With the news that China has lifted travel bans, travelers from across the globe are gearing up to visit the country and provide a welcome cash injection for the Chinese tourism industry. At the same time, the greater Asia-Pacific (APAC) area is getting ready to receive an influx of Chinese nationals as they flock to neighboring countries for business and leisure.
While that’s good news on a number of economic levels, it’s also a tailwind for the APAC commercial real estate (CRE) industry. And, according to recent reports across the region, the two sectors that are anticipating the biggest benefits are multifamily and hospitality.
Apartment sales are on the up
Multifamily sales in Singapore, for example, are expected to improve, with some analysts anticipating a “more than 10% increase in the number of homes purchased by Chinese this year” in the city-state.
A recent article in the Australian Financial Review (AFR) adds that another possible effect of China’s reopening is an uptick in Australian apartment sales. AFR says: “At a time of little new apartment supply, Australia’s residential developers will benefit from returning demand from returning foreign migrants.”
AFR notes that luxury apartments in particular are likely to see elevated sales but states that overall Australia is “lower down the list of countries to directly benefit from China’s reopening.”
Tourism and hospitality boost
Countries like South Korea and Japan are expecting a bigger boost, especially from the tourism and hospitality sectors. Likewise in Thailand, hospitality is gearing up for a major influx of Chinese tourists, with Thai Deputy Prime Minister, Anutin Charnvirakul, stating:
“The arrival of tourists from China, as well as from countries around the world to Thailand is expected to increase continually. This is a good sign for Thailand’s tourism sector,” adding “…it will accelerate the economic recovery after our suffering from the Covid-19 pandemic for three years.”
The reopening is also a positive signal for the hospitality sector in many other South-East Asian countries, which have battled low hotel occupancy and slow revenue recovery over the last three years.
Worth noting, however, is that some APAC countries have introduced restrictive new travel policies regarding Chinese nationals, including Covid testing requirements, which could act as a headwind to recovery.
Economic ‘silver lining’
At the start of a year where murmurings of recession have kept economic prospects largely subdued, China’s reopening is a strong positive signal for the global economy.
“China’s sudden reopening is set to offer a boost to a flagging world economy. The growth impulse will be felt through services sectors such as aviation, tourism, and education as Chinese people pack their bags for international travel for the first time since the pandemic.”
FinCEN Alert Could Mean Greater Scrutiny for CRE Markets
A new alert issued by the U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN) is warning banks and other financiers to be on the lookout for potentially suspicious investments into US commercial real estate (CRE). FinCEN says some of these investments may be an attempt by Russian oligarchs to use CRE to move or hide funds and avoid international sanctions.
What this means for CRE firms is that there may be greater regulatory pressure, and greater scrutiny, in the cards.
Shoring up ‘vulnerabilities’
FinCEN points out that there are “several vulnerabilities in the CRE market” that could be exploited to avoid sanctions, including the fact that CRE markets and transactions: “involve highly complex financing methods and opaque ownership structures that can make it relatively easy for bad actors to hide illicit funds in CRE investments.”
Part of the challenge lies in the fact that CRE transactions often involve trusts, private companies, and other legal entities as buyers and sellers, making it tricky to pin down ownership.
Risks and regulations
While it’s not yet clear what specific requirements may be incoming, in a recent CoStar article on the matter, bank regulatory attorney, Dan Stipano noted that: “FinCEN has started a rulemaking process that would impose requirements to prevent money laundering on the commercial real estate industry.”
He added that the process is still in the early stages, however, and that we don’t know which aspects of the industry new regulations will target.
Ongoing developments
The move to take a closer look at US CRE investments is part of a bigger trend of scrutinizing property markets across the globe. Back in December 2022, a FinCEN Financial Trend Analysis noted that CRE markets in Turkey and the United Arab Emirates had “become a safe haven” for this kind of illicit activity, and the UK National Crime Agency issued a broader “Red Alert” on sanction evasions in July.
Taken together, these moves add up to a global environment where CRE investments (and investors) may have a tougher time finding financing and completing the required diligence processes needed by increasingly cautious lenders.
That said, the good news is that the Commercial Real Estate Finance Council (CREFC) is also keeping a close eye on the situation and have noted that they are: “working with policymakers to educate them on the CRE finance markets, including how the industry works to prevent, detect, and report illicit activity.”
Last month, we had the first part of our “double period” and discussed various types of loan structures that can be utilized by a real estate investor. This month, we are going to roll into the second part of this discussion and highlight various key terms associated with loans.
There are two specific documents. The first is the mortgage, which pledges the real estate as collateral for the loan. Equally important is the promissory note (usually called the note), which is the document that contains the terms and conditions between the borrower and the lender. It memorializes the deal that both sides need to live with, so it’s important to understand some key components.
Loan amount
This is the amount of money the lender has provided. If funds are going to be held back from the full amount, the note will specify when and how the borrower will receive these additional funds.
Method of repayment
As discussed last month, there are all types of loans, including fully amortizing, partially amortizing, interest-only, participating, etc. This section of the note will detail exactly how, when and under what conditions the loan will be repaid.
Interest rate
The contract interest rate will be clearly stated in the note, along with a description of any future adjustments to this rate. For example, if the loan is tied to an index, this section will clearly state the index, the specific timing associated with future adjustments and any margin or spread that will be applied over the specified index.
Term
The note will include the initial date of the loan and the maturity date, or when the outstanding loan balance must be repaid to the lender. Some loans have a term that matches the amortization period. For example, loans originated by a pension fund will often have a 15-year term that matches up with a 15-year amortization period. However, most loans will have a term that is shorter than the amortization period. It may be amortized over 20 years but have a term, when the loan balance must be repaid, of five years.
Acceleration clause
This clause is always included in a note, as it gives the lender a strong position to force repayment. Under an acceleration clause, the lender has the right to declare the entire loan balance due in the event of default, which can be defined to include missing one or more mortgage payments, failing to keep the property maintained to building codes, failing to pay insurance premiums or property taxes, having a key loan metric such as debt service coverage ratio fall below a specified threshold, etc.
Because lenders have a direct interest in a property’s ability to generate income, they may use various mortgage covenants to specifically outline various controls. For example, a lender may have to approve leases that exceed a certain size threshold or consent to various repairs that exceed a certain dollar amount.
Most loans will have a grace period that allows the borrower the opportunity to cure some of these defaults.
Prepayment provisions
A lender may want to protect the yield received on a specific loan by specifying a time period which the loan cannot be prepaid, often called a lockout period. Or the loan may be allowed to be repaid with an associated pre-payment penalty. Certain loan products, most notably CMBS loans, will include a variation such as defeasance and yield maintenance, which allows the borrower to repay the loan according to a fairly sophisticated formula that again results in the yield being protected.
Due on sale
This clause will require full repayment of the loan upon the sale of the underlying real estate collateral.
Escrow/reserve accounts
A lender may establish various accounts that are used to withhold funds that are earmarked for specific events. The most common examples are escrow accounts for real estate taxes and property insurance premiums, as the lender will want to ensure that sufficient funds are available to pay these obligations when they become due. Reserve accounts go one step further and will withhold funds associated with a significant future expenditure. For example, if the roof on a large warehouse is anticipated to need replacement in a few years, the lender may require that the owner establish a reserve specifically to hold funds associated with this future replacement.
Property management & operation
Because lenders have a direct interest in a property’s ability to generate income, they may use various mortgage covenants to specifically outline various controls. For example, a lender may have to approve leases that exceed a certain size threshold or consent to various repairs that exceed a certain dollar amount.
Loan guarantees
Lenders may require additional security for the loan, beyond the value of the property, and a personal guarantee from the borrower is a common way to accomplish this. In the event a loan is personally guaranteed, the lender can require the borrower to pay any shortfall in the event of default or foreclosure. As a result, the security of the loan is beyond just the immediate real estate collateral and is extended to include other assets controlled by the borrower. A related concept is joint and several liability. If two or more borrowers are a party to a recourse loan, a joint and sev- eral loan guarantees the lender a right to recover the full amount of the deficiency from any of the borrowers, regardless of their ownership interest in the property.
Carveouts
Although not all loans contain guarantees/recourse, even non-resource loans will have some personal liability. These are commonly called carveouts and include full personal liability in certain events or circumstances. These circumstances include acts of fraud, misrepresentation, omission of facts or causing environmental damage to the property. Now that we have discussed the various forms a loan can take as well as the common terms and conditions they will contain, it’s time to get to some numbers. But that will have to wait until next month, when we head to the eighth and final period of the school day.
In our first installment of “By the Numbers”, we looked at a common metric for return on investment: a property’s capitalization rate or “cap rate.” As we saw there, many factors can influence a property’s cap rate and determining what makes for a “good” rate is often a lot more complicated than just looking for the higher number.
In addition to cap rates, however, there are several other metrics investors and commercial real estate (CRE) professionals can use to determine returns. Another common return metric that can tell you a lot about a property’s investment potential is the Internal Rate of Return or IRR.
IRR defined
Investopedia defines IRR as: A financial metric, used to measure the profitability of an investment, that takes into account the time value of money.
In other words, the IRR metric accounts for the fact that money received earlier is more valuable (given inflation and the potential to generate interest). This also means that, to calculate IRR, you need to have some idea of the cash flows a property will produce each year over the period of investment.
For example, an IRR calculation would include what you initially paid for the property, the amount you expect it to generate in rent each year (which would vary), and the amount you expect to be able to sell the property for later.
The actual equation to calculate IRR is fairly complicated (the Corporate Finance Institute gives an excellent breakdown here) and you’d typically use software or an online calculator to determine it. For the purposes of understanding the importance of this metric to CRE investing, however, it’s more useful to break things down in terms of what IRR tells us about an investment.
IRR essentials
Because IRR considers cash flows on a yearly basis over multiple years, it allows investors to see when they could expect a full return on investment, and how much profit they would make each year thereafter.
Comparing the IRR of two properties can therefore give investors a more nuanced understanding of how each will perform over time, and which is likely to be the better investment. All else being equal, a property investment that generates the same earnings sooner will have a higher IRR.
A “good” IRR?
Importantly, like cap rate, IRR is another metric where simply having a “higher value” doesn’t tell you whether a specific property is a better investment. For example, two properties might have the exact same IRR, but one generates a lot more profit over time than the other. The catch is that those profits are paid out later.
Real estate investment platform ArborCrowd gives a useful example:
As the above scenarios show, with the same initial investment, but different cashflow horizons, the IRR is the same. The difference between the scenarios lies entirely in when returns are provided, and how much those returns are.
The value of the investment therefore really depends on what the investor’s expectations are. Would they rather wait longer for a bigger payoff, or could short-term gains be put to use in a way that generates more money elsewhere?
As with all things CRE, the exact value that constitutes a good IRR also depends on the sector, and the risk, involved in the investment.
IRR and other metrics
Like many return metrics, IRR can help investors understand specific information about a potential deal. IRR is useful in that it takes into account cash flows generated over multiple years and gives a view of returns on an annualized basis. Worth keeping in mind, however, is that IRR relies on forecasting cash flows (and a potential exit sale price), and many risk factors can affect those valuations in the long run.
By comparison, cap rates provide a “snapshot” of the income a property generates in a year in relation to its current value. It’s a less nuanced metric, but one that can also tell investors something about immediate risk versus reward.
In addition to these two, there are several other metrics the savvy investor should consider. We’ll be examining those in detail in future installments, so be sure to check back for more insight into CRE “By the Numbers.”
With lunchbreak now behind us, the school day moves on as we head to fifth period. We lingered a little too long at the lunchroom table and our next class is a double period so there is no time to waste!
It’s very popular for a real estate investment to include capital from sources in addition to the investor’s equity. The most common form is a mortgage, sometimes called a permanent loan, and many think that a loan is a loan is a loan. But that is not always the case. While a traditional mortgage is a very common tool used by investors, it’s not the only way to use other people’s money (OPM). To learn more about some alternatives, read on.
Construction loan
A construction loan is specifically used to finance a construction project. These are typically negotiated between a developer and a lender, with the loan being used to fund construction costs. But it is very different in its structure and characteristics. Construction loans have relatively short terms, usually one to three years, while permanent loans are much longer. A construction loan is disbursed from the lender to the borrower/developer gradually as the project progresses. These usually take the form of “draws,” with the borrower making a request to fund a specific amount. During the time, the only repayment obligation is the interest associated with the outstanding loan balance for a given time period and the interest is based on a short-term variable or floating rate. Once the project is completed, the entire outstanding balance is due in full. This is usually accomplished by using a permanent mortgage.
Bridge loan
A loan is sometimes used to cover the time period between the construction loan ending and the permanent loan commencing. A common scenario is the development of a speculative project, where the building is completed without sufficient tenant commitments in place that would be necessary to qualify for a permanent loan. The construction lender will want to have their loan retired when the project is physically completed but the permanent lender may not be willing to disburse funds until the building is substantially occupied. A short-term loan, sometimes called a “mini-perm,” is a common way to fill this gap.
Second Mortgage
Mortgages are ranked in terms of priority and any type of mortgage that is subordinated to the first mortgage is called a second mortgage. Second mortgages carry greater risk than first mortgages because of the potential to be eliminated should there be a foreclosure of the first mortgage. This is particularly true if the value of the property has decreased since the loan(s) were originated. Therefore, second mort- gages usually carry a higher interest rate and have a shorter outstanding term. The second mortgage holder typically gives notice of this encumbrance to the first mortgage holder and the first mortgage holder usually must consent to allow the creation of a second.
It’s very popular for a real estate investment to include capital from sources in addition to the investor’s equity. The most common form is a mortgage, sometimes called a permanent loan, and many think that a loan is a loan is a loan. But that is not always the case.
Mezzanine loan
An alternative to using a second mortgage to obtain additional financing is to use a mezzanine or “mezz” loan. It is different than a second mortgage because it is secured by the investor’s equity in the property instead of being collateralized against the real estate. As a result, if there is a default on repayment of the mezz loan, the lender would engage in legal proceedings that would give them an equity interest in the property. The mezz lender usually will enter into an agreement with the first mortgage holder to have a right to take over the mortgage should there be a default by the borrower. Mezz debt typically has an associated interest rate that is several percentage points higher as compared to the first mortgage and the repayment of the mezz loan ranks ahead of any cash distributions made to the equity investor but obviously behind any loans that have priority.
Convertible loan
This type of loan is similar to a mezz loan in that it is provided to the borrower and collateralized against the borrower’s equity interest. But in this instance, the loan holder has the right to convert the debt into a share of the equity rather than have the obligation repaid or retired. The timing, terms and result of a conversation will vary and be clearly spelled out in the loan document.
Participation loan
This is a mortgage secured against the real estate that typically has an associated interest rate lower than that of a traditional loan. In exchange for achieving a favorable rate, the borrower agrees to allow the lender to share in the upside of the investment. This sharing can come from various sources. The lender could receive a percentage of gross income, net operating income or cash flow after debt service and/or can share in the gain achieved because of the property being sold or refinanced. The agreement related to a participation loan is highly negotiable and there is no standard structure.
Joint venture
While not a loan in a traditional sense, a joint venture has several characteristics of an encumbrance in exchange for a stake in the real estate. In a joint venture, or JV, two or more parties share in the ownership of a real estate venture. This can be an effective way to pool equity from more than one source, as well as include parties with different expertise, capacity or access to capital. As with a participating loan, there are all sorts of arrangements and structures for a JV.As you can see, a loan is not always a loan, at least not in the way we traditionally think. Next month, we will roll into the second part of this class as we will dig a little deeper into some ways to analyze a few of these alternative approaches, as using OPM sometimes is a result of thinking outside of the box.
Alec Pacella, CCIM, president at NAIPleasant Valley, can be reached by phone at 216-455-925 or by email at apacella@naipvc.com.
NAI Pleasant Valley - Cleveland, OH 