growth of the U.S. economy created one of the longest bull markets in U.S. real estate in the memory of current market participants. The actions of the RTC, organizing and selling large pools of assets for prices which in hindsight, represented significant discounts to their value, the resurgence of the REIT market and the advent of CMBS financing both of which brought significant amounts of Wall Street capital to real estate and, in the case of REIT formations, allowed a broader participation in the real estate industry, all helped create very large pools of capital that fueled the resurgence of the U.S. real estate industry.

Those were good times. Prices were cheap, capital was coming back and astute market players that acted early created some of the largest pools of wealth that the real estate community has seen. The question we face now is are we on the eve of an inevitable upturn in the real estate cycle or are we just feeling a blip in a prolonged period of real estate malaise?

To try to understand this question, the first thing is to look at what got us in this predicament. Things were so good from 1993 to 2000, and while there was a blip in 2000 due to the bursting of the tech bubble, it was a minor blip and then another long run until late 2007 and 2008. Those who had not been around in the late 1980s and early 1990s must have thought real estate was the best business ever. It never went down. That is certainly what U.S. homeowners seemed to believe. And then the music stopped. Looking back to 2007 and 2008 it is hard to pick the precise cause of the real estate and economic collapse but certainly it was a combination of (i) the precipitous collapse of the U.S. housing market, the nest egg and piggy bank of so many Americans and the dream of so many young families, (ii) the collapse of the mortgage backed securities, because once the housing market began to collapse, the mortgage backed securities that funded so many residential mortgages and that had been engineered and reengineered to squeeze out the last ounce of liquidity simply could not bear up under any type of scrutiny and that market began to collapse, (iii) the collapse of the general economy, since consumers were out of the market due to the housing collapse and so many institutional investors, FNMA, Freddie Mac, banks, pensions funds, etc. had large positions in mortgaged backed securities in their portfolios, the general economy began to falter, and (iv) finally, the collapse of faith. While it may seem a little simplistic it seems to this author that in the final analysis, in any sophisticated economic system, the real glue that holds things together is economic faith, faith in a future, faith in economic asset values, faith in growth as a principle. Once that faith is gone no asset looks good, the future does not look good and investors are left wondering if there is any safe place to invest. That is what happened to the global economy in 2008.

The result for the real estate economy was a precipitous price devaluation and a precipitous cessation of transactions. There were no sales. There were no refinancings. Due to lack of demand, whether at retail stores, in home sales, for new (or used) office space or for warehouse space, transactions in every sector dried up. There was no faith so how could anyone plan on or make an investment in the future. Those of us who base our livelihood on real estate transactions know that clients who for decades had been doing a steady stream of purchases, sales, developments, loans, simply stopped doing deals and the work stopped. From 2008 to 2010 we were in a real estate deep freeze. Thus, as we look forward to the future, the question is: has faith begun to replace fear?

Certainly as we look across real estate markets there is significant evidence that market players believe that there are reasons to start making more bets on the U.S. real estate economy by actively deploying capital. The following are some of the signs in this regard:

• AFIRE News reports in its Jan./Feb. 2011 issue that “Foreign investors have set their sights on targets in the US again.” While interest seems to be focused on New York, Washington and a few other gateway cities, when AFIRE members were asked which countries provided the best opportunity for capital appreciation, the US captured 65% of the votes.

• In the “Property Report” of Wednesday, July 27, 2011, the Wall Street Journal reports that in an effort to capitalize on the real estate price recovery Lehman Brothers anticipates selling the balance of its $13.2 billion of real estate holdings beginning at an accelerated pace over the next 3 years.

• The Commercial Mortgage Alert reports in its May 20, 2011 edition that the CMBS pipeline for the balance of 2011 looks to be in the $39-$40 billion range that industry experts predicted at the beginning of 2011. This level is still a long ways below the $200 billion peak of the CMBS production in 2007 but it is a significant improvement over the $11.6 billion in 2010. More significantly, important market players, Deutsche Bank, UBS, Wells Fargo, RBS, Credit Suisse, J.P. Morgan, Morgan Stanley, Goldman Sachs, Citigroup and Bank of America have established platforms and become active in the CMBS market.

• Another significant change in the real estate capital markets is the advent of large private mortgage lenders. These entities are generally private equity funds and REIT’s that have been formed in the last few years to take advantage of the scarcity of real estate loans. Examples are Prime Finance, which as originated over $500 million of loans in 2011, including three large floating bridge loans, as reported in the May 27, 2011 edition of Commercial Mortgage Alert. Ladder Capital which has originated a number of very large loans, including a $230 million fixed-rate loan on a midtown Manhattan building, as reported in the July 8, 2011 edition of Commercial Mortgage Alert.

• Transactions in multi-family properties have reached an almost frenzied pace with well located properties trading at capitalization rates reminiscent of 2006 and 2007. Real Estate Alert’s Deal Database which tracks sales of properties in excess of $25 million reports that sales in the first half of 2011 more than doubled to $12.8 billion from $5.2 billion in the same period in 2010. The activity level in apartment transactions has been so robust that a number of fund sponsors have now undertaken significant development activity in this sector. Of course, the growth in multi-family properties is benefitted by more stringent lending standards in the single family sector and the inability of the single family housing market to find any kind of a bottom.

• In the industrial market there was an increase of 176% in the first half of 2011 from the similar period in 2010, as reported by Real Estate Alert’s Deal Database. In the first half of 2011 there were $2.8 billion of large industrial property transactions.

• In just a snapshot view of the national market in luxury hotels, in San Francisco the Four Seasons, St. Francis, Mark Hopkins, Stanford Court, Huntington and Mandarin hotels have all traded or had significant interests in their capital stacks trade in the last 9 months. Like the luxury hotel sector generally, these properties were hit hard by the recession but there is now no shortage of capital for acquisitions as the recession abates.

• While the Bay Area may be a geographical aberration due to the boom in the tech sector, in the last 9 months there has been the acquisition of the new Facebook campus in Redwood City by RREEF, a game changing major lease by Twitter in the mid-Market Street area of San Francisco, expansions of the Apple campus, a 1,000,000 square foot sale of a Bank of America campus in the East Bay and numerous other smaller campus and multi-building project purchases, along with virtual tsunami of smaller building purchases and sales.

There can be little doubt that there is significant capital available for real estate and that the market in some product types and in some geographic locations is returning to a pre-recession level. The issue for real estate capital providers (and real estate practitioners) is whether we are on the edge of a prolonged real estate growth period, like 1993, or on the top of a short term bubble that may quickly burst? The answer is far from clear. Even though the above list shows a number of positive trends, there are also serious clouds on the horizon.

• The U.S. unemployment rate still remains above 9%.

• As this article is being written the Dow Jones Industrial Average has plummeted by almost 2000 points in the last several weeks.

• The U.S. debt situation shows no clear resolution and little sign of the political will to seek a bipartisan solution.

• Standard & Poor’s has just down graded the U.S. debt rating and threatens to down grade the debt of a number of other Western developed countries.

• The European debt situation, maybe even more than the U.S.’s own debt issues, is a serious impediment to global economic growth and may plunge the world economy into a double dip recession.

• State and municipal governments across the U.S. are almost uniformly in serious fiscal condition.

• Recent CMBS issuances have faced severe market pressure.

• The U.S. housing market remains in a deep depression with little sign of any near term recovery.

In the final analysis, the real estate economy is a function of the greater business economy. If businesses are growing, hiring more workers, creating job growth and income growth, using more space and allowing the formation of more households, the real estate economy will prosper. To the extent that these elements falter, the real estate economy may hold on for a while, due to the long term nature of real estate as an asset, but in the end the real estate economy will follow suit. Thus, like the rest of the world economy, the real estate economy is in a very uncertain time. It is beyond the scope of this article, and beyond the author’s expertise, to provide any definitive economic analysis of these swirling economic winds or predict levels of activity in the future (not that definitive analyses from even the most renowned experts have proved particularly useful in recent years) but it is worth looking at what is actually happening now with those entities that provide capital in the current markets.

Private Equity Capital

There is simply too much capital in private equity funds for these investors to retreat completely from the market. Admittedly many funds have been “burned” by investments made in 2006, 2007 and during the recession, but even the hardest hit of these investments are beginning to show significant improvements and funds that were projecting negative returns in the last three years are inching back to even. This is very good news for the real estate private equity world. Many funds have residual capital to invest or are able to raise new capital, although not at the frenzied pre-recession levels. So what are the attributes of this new capital?

• Core funds, those investing in fully leased, well located assets, where there is little leasing or rental rate risk, are well subscribed and active players in the market. Of course, the return on core assets has been bid down but buying solid assets with 4% to 5% cash on cash returns, with conservative leverage at very low rates, looks like a solid investment in the current environment. The problem with these funds for the fund sponsor is that they are not particularly lucrative due to the difficulty of producing significant returns to the fund sponsor beyond the management fees.

• For opportunity funds, it is a truism that high return projections necessarily require investments that have higher risk profiles. In the current environment one might think that investors, and sponsors, would shy away from this model but this does not seem to be the case. There are still many funds projecting returns in the mid-teens to 20% range, and if you look at unrealized returns on investments that have been made in the last year many funds are exceeding these levels. To make this level of returns these funds have to invest in (i) the hottest markets (the Bay Area, New York, Washington D.C., gateway cities generally), and (ii) the hottest product types, multifamily, tech office space, gateway industrial facilities, discounted loans and restructuring opportunities.

• Funds are still looking for joint venture opportunities with experienced development partners but the terms of these joint ventures are much more favorable to the fund investors than in the past. Terms that we typically see are:

o More investment required from the developer partner.

o Greater control by the fund. The fund will often be the managing member of the JV with the developer partner designated as the administrative member, or some similar title.

o In 95/5 joint ventures, the fund will almost always have full control over major decisions such as budgets, financing and refinancing, sales and leasing. Even in 80/20 joint ventures the fund will retain substantial control. Development partners will often take almost any terms required to get access to fund capital.

• Fund investments will generally be leveraged but the leverage is much less than in the past, usually just a single 60% to 65% LTV mortgage loan with no mezzanine or junior debt. Current interest rates on this type of financing can be very favorable so this can provide a real boost to IRR projections.

• Since almost all financing requires some type of recourse, whether it be partial principal recourse, completion guaranties, environmental indemnities or just a standard non-recourse carveout guaranty, both the fund and the developer partner often have to sign on to these guaranties and in such cases these guarantors will typically have some kind of prorata loss sharing agreement among themselves.

Bank Lending

There are loans available from major U.S. and international commercial banks for real estate projects (at least there have been until the current market turmoil). Since interest rates remain at historically low rates, these loans can be hugely accretive to a project’s IRR. In fact, it is these low interest rates that are helping older projects begin to turn around, that allow core projects with very low initial cap rates to make sense and allow opportunity funds to have more confidence in opportunistic investments. The terms of these loans and their documentation will be familiar to experienced real estate practitioners. The form of the documentation remains largely the same (there is no new silver bullet in terms of real estate loan documentation) but the terms are a little tighter.

• As noted above, the LTVs are in the range of 60% to 65% with virtually no transactions above that level. LTVs are calculated on actual rents in place with discounts for above market rents. Thus the values are real values and are significantly discounted from pre-recession levels.

• Many loans require some level of recourse from a credit worthy entity to obtain the most advantageous pricing. Often this is not full recourse, maybe only 10% or 20% recourse, but again significantly more conservative than pre-recession underwriting. Since these guaranties must come from a credit worthy entity, we are seeing the funds themselves providing these guaranties.

• Loans today typically have stringent financial and operating covenants. These are not “covenant lite” loans. Although the lending market is very competitive, assuming the real estate economy remains relatively stable, one would expect that these covenants will gradually be relaxed as a result of competitive pressures.

• It is often the case that the first mortgage lender will take a pledge of the equity interests in the borrower in addition to the first mortgage.

• Since interest rates are at such historically low levels, on floating rate loans the lender will require the borrower to purchase an interest rate hedge product as additional protection.

The CMBS Market

CMBS loans were one of the major drivers of the pre-recession real estate boom. It is hard to imagine that we will be able to have full recovery from the recession without a resurgent CMBS market. There will simply not be enough money to handle the refinancing of the existing pre-recession CMBS loans along with new projects without a robust CMBS new origination market. As noted above, the good news has been that significant participants have come back to the CMBS origination market. Earlier in 2011 it was projected that there would be $40 billion to $50 billion of originations in 2011.

Unfortunately those expectations have now been trimmed back. The Wall Street Journal reported on Wednesday, August 10, 2011 that “Tremors in the market for commercial-mortgage-backed securities are hindering the recovery of the commercial property sector,” and that analysts were now predicting that the total 2011 CMBS market may only be $30 billion to $35 billion. Three factors have severely dampened this market. First, the buyers of the senior pieces of CMBS have recently criticized sponsors for “low yields and weak credit support. “ Wall Street Journal July 27, 2011. In addition, global investors are reassessing their risk appetites in light of U.S. and European sovereign debt concerns. Of course, maybe these investors will decide that CMBS tranches look pretty attractive compared to the political risks of sovereign debt.

Second, as reported in that same article in the Wall Street Journal (July 27, 2011) “A key funding source that has made the commercial mortgage-backed securities revival possible may back further away from the market in coming months, leaving lenders to scramble or watch their volume fizzle.” The point of this article is that there is a relatively small group of buyers for the “B-pieces” of the CMBS bonds. These B-pieces are the unrated higher risk tranches. The article reports that at the moment there are only about six active B-piece buyers and several of these have indicated that they may be withdrawing from the market, at least for the moment. These B-piece buyers are extremely important in the process because the B-pieces are significantly larger in current CMBS pools than in pre-recession pools.

Finally, the rating agencies themselves are still feeling their way through the post-recession CMBS process (often referred to as CMBS 2.0). On July 28, 2011 Standard & Poors made what has been characterized as a “game changing decision” when it announced a previous inconsistent application in their DSCR test for CMBS pools. Besides the apparent internal confusion that this inconsistency reveals, it forced S&P to pull its rating from a pending issuance and they announced that they would not issue any future ratings until the discrepancy was resolved.

Notwithstanding the current “tremors” in the CMBS market, CMBS will come back. In its basic form it is a good, creative idea that provides lenders, borrowers and investors with loans and investment they are looking for. The particulars of CMBS 2.0 loans are somewhat different, but not as different as you might think, from their pre-recession counterparts :

• Risk Evaluation—CMBS 2.0 loans are simply more conservatively underwritten than their predecessors. The LTVs are more conservative, the underwritten cash flow is more conservative, the economic ratios are more conservative and the data is more easily verified.

• Cash Management—Whether there is a hard or soft lockbox, cash management is almost always a feature of CMBS 2.0 loans.

• Amortization—This requirement is much more common in CMBS 2.0 loans.

• Guarantors—Real guarantors with significant credit are almost always required. The guaranty may only be a non-recourse carveout guaranty but the guarantor will have real credit on the line. Some lenders are also expanding the list of typical non-recourse carveout items.

• Independent Directors—In addition to normal independent director requirements, CMBS 2.0 loans will require that:

o Independent directors may come only from national companies that typically provide such directors.

o Removal of independent directors requires advance notice to the lender.

o The duties of the independent directors under Delaware law can be limited, and do not necessarily include a fiduciary duty to the equity holder, and some CMBS lenders are specifically restrictive regarding those duties or the matters that an independent director must consider in the event of a bankruptcy.

Private Equity Lenders and Insurance Companies

There are two other sources of real estate capital in the market today. One is a very old source and the other is quite new. Insurance companies have been a source of real estate financing since at least the 1970s and maybe even before that. They have always been an important factor, accounting for multiple billions of dollars of originations each year, but their impact on modern real estate capital requirements, which amount to many hundreds of billions of dollars, if not a trillion dollars, per year seems limited. They are important but their presence in the market is not a game changer. Similarly, in the last several years a number of mortgage REITs and private equity debt funds have been formed to take advantage of the demand for capital in the real estate markets. Again, however, the impact of these vehicles totaling in the single digit to mid-teens of billions of dollars, is not a game changer when compared to the overall real estate capital demands.

For reference’s sake it is interesting to note that the documentation format for insurance company loans, loans from private equity fund lenders and mortgage REITs are largely the same as they have been for many years, with some refinements borrowed from CMBS originations and some refinements resulting for changes in law in specific jurisdictions. This similarity over the decades may not be so unusual when it is considered that lawyers are such creatures of habit and many of the same practitioners and same law firms have been originating these loans for years, if not decades. For experienced practitioners it all seems very familiar.

While the documentation for loans from these sources may be very similar, the terms and underwriting are quite different. Insurance company loans are typically conservatively underwritten, much like the CMBS 2.0 loans, with fixed interest rates based on a spread over LIBOR or treasuries that makes these loans very attractive from a cost point of view. On the other hand private equity lenders are typically pricing their loans in the 6% to 7% range, also a fixed interest rate, but are willing to loan on more “transitional” properties and are somewhat more flexible on their underwriting. Many of the private equity lenders come from the equity side of real estate capital and are not concerned about the possibility of ending up the owner of some of these properties, providing the underwriting is sound and the properties are good properties.


What kind of conclusion can be drawn from this picture? From the perspective of a real estate practitioner, it seems very difficult at the moment to analyze the market risks for real estate capital with any degree of certainty. Maybe that statement is the answer. It is just a risky time. There is capital available and for those who guess right in their decisions, there are tremendous opportunities for wealth creation and for building significant real estate platforms but for those who guess wrong it may be another long winter.



[1] The list of elements in CMBS 2.0 loans is taken from an article by Peter J. Mignone, a partner with SNR Denton, appearing in the May/June 2011 edition of the AFIRE News.

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