| COVER STORY, APRIL 2006
FINANCING IN TEXAS
Compiled by Lindsey Walker
In this month’s issue, Texas Real Estate Business provides an in-depth look at the lending climate for the four main property types in Texas.
Office
Austin and San Antonio
After months of predictions and speculation, the Austin office market has finally turned the corner after several years of high vacancy rates and depressed rental rates following the high-tech bust in 2001. According to CB Richard Ellis, absorption in 2005 was approximately 1.1 million square feet (total supply of 31 million square feet) and the year-end 2005 occupancy rate approached 85 percent.
Evaluating Austin’s office market further reveals a vacancy rate of only 8.82 percent in the Southwest submarket (which benefits from highly restrictive development requirements) and 13.69 percent in the Northwest submarket. It was only 18 to 24 months ago that rental rates stood in the $9 to $10 NNN range in these submarkets. Some newer generation space is now garnering rental rates as high as $18 NNN, with the average closer to $14 NNN. In other good news for existing and pros-pective owners, there are currently only three office development projects under construction in Austin, which means little to no space will be brought to the market for another 12 to 18 months.
So where does the Austin office market go from here? Austin will have annual gross revenue growth of 5.6 percent during the next 5 years, according to REIS. This prediction uses job growth as a top factor, coupled with tough development restrictions and business-friendly governments.
The strong economic fundamentals, which are fed by Austin’s diverse, highly educated talent pool and rapidly increasing population, have highlighted Austin as a significant target for office investors. One illustration of this is Equity Office’s recent acquisition of 300 West Sixth Street for approximately $295 per square foot, the highest per square foot price tag in Texas history.
In San Antonio, 2005 absorption totaled 359,617 square feet (total supply of 23 million square feet), building on 2004’s positive absorption of 487,050 square feet, according to CB Richard Ellis. Moreover, the 2005 citywide average vacancy rate fell to 16 percent after posting an average of 17.9 percent the year earlier, and the average gross rental rate climbed slightly to $17.98 per square foot across all classes and submarkets ($20.72 per square foot on citywide Class A space). These positive statistics, while slightly less aggressive than the positives witnessed in nearby Austin, reflect the growing trend of office employment growth in San Antonio. Additionally, with the recent announcement of several corporate relocations, including Toyota and Washington Mutual, San Antonio is clearly on the radar of the national corporate community due to its low costs of living and doing business, along with its growing (and largely bilingual) workforce. The outlook for investor and lender interest in San Antonio is favorable due to a projected continuation of job growth.
All of this positive news has created some challenges in financing office product. Austin is now on every investor’s to-do list, leaving an abundance of capital chasing fewer deals. This increased demand in Austin, coupled with an abundance of available debt and equity capital, has led to cap rate compression. It has become fairly common to see sub 6 percent cap rates on office transactions in Austin, leaving little in-place cash flow to cover debt service payments. In order to mitigate the low cap rates, in many cases lenders have provided 2 to 5 years interest only on 5- to 10-year fixed-rate loans to decrease the annual debt service requirements in earlier years, allowing for continued rental growth as the market continues to improve. While not as dynamic as Austin, San Antonio’s relative stability through cyclical economic swings that have historically impacted other major Texas markets has been a recent and continuing driver of high investor interest in the San Antonio office market.
Additionally, lenders are more commonly utilizing an A/B structure (the B-Note is effectively mezzanine financing, though the entire structure represents a single loan to the borrower) to enable the lender to increase leverage by underwriting to debt service coverage ratio’s lower than the CMBS standard of 1.20x. By increasing proceeds through aggressive underwriting and providing an interest only period, we have been able to effectively magnify the investor’s leveraged IRR and cash-on-cash return.
Though the investment markets have been highly competitive and difficult to enter, Austin and San Antonio should remain strong markets for real estate investment due to projected job growth, decreasing vacancy rates, rising rental rates and high barriers to entry, in conjunction with historically low interest rates.
— Tony Stein and Casey Knust are associates in CBRE/Melody’s Austin, Texas, office.
Office
Houston and Dallas
In Houston, the lending climate for office product is very good, according to Tom Fish, senior managing director of CBRE/Melody’s Houston office. “Improving market fundamentals are attracting plenty of debt and equity capital,” Fish says.
Downtown Houston has made a comeback as far as office lending is concerned, and the suburban areas in or near major, master-planned communities also are hot. “The struggling regions are in the locations that have continued to transition into higher-density, lower-income areas,” Fish says.
In Dallas, the lending environment also is vibrant, according to Jay Wagley, managing director of CBRE/Melody’s Dallas office. “Lenders are paying close attention to sponsorship, quality of the products, tenant base and location,” Wagley says. “There is an ample supply of capital for the right deals, and both on book and securitized lenders are very active in the marketplace.”
Hot areas in the Dallas/Fort Worth area include downtown Fort Worth, uptown Dallas and Preston Center. “Downtown Fort Worth has benefited significantly from the activities surrounding the Barnett Shale Gas play that has spawned considerable tenant activity,” Wagley says.
It all comes down to interest rates when trying to figure out how the lending environment will change in Houston, Dallas and the rest of Texas this year. There has been an uptick in rates during the first part of 2006, and, if that continues, cap rates won’t be too far behind, according to Fish. “Many are predicting a continued increase in both short- and long-term rates,” Fish says. “With the yield curve as flat as it is, a good case can be made for rates going in either direction.”
Wagley agrees. “There is more upward pressure on rates than downward pressure, and I think rates could widen,” he says. “If the cost of money continues to go up, you will see cap rates inch higher. There seems to be good leasing velocity and, if the local economy continues to show momentum, office rents will move higher.”
In Dallas, the way outsiders perceive the market is significantly impacting the lending arena. “The biggest factor that affects our financing market is that we are not perceived as a supply constrained market,” Wagley says. “As long as the dollars are available to build, developers will take advantage of the opportunity. We have an ample land supply, and you will continue to see development pushing northward in the Metroplex. As a result, lenders in North Texas pay close attention to their loan per foot, tenant base, debt service coverage rations and the health of the specific submarket within which they are lending.”
“Texas used to be considered unique as a real estate market,” Fish says. “Now, real estate capital flows globally and we are just another market. However, our demographics are shifting rapidly. We are getting a much younger and more ethnically diversified workplace and population than we have ever had. It will be exciting to see how this impacts future development demand.”
— Tom Fish is senior managing director in CBRE/Melody’s Houston office. Jay Wagley is managing director in CBRE/Melody’s Dallas office.
Retail
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Don Hickey,
iCap Realty Advisors of Texas
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The Texas retail market is a sector of commercial real estate that is as diverse as Texas is big. The housing market, population statistics and the employment rate can all affect the retail market. In addition, real estate pricing in Texas has gotten more aggressive during the past few years as interest rates have stayed low and investment interest from out-of-state buyers has increased due to the future appreciation potential of Texas retail properties.
Because Texas is such a large state with varying market conditions, retail activity can differ from city to city. Both Austin and San Antonio have experienced recent economic expansion, which has been illustrated by higher employment rates, strong housing markets and lower office vacancy rates. Recently, Dallas has also proven to be an excellent market for retail development. An increasing population, higher employment rates and 47,000 housing starts in 2005 are all factors that have contributed to this growth. Houston experienced a population boost in the fourth quarter of 2005 because of the influx of hurricane evacuees. Most of the initial boost has subsided as evacuees return home or find permanent housing elsewhere. Long-term effects on Houston’s retail development due to this unstable population increase are yet to be determined.
The coming year may prove to be good for the Texas retail market. With companies like Samsung Electronics announcing plans for expansion within Austin and FedEx building a new distribution center in Dallas, new jobs will be the driving force for new retail development. According to Integra Realty Resources’ 2006 Viewpoint magazine, many Texas retail markets will continue to be in the expansion period of the retail market cycle this year. During this time, decreasing vacancy rates, moderate to high new construction, high absorption, moderate-to-high employment growth and medium-to-high rental rate growth is expected to occur. Texas markets projected to prosper during this expansion period are Austin, Fort Worth and San Antonio.
One of the biggest factors that may indirectly affect retail real estate investment in the coming year is a possible shortage of building materials in construction and development. Many resources and contractors that are normally available in Texas are tied up in the recovery efforts from hurricanes Katrina and Rita. If past trends continue as predicted, the ingenuity of those involved in the Texas retail market may be strong enough to push through these shortages without causing production to slow down or prices to increase.
— Don Hickey is a principal with iCap Realty Advisors of Texas.
Multifamily
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John Caulfield,
Arbor Commercial Mortgage
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For multifamily permanent loans, Texas is a borrower’s market. The lending climate is still aggressive due to the number of capital sources available to borrowers. In general, job growth has resumed, in-migration is occurring and new starts are beginning to abate.
Fannie Mae and Freddie Mac always are popular for permanent loans and compete for quality properties. Conduit lenders are offering competitive quotes in both loan amount and payment terms. The FHA lenders have a solid niche for new construction and renovation lending. In the permanent financing world, there appears to be a trend toward general compression of cap rates, as Treasury yields remain historically low. Also, spreads continue to get thinner — especially for quality real estate with top sponsorship.
Houston received a tremendous shot in the arm from relocations due to hurricanes Katrina and Rita. Job growth was already trending up before the hurricanes, and the unprecedented absorption of 100,000 new residents pushed apartment occupancy levels to more than 90 percent. The market has been heavily laden with concessions for several years; however, the Katrina swell has nearly knocked the free rent out of the market. The short-term effect has been very good for Houston. The long-term effect still is unclear; however, delays in rebuilding New Orleans will benefit Houston.
There are certain submarkets around Dallas/Fort Worth (D/FW) that are still working through too much inventory added in the early 2000s. Job growth is good and demand for units is absorbing the excess supply. Average occupancy levels in D/FW finally broke above 90 percent in December. Areas with predominately older product are hardest hit right now as they struggle to compete with the new product. However, another round of robust construction could derail our economy.
Expanding job growth from technology and energy sectors will drive occupancy levels higher, which should result in some gradual rent increases later in 2006. Experts anticipate that most investor interest will be in Austin, Houston and D/FW, in that order.
Even with gradually lowering cap rates, lenders still will be constrained by loan to value. As markets begin to show demonstrated improvement, concessions will decrease and there will be continued owner focus on controlling or shifting variable expenses.
Long-term Treasury yields will gradually drift higher during the year, with the 10-year Treasury in the 4.75 percent to 5.00 percent range. The overall U.S. economy is improving and it doesn’t look like the federal government will be able to cease its quarter-point increases until at least the fourth quarter. The overall effect on Texas acquisition financing will be minimal due to being constrained by LTV. There could be an increase of 75 to 100 basis points in the Treasury yield before rates impact underwriting.
Investors seeking a decent return and cash flow might consider acquisitions in secondary markets such as Longview, Tyler, Lubbock and Abilene. These markets in general haven’t seen much in the way of new supply, yet their local economies appear to be fairly steady. Rent increases will be minimal, but return on capital should be higher than the major metropolitan markets.
— John Caulfield is senior vice president, capital markets and national sales with Arbor Commercial Mortgage.
Industrial
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Chris Martineau, Wrightwood Capital
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The industrial marketplace in Texas is trading at historic highs reached through intensely competitive bidding and, thus, presents several challenges to lenders. Cap rates have reached new levels as capital flows into Texas. The lending environment for industrial property remains very strong, and lenders are competing aggressively for large, modern industrial distribution projects. Even older properties are in demand as absorption and rental rates are trending upward. The commercial banks and life insurance companies continue to seek additional opportunities in what has traditionally been an asset class with relatively low volatility. With higher allocations for real estate by both investors and lenders, the competition increases and it becomes harder for lenders to differentiate themselves. Lenders that can provide flexibility with respect to term and prepayment will have a distinct advantage.
Pricing for industrial properties is relatively tight with spreads ranging from 110 to 130 basis points. From a lender’s perspective, pricing is becoming the hardest part to differentiate. One factor lenders are seeing more of a demand for is the ability to offer a prepayment option. Owners and investors would prefer to maintain flexibility as more capital flows into the marketplace. Defeasance and yield maintenance is a significant obstacle to owners that may want to exit a property after a shorter hold period than originally anticipated. The permanent liquidity in the marketplace, which has allowed for more investors, more capital sources and more competition, is a national trend — and Texas is no exception. Cap rates and the cost of money for industrial product should continue to remain low, and, as a result of this, there will be even more investors and more lenders competing for quality industrial property.
While most areas of the state are healthy, industrial areas that are involved with global trade are experiencing tremendous growth. For example, the port area leads Houston with new construction, and the inter-modal properties around Dallas/Fort Worth are seeing solid growth, with no sign of slowing down. Any industrial property with Freeport status is currently in demand. Most Texas markets have experienced positive net absorption and rental rate increases during the past year. Houston’s port continues to flourish and Dallas/Fort Worth is becoming an inland port. The Rio Grande Valley, San Antonio and Austin are all in position to take advantage of the demand in the market and lenders are aggressively competing for this business.
As 2006 continues with an interest rate environment that would suggest further increases, investors will have to settle for lower returns and lenders will have a harder time underwriting deals — but deals will get done. Lenders will continue to provide financing in an even more competitive environment, as more and more money chases these same deals. The unprecedented inflows of capital competing for property will keep the pricing low, which will continue to make it that much more challenging for the lenders. But, as we look ahead at the industrial market in Texas, there seems to be little sign of any change. Differentiation of product offering, service and commitment to investor satisfaction will become ever more important in the industrial product market and the rest of the commercial real estate industry.
— Chris Martineau is senior director, investments, in Wrightwood Capital’s Dallas office.
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