Feature Story: Uncertainty creates financial market opportunities

Financial professionals discuss creative strategies, including ‘dequity’

By John B. Mugford

When a group of financial professionals gathered recently to discuss the state of the healthcare real estate (HRE) capital markets, Gary Bechtel, CEO of Grand Rapids, Mich.-based Red Oak Capital Holdings, had this to say:

“I’ve been in this business for a while, and I’m seasoned, not old, but I’ve never seen the market more confused – not just on the medical, healthcare side, but really across all asset classes and all of the lending programs as well.”

He added, “what we have today … is the most rapid rise in interest rates in modern memory, and this creates a lot of uncertainty, and uncertainty, historically … (causes) a contraction from traditional sources of people who say, ‘Well, I’m going to step back. I don’t know where the bottom is. I don’t know where things are going. I don’t know where rates are going. I don’t know where the economy’s going. I don’t know where property values are going. I don’t know where cap rates are going. I’m confused.’ Hence my statement it’s the most confused market I’ve seen in a long time.”

Mr. Bechtel also noted that although such a market can cause pain for some, as it probably will during the next 12 months or so, it will also present opportunities for others.

“We’ve never been busier,” he added. “We’re in this contraction of the traditional lending sources, right, as part of the non-bank alternative lenders, which is a space that Red Oak plays within. We can come in and fill that void. You might not like the rates right now, but we’ve got capital.”

Mr. Bechtel was part of an HRE financing panel discussion during the Connect Healthcare Real Estate Conference held Sept. 27-28 at the VEA | Newport Beach Marriott in Newport Beach, Calif. Glendale, Calif.-based Connect Media presented the conference.

Emma R. Kyser, a real estate attorney and shareholder in the Houston office of Polsinelli, moderated the session, which was titled “Healthcare Real Estate Finance: Finding Footing in Healthcare’s Capital Tsunami.”

Another panelist, Michael Borchetta, a director on the investment team with Chicago-based Harrison Street Real Estate Capital, noted that despite the turmoil in most business segments, the medical office building (MOB) sector has strong fundamentals, as it has “good credit, long-term leases and, in a lot of cases, you have stable occupancy.”

Unlike some other real estate asset classes, “from a stabilized standpoint, there’s financing available,” Mr. Borchetta added. “It may be at a higher rate and a lower lever point than we’ve all grown accustomed to over the last three or five years, but there is capital there.

“The challenge, and where I get concerned, is that as we look at more transitioning assets and where that liquidity gap is at right now. That’s why we’ve seen more alternative (lending) sources try to step in and fill the void, but those are very expensive, and I think that’s where there’s a little bit of a mismatch right now in terms of transactions and volume occurring.”

Katelyn Girod, a senior director in the Newport Beach office of Capital One Healthcare, part of McLean, Va.-based Capital One Financial Corp. (NYSE: COF), was the third panelist.

She noted that many investors “are pulling out right now and saying they want to pause and reevaluate. There are some other people saying they want to take advantage of this. There are only so many people going after certain deals, but the flip side of that coin is that there are lot of investors going after … really attractive deals, which are out there.”

Ms. Girod also noted that for investors who are willing to “put their capital to use right now, they are getting assets at a much lower value than what we’ve seen in the past, as cap rates have been (going up on some deals). A lot of it just depends on what type of transaction you’re looking for and if you can get the financing for it.”

For the most part, the panelists noted that although the transaction volume is down in the MOB and HRE space, deals are getting done. And, to facilitate that, lenders – and borrowers – are getting more creative.

“Money makes the world go round,” Mr. Bechtel of Red Oak Capital said. “You need capital in this business to acquire, to rehabilitate, to put long-term financing on something.

“One of the most interesting things I’m seeing … is the creativity within the capital stack these days, especially as rates have gone up,” Mr. Bechtel of Red Oak Capital said. “You could produce less debt, less leverage from the senior (loan) standpoint and the borrowers, generally speaking, don’t have as much, or don’t want to put as much, equity into deals. And, as a result, we’re seeing multi-layer in the capital stacks to acquire deals. As the saying goes, ‘Live by leverage, die by leverage.’

“So you’ve got to use leverage properly, and you’ve got to structure it properly but this is a very interesting time from a structured finance guy standpoint in that the deals getting done are very creative from a structural standpoint in the use of common, craft, mezz, senior (loans). It’s really quite interesting to me, even all the years that I’ve been doing this and it’s something I haven’t seen previously.”

Lots of creativity taking in lending

As noted, the panelists agreed that they are seeing plenty of creativity in the lending and equity markets market when it comes to getting deals completed.

Mr. Bechtel noted that the financing and lending environment used to be “pretty straightforward, pretty generic, right? You know, (some investors had) had equity, maybe some mezz (mezzanine loans) and senior debt and … bids to review. Now, things have gotten pretty creative, especially in the challenging rate environment that we’re in and will be in for a while. I think that’s an interesting topic.”

Ms. Girod of Capital One noted that some borrowers are asking for higher loan-to-value (LTV) leverage ratios in their deals.

“Some borrowers want a higher leverage option, given where the market has gone,” she said. “If you’re loan-to-value doesn’t pan out and you’re looking at potentially higher leverage on the same deal, based strictly on the values, I think people are starting to get more creative with structure.”

As an example, Capital One, she said, is offering “an investment vehicle called our UniTranche product,” which entails rolling all aspects of a loan “into one set of senior loan documents. This creates an easier transaction to get done than a typical either A, B or mezz loan. But the rates are slightly higher than what you’d see on just a senior loan.”

She added that for borrowers who want to “push the lever scale, we can find up to 80 percent LTV within that vehicle. We’ve seen a lot of people start to take advantage of that higher leverage now, based on the types of transactions that they want to get done.”

“There are options out there, and I think people are starting to get creative with what they’re doing, which is different than in the last few years, when it was kind of, ‘rinse and repeat a lot of the transactions that we’ve seen over the years.”

Mr. Bechtel added that his firm is even providing, in some deals, “an equity component within the debt structure.

“We call it ‘dequity’ because it’s a cool word,” he joked. “It’s just a stretch senior (loan), and it allows us to win a lot of deals … but it also allows us to provide the borrower with liquidity so they don’t have to go out and raise cash or they don’t have to bring it to the table.”

“So, because most of the deals we see when we stretch, I mean today if I’m stressing to be able to have, probably stressing it on a medical office deal, probably stressing the 6.5 percent coupon… Whereas a year ago, 85 percent to 90 percent of the deals were LTV constrained on the exit. Today, 85 percent to 90 percent of deals are coverage constrained on the exit. And again, as I stated earlier, I don’t see rates going down, at least appreciably, anytime soon.”

Mr. Bechtel noted that as borrowers look “forward two or three years, when they believe they’re going to exit our bridge loans, I don’t see rates being in a much different place, even if they drop 50 basis points. It doesn’t move the needle, appreciably.

“Most deals are going to be coverage-constrained versus LTV-constrained. So, there’s going to have to be another component to do these stretch seniors, where you take an equity position, and bridge that gap of what you could generate today, or it can generate the future, as a payoff versus what is actually needed to pay off.

“So, I think lenders are going to get very creative. I mean, there’s plenty of capital being raised for alternative type of investments… We’ll figure out how to make most of these work, even though not every deal’s going to work out.”

Where are the opportunities?

When Ms. Keyser, the moderator, asked the panelists where they see lending opportunities in the market, Mr. Bechtel of Red Oak Capital said, “We have to define opportunity for who, right? If we’re talking about opportunity for the alternative lending or non-bank lending space, we should define those investors who are looking for great opportunities, because rates and returns have gone way up from where they were a year or so ago.

“However, if we’re talking about owners of real estate, or potential owners of real estate, I would add that, again, with pain comes opportunity. There are going to be a lot of discounted opportunities out there, right? When you see office values, or the values of other asset classes, falling, and the values are falling for various reasons, there’s an opportunity.

“If you have cash and you have foresight and staying power to go in and buy some of these assets at a pretty low number relative to where they were two or three years ago. When you see office buildings in San Francisco go from $400 a foot to $60 a foot, (which has happened recently), that’s a leap of faith to buy at $60, because it may go to $40. Who the hell knows?

“But, therein lies the opportunity to reset the basis of that building. So, for those that are in a buying mode, or raising capital to take advantage of these opportunities, again, there’s the opportunity. But there is the chance of losing, right?”

Mr. Borchetta of Harrison Street added that in today’s market, with a resetting of rates, “I think it’s an interesting paradigm, just this reset in terms of the pricing or what that means for liquidity, ultimately, on the common side if we’re not getting an excessive debt, we’re not doing a good job as fiduciary for our equity investors and what they’re expecting. So that reset of pricing is triggered from really starting senior debt to mezzanine debt and (preferred) solutions all the way up to common.”

Ms. Girod of Capital One added that she does not think opportunities are arising in “specific product types or necessarily in certain transactions.

“We’re looking at everything on a deal-by-deal basis, as we always do. What we’ve seen, however, during most of this year is that there’s a good number of recapitalizations going on in the market. There are also a handful of smaller deals that are kind of being pooled into larger portfolios.

“But most of the bigger transactions that are happening right now are recapitalizations, and there’s been a handful of those larger deals taking place,” she said.

Where is the market going?

Mr. Bechtel of Red Oak Capital, in noting where he thinks the market is going in terms of acquisitions, lending and interest rates, said, “I think it’s going in the wrong direction. I don’t consider myself a pessimist as, hopefully, I’m a realist.

“But, I think I think we’re going to be looking at a high interest rate environment for the foreseeable future – maybe the next nine to 10 months, maybe the next nine to 12 or 15 months. I don’t foresee a lot of downward pressure on rates during that time. There’s no reason for it, especially when you look at some of the other factors that are involved.”

He noted that from a real estate standpoint, “We really don’t know where the bottom is for rates, whether it’s in medical or office or multifamily or hospitality, or some of the other asset classes. So, the state of the market to answer your question, Emma, is ‘confused.’ But look, there’s going to be opportunity in that. There always is. And there’s going to be a lot of pain for some. For example, I wouldn’t want to be an owner of an office building in downtown San Francisco.

“But there are some great opportunities in the medical office space and acute care and in other parts of the healthcare space. So (as) the saying goes, ‘When there’s adversity, there’s opportunity as well.’”

He said Red Oak Capital is “deploying cash, and we’re raising money because investors want to invest in a higher-yielding product, by default. We’re deploying that money at higher-yielding opportunities that we see in the market because of the current lack of capital, the lack of liquidity in the market that allows us to take advantage of the space that we operate within today.”

Other topics covered

During the panel discussion, a number of other topics were raised. They included, among others, the following:

■ There’s been a drop in life sciences deals. When asked about what types of deals are not taking place, Ms. Girod noted, “There’s really only one type of deal that we’re not doing, one that I will say we’ve seen a big slowdown in, and that, even more so than the traditional medical office deal, is on the life sciences side. We haven’t seen a whole lot of activity on the life sciences side, which in the last, call it five to seven years, had been growing like crazy and everyone wanted to get their hand in there. But, that volume has come down significantly, and there’s just really not a huge interest in this place right now, it compared to what we’ve seen in the past. So again, nothing that we’re not doing, but it, just every deal has to pencil out. So it really depends. What price are you buying at, what leverage point do you want and can you service the debt based on where rates are today? It’s all just a little bit of making the deal fit within the parameters we’re working with.”

■ Although some asset classes, such as office, might see a lot of owners trying to “hand back the keys” of buildings to their lenders as loans come due in the next couple of years, Ms. Girod said it is more likely that the medical office market will see more transactional activity instead. “If you’re looking at a three-year deal that had extension options, which is a lot of what we have done, the three-, five- and seven-year deals, well, those are coming due next summer,” she said. “So, what happens? If you’re staring in the face of an LTV (loan-to-value) requirement, your building is not going to appraise out and you’re either looking at a significant paydown or hopefully not giving the keys back to a lender. But, it will likely force you to sell at maybe a price that you wouldn’t have accepted this year or last year, but a price that is maybe more in line with where rates are at and where the current environment is.” She added that the “passage of time will cause activity” in the MOB sector. “We’re seeing less activity, less transactions this year. But by the nature of the passage of time, there’s going to be activity next year and in … the coming quarters because people have to figure out what they’re going to do with their debt that’s maturing or with options that they need to figure out.”

■ Although other real estate classes, including office, are facing a “refinancing cliff” of loans coming due within the next year or so, Mr. Borchetta of Harrison Street said that when one looks at the medical office sector, “we really didn’t see some of the higher-levered behavior that you saw in other asset classes.” As a result, he noted, “You don’t have a lot of highly levered players in this pool. So, as we think about the refinancing risk and cliffs, there’s certainly a de-levering that’ll probably occur. If you were at 70 or 75 percent, that replacement loan may be at 60 or 65 percent, which may require some form of paydown. But, I don’t see a big, kind of catastrophic cliff in medical office that other sectors might be facing.” And that’s because, he said, “the fundamentals are strong in this space. You see rent growth and upsized rent growth in some cases that are more than what we’ve had before. So, I see it more as a de-levering in the system versus some meaningful drop. And again, I think this is where you really see the difference between groups that are kind of well-heeled and in it for the long haul, and groups that are in it more as either merchant builders or entered the space recently as opposed to those who have been committed to it for 10, 20 years.” 