Comments from Dealmakers: Deal Flow

This is the third of six installments of my notes and comments from Institutional Real Estate, Inc.’s Dealmakers Summit (Sept. 14 – 16, 2009). This section regards the state of ‘deal flow’ for commercial real estate.

DEAL FLOW

It is no secret that deal flow is off more than any real estate professional would like. Many in the real estate industry are highly dependent on deal flow for their livelihood. We should not be shunned for this, in a functioning system we need dealmakers, we are the fabric of the system. I don’t know if most professionals have come to grips with just how much deal flow is off, however. Many experts at the conference calculated that deal flow is off 90% or more; some are saying 95%. Ouch.

The general perception is that real estate still hasn’t been squeezed enough. The ‘kick the can down the road’ mentality is prevalent right now. Therefore, most experts aren’t predicting the tsunami of deals in 2010 like some had hoped.

WHAT KIND OF DEALS ARE GETTING DONE?

The deals that are getting done have one of two components: either they are “orphaned assets” (missed CMBS pool) or they have a “capital vacuum” (deals that can’t be fully refinanced and where there is not enough equity). A common theme of the conference was that “distress sells best.” Which leads me to conclude that every viable deal probably has a distress component to it.

Because of the distress, more deals will be done with structure. That is, it likely won’t be just the seller and buyer at the closing table; rather you’ll see the existing lender, a mezzanine lender, senior equity and possibly subordinated equity to boot.

Also important to note, is that industry players are going to have a strong desire to keep their ‘lumps’ out of the public so most deals will be off-market.

This tells me that dealmakers need to: (1) make new relationships, the old ones aren’t going to be enough, (2) learn as much about structure as possible, and (3) figure out how to get off-market deal flow going.

EARLY INDICATORS

Banks are still in workout mode on commercial real estate as compared to foreclosure mode. Add to that the fact that some foreclosures can take up to two years at it may be a while. Most of the deal flow is residential right now. The FDIC is still dealing with $15 to $20 billion of distressed residential deals and there is likely more to come (CA arms to blow up in 2010). As a result, commercial deals appear to be on the backburner at banks and the FDIC right now.

Banks will, on the other hand, sell management intensive and high-risk properties, e.g. hospitality (management, liquor licenses, etc.). Syndicated bank loans will also be sold early because of a lack of consensus from various stakeholders. Most experts agree that the 4^th quarter will start to show more commercial real estate deals and it should start with syndicated loans and hospitality. But this won’t go away anytime soon, deal flow from lenders will continue for four to five years.

Consensus among the institutional investors is that entrepreneurial ultra-high-net-worth (UHNW) investors will be first actors and will likely make the most money.

A leading indicator to watch for is institutional investors buying core. They will start with core because it is cheap from a price per foot perspective and will only buy vacancy after the core opportunity dries up. Although logic would dictate that it should make sense to dollar-average into this market (i.e. no one is really capable of timing the bottom), we probably won’t see that materialize.

Therefore, if you are watching for early signs of a return to deal flow, watch the UHNW investors, the banks for selling hospitality and institutions starting to buy core assets.