A Wealth of Financing
Commercial Real Estate Funding Sources Abound in This Strong Yet Cautious Market.
Money, the driver behind the wheel of many commercial real estate transactions, is readily available in most property markets and geographical locations.
Now that the market has recovered fully, commercial banks, Wall Street firms, conduits, pension funds, and life insurance companies all have funds to loan or invest and are looking for deals. Even European investors and private domestic money are more active. And real estate investment trusts, stalled at the red light because of undervalued stock, are finding new ways to do deals.
But no one is tossing about money with abandon. Caution marks today's market. That's especially true for construction financing, in which lenders want not just strong product in strong markets or submarkets, but want projects that will come to market in less than two years — before a market change.
It's far different than the feast or famine cycles of the past. Today's players not only know what happened in the fall of 1998, but they also remember the commercial real estate bust of the late 1980s and early 1990s.
"Financing is readily available," says Dennis Yeskey, partner in charge of real estate capital markets at Deloitte & Touche in New York. "We're not in a credit crunch. Money is available and it's at a pretty low rate historically."
"There's capital available for both debt and equity," agrees Robert G. Byron, managing director in charge of investment banking at Jones Lang LaSalle in Chicago. "Pension funds have come back to the marketplace. And insurance companies and finance companies are providing equity. But REITs are not active."
"It's a borrower's market, and will continue to be this year," adds William Simms, a director with Advantis Commercial Real Estate Services in Atlanta. "There's a great deal of capital available for properties that have solid operating histories."
Lenders generally prefer multifamily properties, followed by office, retail, and industrial, with spreads over Treasuries or London interbank offered rates rising in that order. Generally they all look askance at hospitality and recreation-related real estate, especially for new construction.
Lenders are demanding more from owners and developers in terms of equity, leases, and property history. But investors and REITs, when not chasing class A buildings, seek properties with upside potential — properties that can be upgraded in everything from tenant class to technology to repaved parking lots and then repositioned.
To protect themselves against possible downturns, lenders want properties that are 100 percent leased for the long term. They also consider property management.
"Lenders have always been interested in management experience but [are] more so now than they used to be," says Edward Craine, CCIM, a principal at Smith-Craine Real Estate Finance in San Francisco. "They want to know the résumé of the borrower and/or the management company. They expect more from a manager.
"Underwriting is light years ahead of where it was," he adds. "Reserves for maintenance and vacancies are being added in now. People tend to be a little more realistic about how a property is going to perform. And current debt-coverage ratio guidelines are much more realistic and much more strictly enforced."
"Underwriting is pretty tight," says Anthony Levatino, CCIM, a loan officer at GMAC Commercial Mortgage in Dallas. "We pay a lot of attention to lease rollovers and project what it's going to cost to replace tenants and redo the space for them. That wasn't done a few years back."
"As much as rents have been going up and as strong as appreciation has been, lenders are less likely to underwrite based on projections," Craine says, noting that previously, property owners projected increases in rents and property values "with no end in sight," which left lenders in "big trouble" when the market declined.
"Lenders don't want to make reckless loans," he says. "Even though the market is better, the memory of the last recession is still painful."
Atlanta-based Newport Mortgage Co., for example, even may boost a property's operating costs, if expenses such as management fees, replacement reserves, maintenance, and repairs are below industry norms, explains Brad Cox, CCIM, CPM, director of commercial and multifamily loan origination for the Southeast. "And even if they're 100 percent occupied with a long waiting list, we'll usually use a minimum vacancy of 5 percent," he says.
In addition to the property and factors such as functional obsolescence and the need for repairs, lenders also look closely at the borrowers and their history, explains Tom Pacha, a managing director and group credit officer at Heller Financial in Chicago. Especially for construction loans, they look at the organization, its experience, and whether it may be stretched too thin among too many cities.
Further, to protect against market changes, loan terms have shortened. "A 10-year loan is now pretty long term," Byron says. "Loans are getting down to the three- to seven-year range."
"Banks are basically interim lenders these days vs. holding for the long term," says Marc Thompson, CCIM, CRE, vice president of commercial real estate financing at First Bank of California in Concord. "They need to be more fluid in their asset allocations and want to be in and out of markets."
"We feel more comfortable having a shorter time horizon," agrees Kenneth Moczulski, managing director of Transworld Properties in Houston, which does construction lending for small developments. "It's easier to forecast what the market will look like in 12 months. A big high-rise apartment complex will take 24 to 30 months to deliver. We feel more comfortable forecasting one year out rather than two or three years out."
Changing Investor Standards
Everyone is chasing class A properties, but because many multifamily, office, and industrial buildings in the $10 million and up range already have been acquired by REITs, few such properties are left in the market, Cox says.
But there is a market for class B and C properties, if value can be boosted in excess of acquisition cost through repositioning. "If you're a buyer, you don't want everything perfect or else there's no potential for you. You want to be able to do something to the property," Yeskey says.
But even these properties are becoming difficult to find, according to Cox. "As far as acquisitions are concerned," he says, "everybody and their uncle are going after good upside potential, but they are difficult to find because a lot of the stuff has been bought already."
REITs, struggling to raise equity because of low stock prices, are trying to increase the value of their current holdings, placing development, management, and value enhancement of their properties over acquisition, which reduces the need for external capital. If they do invest in existing properties, many rely on joint ventures that enable them to expand their sources of capital or leverage their existing capital.
Once lines of credit are used up, and with stock undervalued, REITs can't afford to buy properties to the extent they had been buying them, notes Cynthia Shelton, CCIM, vice president of acquisitions at Commercial Net Lease Realty, an Orlando, Fla.-based REIT.
"That means we have to be choosier," she says. "Maybe we have to have partnerships or joint ventures or have to sell a few of our properties and use that cash for future growth."
Lenders are most willing to provide money to refinance and acquire apartment buildings, followed by office buildings, shopping centers, and industrial properties, says Robert M. Greer, a senior director of the financial services group at Cushman & Wakefield in Stamford, Conn. Little is available for hotels.
"The operating environment for hotels, with the exception of limited service hotels, is incredibly good," Byron says. "But it's virtually impossible to get financing for hotels."
Also difficult to finance are small strip shopping centers, according to Levatino, because of their size and lack of anchors. "Those are typically short term — three to five years," he says. "You have to put a lot of study into it to evaluate your risk."
Whatever the property type, with the exception of hotels, almost any location is favored except Dallas and Atlanta, which are considered overbuilt.
"It doesn't have to be [in] a major metropolitan area with a strong economic base," Cox says, noting that his company recently financed a multifamily development in an Alabama town of 20,000. "The borrower was strong and the property was nice [and] clean. We have financed properties that are in blighted areas … all the way through to flagship-type properties," he notes.
There's also an increasing desire for infill properties and properties that can be converted, especially from office to residential, in inner-city areas, Cox says, noting that many cities now offer tax abatements for such conversions.
But preferences still exist. Moczulski, for example, sees several "exciting or hot" areas: the East Coast, especially the Boston and Washington, D.C.-northern Virginia markets; the Denver and Chicago metropolitan areas; and, on the West Coast, Orange County, Silicon Valley, the San Francisco Bay area, and Seattle.
Who's Got the Money?
No shortage of funding sources exists for most any area or property type. "All the big names, the established people, are still in the game," Greer says. "But they have different appetites for different types of properties and different credit spreads."
"The short-term money has always been commercial banks. On the shorter side you're also getting conduit money, most of it from investment banks," Yeskey says. "As you go out to seven to 10 years, you typically end up with insurance companies."
"Banks continue to expand their product lines," Simms says. "They'll look at properties they wouldn't have looked at two, three years ago."
Major national firms continue to be active in the large-loan market of $20 million to $50 million and up. But commercial banks are especially active in the small-loan market and others now are jumping into this market.
"A trend we've been noticing is that smaller loans seem to be more attractive to even the largest lenders," Byron says.
A year ago, Heller Financial began a program for loans of $500,000 to $2 million secured by multifamily, office, industrial, retail, and other commercial real estate, Pacha explains. And early this year, GMAC Commercial Mortgage began a small-loan program in that same range, Levatino says. He notes that, in addition to the need, the origination and underwriting costs are lower than for large loans, especially for appraisal, engineering, and environmental reports; legal fees; and underwriting staff time.
"Pension funds are looking to take advantage of the stability and strength of the real estate market today," Simms says. "However most pension funds still remain fairly cautious regarding properties and their location. They're fairly conservative; they want to provide 65 percent loan to value, tops.
"Life insurance companies are the mainstay of the commercial real estate industry," he says. "They continue to be a leading source for long term — 10 years, fixed-rate money, 30-year amortization — for all product types: multifamily, anchored and unanchored retail, industrial, office, medical office."
Mortgage brokers are most important in smaller markets where large commercial banks and investment banks don't have offices, Pacha says.
There are even some new players. European investors, especially Germans, now are active across the country, not just east of the Mississippi, compensating for the exit of Asian investors, Moczulski says.
And private money sources are becoming more active, says Carol Houst, CCIM, a director at Finova Realty Capital in Los Angeles. "There's more of it now than there was 10 or 15 years ago," she says.
"We have relationships with private family trusts and many other private individuals who are interested in placing hard money loans. Someone in the family has had real estate experience so they're savvy enough to spot intrinsic real estate value. A lot of different deal structures can be made," she says. "Yields on T-bills and other conservative debt have been so low and they're looking for higher returns."
Even conduits and commercial mortgage-backed securities are back in the game. The character of conduits is expanding to include big banks and their subsidiaries, special capital market groups, and security firms, including major Wall Street investment bankers and small, independent off-Wall Street firms.
Conduit loan sizes have been growing and life companies and commercial banks have implemented their own conduits to take advantage of the increasing importance of conduits as a way to sell loans into the secondary market, replacing some CMBS issuance.
"The CMBS market is very healthy. Some lenders have come back in," Simms says, noting that Wall Street firms remain viable conduits.
Mezzanine and bridge financing sources also are returning to the market, creatively structuring deals, often with exit fees, participations, or other ways of splitting profits. "We've gotten very active with 10-year money in bridge and mezzanine debt and equity financing," Houst says. "Our mezzanine programs look like equity but are structured in the form of debt. There is a lot of flexibility in it. We look for projects that have value-added opportunities."
"We've found there is a void for mezzanine financing for to-be-built projects, so we see some nice opportunities there," Pacha says. "We come in with a mezzanine loan for three years up to five years for part of the equity until the developer sells the property or puts permanent financing on it."
The syndicated loans of old with a lead lender selling off pieces have largely gone away, replaced by informal club loans, Byron says.
"Just a few years ago, it would have been very unusual to see more than one life insurance company take down a loan for $50 million in a joint venture," he explains. "But now, even the largest of the funding sources seem to want to consider the option of having a partner in the loans they're making. No one lender has the obligation to fund the whole thing. It gives them some diversification but it makes it a more cumbersome process for borrowers to have to deal with multiple lenders."
"With the inflation of prices, you're seeing a lot of repositioning or bridge financing where you have an existing office building," Thompson says. "The tenants are leaving and a new investor is coming in, buying the shell, and putting in new tenant improvements, new wiring for high-tech, [and] repositioning the asset."
"Development is becoming a little more attractive because we have not had much development in 10 years and it's time in the cycle for development to come back up again," Yeskey says. "There's credit companies and specialty finance companies and some REITs [as construction finance sources], but most of it is commercial banking."
Construction lenders also seek terms of no more than five years, but usually three years — and as little as 18 months — according to Yeskey, Simms, and others. Construction lenders also want some preleasing, from 40 percent to as much as 75 percent, or enough to know there's sufficient market demand to lease up the building in reasonable time once it comes to market. They also seek more equity from developers, according to Simms and others.
"One of the problems with construction financing is you don't know what the market is going to be when you get out of the ground and you're ready to lease up," Thompson says. "You could have no market to absorb your product. So you have marketing risk as well as construction risk.
"So we'd rather stick with construction financing, which lasts from 12 to 24 months, and two- and three-year bridge financing, and with some miniperm financing of less than five years," he explains.
Rates and Terms
Financing terms are less generous than in the past. LTV ratios will vary from as low as 50 percent for new hotel construction to 90 percent to 95 percent of the purchase price for office and multifamily buildings to which value can be added by upgrading, Greer says. For other office and apartment buildings, borrowers can get up to 80 percent.
Heller provides floating rate loans of up to five-year maturity with 75 percent to 95 percent LTV for properties that can be repositioned, Pacha points out.
Rates are tied to either Treasuries, especially for bank loans, or LIBOR. Many institutional investors prefer acquisition loans tied to LIBOR, Greer says, "because when you do that you don't have a huge penalty to pay the loan off if you want to sell. If the permanent loan is based off the 10-year Treasury you have to be prepared to live with it because of the prepayment penalty."
Most mezzanine and bridge financing, says Houst, is now priced over LIBOR.
Spreads run from the high 100s to the high 200s, depending on property type, and are the lowest for multifamily and the highest for unanchored retail, with anchored retail, office, and industrial falling in between, according to Cox.
But for small properties, says Craine, spreads often may run from 350 to 450 basis points. Spreads also similarly are high for many single-use type properties, he adds.
"A typical deal on a smaller commercial property," he says, "would be written toward a 25-year amortization and a five-year or 10-year term, fixed rate or, if floating rate, maybe one adjustment."
Teaser rates are a thing of the past, according to Craine. "Now lenders are saying, ‘Let's go either fixed rate or fully indexed rate and underwrite on that.' And debt service coverage, which was 1.1 percent is now more like 1.2 percent to 1.3 percent. So they've already built in a cushion for a down market." Debt service coverage ratios run from 1.25 percent to 2.25 percent, he and others say.
While loans made by banks typically are recourse, loans made by investment banks and credit companies — partly because of higher quality underwriting — typically are nonrecourse, Pacha points out.
Most of Advantis Commercial Real Estate Services' loans, for example, are nonrecourse, says Simms, especially when "there's a good borrower, a good operating history, and a good location," although some loans have limited recourse, such as for unanchored retail.
These loans typically are fixed rate for seven- and 10-year terms with 15-, 20-, 25- and 30-year amortizations and the company is willing to cap legal fees at $8,500 to $10,000.
Most of Simms' refinance loans are priced from 6.75 percent to 7.5 percent, he says, noting that the loans being paid off carry rates of 9 percent to 10.5 percent.
"If a borrower is looking for the best interest rate and wants to negotiate terms," says Simms, "then it's going to be a life insurance company transaction because they will keep the loans in portfolio and don't have to dance to the rating agencies."
So the good news on financing continues, and, "There's no reason to believe the market will change," according to Yeskey. "Obviously it depends on the economy and interest rates. All of real estate is always impacted by economic growth, job formation, a recession. But right now, real estate has been doing fairly well."