Financing Exists for Commercial Real Estate Deals, But Lenders Are More Cautious in This Changing Market.
The robust economy, a proliferation of high-tech businesses, and Americans' growing affluence have driven commercial real estate's momentum for the past five years. Supply and demand generally are in equilibrium throughout the country, with pockets of actual shortages in office and multifamily in some areas. While capital is not available for every borrower and every project, enough money is flowing with the right rates and terms to meet the needs of most developers and investors.
However, many lenders are taking a more conservative, disciplined approach to financing in response to the softening of some markets and anticipated interest-rate hikes. Lenders gradually have tightened underwriting standards and are looking for sustainability and moderate transaction volume. Value creation generally is in the low single digits vs. the 5 percent to 10 percent annual increases of the mid-1990s. There is less room for error and less incentive to take large risks in today's market.
Still, opportunities exist for smart borrowers and lenders, both in traditional property segments and in niche segments such as hotels, medical buildings, vacation ownership, and affordable housing. Competing for the best deals, innovative lenders are offering special products — including float-to-fix and mezzanine financing — suited to today's climate. Fixed-rate lenders even are moving aggressively on floating-rate debt. Finance companies — which often have a higher appetite for risk — are doing well in this climate, taking up the slack as more conservative lenders pass on deals they might have taken two to three years ago.
When looking for financing, commercial real estate professionals should take into account all aspects of lending, including the status of various capital sources, outside factors and trends that influence lending, and the types of properties that lenders prefer.
Although some thinly capitalized lenders left the market after the commercial mortgage-backed securities problems in fall 1998, diverse lenders continue to populate the commercial real estate financing market. Today's lenders include the stalwarts — commercial banks, savings institutions, credit unions, life insurance companies, pension funds, issuers of asset-backed securities, finance companies, and mortgage companies. They also include some wealthy individual investors seeking good returns and a growing number of European investors. CMBS and real estate investment trusts are less active than in the mid-1990s, but both remain important capital sources as well.
Among portfolio lenders, diversification is the watchword. Lenders with a national presence, a strong balance sheet, access to the capital markets, a broad product mix, and expertise in multiple areas can handle rising interest rates and a slowing economy. Diversification allows them to balance debt and equity, use the capital markets to generate funds and offer more products to borrowers, and respond to oversupply in any given market or property type with activity in another market or property type.
While pricing is important in financing, relationships are important too. Good financial partnerships with lenders can help borrowers and brokers identify and maximize available opportunities. Borrowers seek lenders that are known commodities, will stay in the market, and will help make the most of this market's opportunities. The current status of some primary lending sources varies.
Commercial banks continue to dominate the commercial real estate lending landscape, with $518.5 billion in outstanding commercial mortgage assets in fourth-quarter 1999 vs. $498 billion in third-quarter 1999, according to the Federal Reserve Flow of Funds Z.1 report. However, commercial banks appear to have lost between 1 percent and 2 percent of the overall commercial real estate market to public capital sources in the past few years.
Banks continue to be conservative, with financing generally under 75 percent loan to value. Back in June 1998, the Federal Reserve asked banks to watch their lending standards, citing banks' exposure to REITs. In response, many banks lowered LTVs, tightened preleasing requirements, raised rates, or left the market.
In some ways, the impact of the Fed warning has lingered, keeping the amount of capital from banks fairly restrained. Recently even more institutions have tightened their credit standards, citing a more uncertain economic outlook, industry softening, and a reduced appetite for risk.
But banks remain a primary source for short-term financing and offer competitive pricing because of their conservative LTVs, which are a couple of hundred points over the London interbank offered rate. Banks have strong balance sheets and increasingly are diversifying their product offerings to appeal to a wide range of borrowers.
CMBS issuance continues to be well below fall 1998 levels. Although it remains an important source of capital for the market, some questions exist as to how significant a role it will play going forward. CMBS issuance totaled $78 billion in 1998 vs. $62 billion in 1999, with a projected $40 billion to $50 billion this year. But first-quarter 2000 CMBS issuance was only $8.2 billion, below projections and the weakest first quarter since 1997.
Sources are more conservative now, pricing at higher margin levels to hedge against sudden spread increases. Many conduits are joining together to pool loans, shortening warehouse times, and going to market more often to decrease interest-rate risks. If securitization becomes unattractive due to unfavorable spreads or if the class B buyer market is too thin, traditional lenders that are active in the capital markets can hold CMBS in their portfolios until conditions improve.
Borrowers are staying away from long-term loans to avoid being locked into high interest rates. As a result, some lenders are offering short-term, fixed-rate CMBS products. Other lenders also have begun to think about offering floating-rate CMBS products.
REITs continue to retrench from their mid-1990s heyday and are not a major factor this year. The composite market capitalization for REITs was $124 billion in 1999, down from $138 billion in 1998, according to the National Association of Real Estate Investment Trusts. The figure for this year is expected to be even lower.
The equity markets have turned their backs on initial public offerings and secondary offerings, and money has flowed away from REITs to dot-coms and other high-tech companies. Today, REITs are focusing on increasing the value of their holdings by improving internal efficiencies and only selectively pursuing acquisitions and sales.
Life Insurance Companies.
Similar to CMBS, this capital source lost a small percentage of the overall commercial real estate market. Life insurance companies are enjoying moderate transaction growth, with $177.1 billion in commercial mortgage assets in fourth-quarter 1999, up from $174.6 billion the previous quarter.
Life insurance companies continue to be interested in long-term — seven to 10 years — fixed-rate deals that amortize up to 30 years. As generally is the case, these lenders are likely to be less active in the second half of 2000 as they use up their allocated funds for the year.
Transaction growth has been fairly flat for pension funds, with $21.7 billion in commercial mortgage assets in fourth-quarter 1999 compared with $21.2 billion in the previous quarter. Pension funds remain conservative, with only up to 65 percent LTVs and, like life insurance companies, are likely to be less active in the second half of 2000.
These lenders had $33.2 billion in commercial mortgage assets in fourth-quarter 1999, up from $31.7 billion in the third quarter. Finance companies can be more flexible than many other sources, with the ability to offer nonrecourse financing, creative structures, and fast approvals.
In first-quarter 2000, finance companies funded a wide variety of property types — from self-storage to industrial — where the risk/return balance was stable. They also were major sources of financing for non-class A property and for contrarian deals such as hotels and health-care properties. By the end of the year, finance companies should replicate or increase their 1999 volumes.
Like banks, finance companies are likely to stay in the market even if a downturn comes. These lenders have a balance sheet to fund against for strength in a changing interest-rate climate and can shift capital as needed to whatever markets, property types, or financing tools are most attractive. They can stay active because of their product diversity and their willingness to shift capital and resources to new opportunities.
Factors and Trends
Since summer 1999, the Fed has raised interest rates six times to cool down the economy and try to head off inflation. Further hikes likely will increase lender vigilance about pricing risk. Despite such increases, the market should continue to do well, but less property will trade hands as higher rates pinch buyers' leveraged returns.
The market is unlikely to see a sharp downturn or the overbuilding problems of the late 1980s to early 1990s. Commercial real estate borrowers and lenders have learned a great deal since then and understand better how to prevent similar circumstances. Today, both groups have better access to information about supply-and-demand balance in U.S. markets. Also, there no longer are tax incentives that inadvertently support financially unsound building or banking regulations that bolster speculative development.
If oversupply threatens, lenders can quickly reprice or delay deals, which should help level out some of the peaks and valleys of real estate cycles seen in the past.
Underwriting criteria are tightening, as lenders give preference to experienced developers and managers, and to class A properties or class B and C properties that can be upgraded. LTVs are down and terms are shorter than a few years ago. In 1997 and 1998, lenders went above 75 percent LTV for debt transactions in a rising value environment. Today, without that appreciation momentum, lenders are reluctant to go higher than 75 percent LTV. As for terms, they are more likely to be three to five years than 10 years or more.
Mortgage rates rose from 6.8 percent to 8.5 percent between January and December 1999, reflecting an increase in Treasuries from 4.5 percent to 6.2 percent. The higher cost of debt pinches the equity return on acquisitions and development.
Some borrowers are moving to floating-rate loans, although fixed-rate investments remain the choice of many investors. Innovative products like float-to-fix loans are coming on line to meet changing market conditions. Float-to-fix loans offer borrowers LIBOR plus 250 points for 12 to 18 months while the property is stabilizing and then convert to a fixed-rate transaction at a market rate thereafter. Borrowers appreciate this option because it allows them to qualify for more dollars later.
Another option is special-package loans, such as franchise financing that combines real estate, equipment, and other financing together in one loan. This type of financing offers the convenience of one-stop shopping.
Fixed-rate refinances will continue to be down through the rest of the year. A great deal of refinancing occurred in 1997 to 1998, when interest rates were lower. For 10-year loans, the low level of activity in commercial real estate in 1990 to 1991 means less refinancing activity now.
Fewer opportunities are available for floating-rate bridge debt because there are modestly fewer property acquisitions than a couple of years ago.
Technology continues to play an important role in financing as more lenders use it to provide better service to clients. Portfolio management systems with property, escrow, and insurance gives lenders a clearer picture of their borrowers' needs.
This year new Web sites for commercial real estate originations have flourished. For instance, LoopLender, Redbricks.com, MortgageSelector.com, Cyberloan, and many others offer online financing, a convenience that lets borrowers compare rates and terms from various lenders within a few days of applying.
In a typical site, users enter information about the property to be financed, including value, type, location, and occupancy status; the financing desired, including loan amount, type, rate, amortization, and term; and lender preferences such as low loan rates, low interest fees, maximum LTV, and fast approval.
Most commercial properties are performing well, which is driving the demand for financing. In addition, several niche opportunities exist that are attractive to lenders.
The office segment is doing particularly well, especially in central business districts such as Manhattan, the San Francisco Bay area, and Washington, D.C. However, the office market is not seeing the big occupancy jumps witnessed in the mid-1990s. Coupled with rising building costs and interest rates, and only moderate rent increases in many areas, more modest appreciation than in the mid-1990s is expected.
As today's Internet companies — which demand significant amounts of office space today — consolidate, merge, or fail in the coming years, some markets may experience an increase in available office space in the future. Whereas REITs were the big investors in class A office property in the mid-1990s, institutional investors increasingly are active now.
Nationally, multifamily housing is enjoying sustainable growth, as Americans' growing affluence is helping to fuel demand for housing as people trade up for higher-rent space. In Southern California — which has a housing shortage — diverse capital sources are offering financing to buy or build apartments. The investments are expected to return 7 percent to 8 percent plus appreciation. The government still is the largest multifamily lender, but private lenders are reaping the available opportunities as well.
Factors such as increased goods consumption and dot-coms building the brick-and-mortar side of their businesses are helping to drive moderate growth in industrial properties. For example, ground was broken earlier this year for Port Los Angeles Distribution Center, an 81-acre, 1.8 million-square-foot, $115 million development that will serve as a warehouse/distribution facility primarily for consumer products and retail businesses. Stabilized industrial properties are a favorite of today's lenders, second only to apartments.
Retail is proving resilient, with consumers still spending freely, retail sales up nationally, and online shopping so far complementing — not replacing — in-store shopping. The strongest retail investment opportunities continue to be upscale retail properties, particularly those with entertainment components like restaurants and multiplexes.
Properties that act as operating businesses such as hotels and residential health-care facilities are less attractive to some lenders right now. However, those with an appetite for risk are pursuing select opportunities in these categories. Hotel yields can be attractive for full-service, well-located properties. Although health-care properties require more industry expertise to accurately assess the risk and return, they can provide attractive yields if loans are made conservatively.
In other niche opportunities, vacation ownership financing continues to grow and mature, driven along by baby boomer demand. Affordable housing also is favorable; demand for this product far outpaces supply, and special tax-credit investment products attract interest from various investors.
The commercial real estate industry continues to do well, despite a changing interest-rate climate. Lenders generally are addressing interest-rate risk by being more conservative, preferring experienced borrowers and tightening underwriting standards. Still, pricing remains competitive for many types of transactions, and capital is available even for higher risk opportunities. Armed with discipline and the wisdom that's come since the late 1980s to early 1990s down cycle, the commercial real estate industry should remain a good investment this year.