The Lending Landscape(1)

Buyers must learn to navigate a changing course to finance deals this year.

A lthough too much money chasing too few deals still holds true in today's commercial real estate market, the playing field is changing. The Federal Reserve Board continues to hike short-term interest rates, which, coupled with anxiety over the anticipated real estate bubble - specifically the overheated housing sector - is creating an increasingly uncertain lending and investing environment.

The widely held view is that interest rates for long-term, fixed-rate mortgages will increase significantly. Floating-rate debt based on prime or the London interbank offered rate already has gone up dramatically. All eyes now are on Treasury yields, and the consensus is that they will trend upward notably within the next 12 months to 18 months. Should the yield on Treasury rates go up by 250 or 300 basis points, the marketplace will cool significantly. The real estate market will witness more distressed debt and higher capitalization rates across the board, prompting buyers to change their commercial real estate purchasing strategies.

The Lending Climate

During the past few years, many funding sources have gone beyond their traditional comfort zones to achieve a lower yield amid the increased competition in both debt lending and equity investment. During 2005 alone commercial mortgage debt increased 14.2 percent to $2.6 trillion, according to the Federal Reserve. The lines between savings banks, securitized lenders, opportunity funds, pension funds, and commercial banks have become blurred.

First-quarter 2006 saw more than $325 billion in U.S. real estate trade hands, according to Real Capital Analytics. However, the lending arena is due for an adjustment. A slowdown in the influx of new entrants on both the lending and investing sides already is happening. Underwriting criteria are tightening, and some players are turning back to alternative asset classes. On the other hand, opportunistic investors still are finding solid investments in a number of sectors.

A Look at the Market

Condominium investments, hot for several years, now show signs of cooling. So where are the investors that have been aggressively pouring money into high-end condos in major markets turning? Many are shifting to value-added and speculative construction deals in the industrial, office, and retail sectors.

For instance, Hudson Realty Capital teamed up with Tampa, Fla.-based Meridian Cos. to acquire a 58.7-acre parcel in Sarasota, Fla., that includes a 948,578-square-foot warehouse and 29 acres of developable land. The three-building, single-story facility, formerly the home of Winn-Dixie, is the largest Tampa Bay area building sold in nearly a decade. The initial business plan includes reconfiguration, lease up, and sale of the warehouse as multi-tenant distribution space and development of the excess land. Key Bank, which traditionally focuses on condo and land investments, financed the $30 million deal.

Traditionally, entitled well-located land also has been considered a low-risk investment, but current construction costs and interest rates are altering that perception. Cash flow properties, whether they are office, industrial, retail, or mixed-use, are now the frequent investment of choice over vacant land. Office buildings still are trading at historically low cap rates, and in many cases, vacancies and rollovers are viewed as opportunities rather than concerns.

Light industrial and flex office properties prove particularly attractive to investors, especially around neighborhoods that have experienced tremendous residential growth and a plethora of industrial-to-residential conversions. Savvy developers have been acquiring industrial properties in places such as the New York metropolitan area and keeping them industrial, offering displaced commercial tenants existing well-located facilities in which to continue doing business.

In one recent example, HRC and Brooklyn-based PDS Holdings acquired a 138,000-sf industrial complex in Long Island City, N.Y., and plan to invest about $1 million in improvements. Due to the re-zoning of industrial property for residential developments in Long Island City and nearby Greenpoint, the demand for this kind of industrial space is very strong. This property is located in one of New York City's increasingly scarce industrial zones, with great proximity to Manhattan and the major thoroughfares serving the tri-state area.

Condo conversions still are alive in select middle markets that are priced below the top 20 percent and in infill areas such as New York because of the high barriers to entry. At the same time, the condo construction boom in Southern California, South Florida, and Las Vegas finally has begun to show signs of slowing due to rising interest rates and skyrocketing construction costs, which have gone up as much as 40 percent. Opportunity funds, insurance companies, and real estate financiers have pulled back on financing condo projects, specifically with regard to mezzanine loans. With developers borrowing based on prime or LIBOR, both of which have at least doubled in the last 15 months, many developments have stopped in their tracks. The reality is that a number of proposed high-rise developments will not be built. Some of these properties may be put up for sale, depending on whether or not the sponsor has staying power. Those that do will hold onto their land for the five to seven years between now and the next cycle; those that do not will be forced to sell.

The bottom line is that opportunistic investors still are active across several product types. And today's market offers plenty of financing opportunities for stable office, industrial, and retail properties. As always, the key is protecting the downside while still realizing respectable equity returns.

Protecting the Downside

While the pace of job growth and the stock market continue to improve, neither has rebounded as robustly as anticipated. Combined with increased lending competition, this creates a very challenging environment in which to manage risk.

Within this context, U.S. regulators recently proposed guidance for banks and thrifts that lend largely for office, multifamily, and other commercial real estate transactions. The joint proposal by the Federal Deposit Insurance Corp., the Federal Reserve, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision addresses the risks of aggressive real estate lending in an environment characterized by skyrocketing property values.

Under the proposed guidance, lenders whose commercial real estate activity exceeds specified thresholds could face greater regulatory scrutiny and more stringent lending guidelines that are intended to make them less vulnerable to any downturns in the market. This is because commercial real estate loans historically have been a volatile asset group, leaving banks that are highly concentrated in them especially susceptible to market downturns.

The proposed guidance also includes risk management provisions such as continuous monitoring of a commercial real estate downturn and analysis of risk ratings on commercial real estate loans that take into account vacancy, rental, and interest rates as well as inflation.

This guidance would provide for more sound risk management approaches among lenders and ultimately prevent a crash within the commercial real estate market. Generally investors can manage increased risk two ways - either pursue a wider array of deals while maintaining yield requirements (thus increasing risk on the asset level but maintaining yield), or lower yield requirements while choosing investments more selectively (thus decreasing yield but maintaining risk profile). For more information on the government's proposed guidelines, visit the Office of Thrift Supervision Web site at www.ots.treas.gov.

Sound investment strategies certainly vary, but creating the right risk-adjusted returns is critical across the board. Today's investment environment is not an easy one, and everyone in the commercial real estate industry is facing the same challenges. However, the government's proposed regulations should support a variety of lending approaches, enabling active players to achieve desirable yields while better protecting themselves moving forward.

Spencer Garfield

Spencer Garfield is a managing director of Hudson Realty Capital LLC, a NewYork-based real estate opportunity fund manager. Contact him at (212) 532-3553 or sgarfield@hudsoncap.com.


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