| COVER STORY, FEBRUARY 2010
LENDERS AND BORROWERS TWO-STEP INTO 2010
The lending climate has improved, but banks and borrowers still have to tread carefully to refinance or close new loans.
By Jaime Lackey
Ask people active in the commercial real estate sector about their predictions for economic recovery, and you may hear complaints that the banks are not lending enough to help the recovery.
Everyone is asking banks to lend money — from the federal government to real estate owners and developers. However, banks have to meet strict guidelines, especially since the Office of the Comptroller of the Currency (OCC) requires higher loan loss reserves. (The OCC is a bureau of the U.S. Department of the Treasury; the OCC supervises national banks as well as federal branches and agencies of foreign banks.)
“In 2010, banks will underwrite to OCC compliance. They have enough criticized loans on their books, which has caused the dramatic increase in capital required for loan loss reserves,” says Paul Gardaphe, senior vice president with The Woodlands, Texas-based Q10 | Amegy Mortgage Capital.
Ronald Reese says, “Commercial lending has dramatically changed in the past 2 years and the resulting effects will be long term.”
Reese, senior vice president and managing director with the Dallas office of Northmarq, says, “All commercial lenders have resorted to much more conservative underwriting — including lower market rent and occupancy assumptions as well as higher underwritten cap rate assumptions.”
In addition, he notes that the limited number of arm’s length transactions over the past 2 years make it difficult to find market comparables. As a result, lenders are underwriting to worst-case scenarios.
According to James Behanick, lenders are also more inclined to underwrite from historical figures as opposed to pro forma, due to the recent economic challenges. Behanick is an investment analyst with The Woodlands, Texas-based LMI Capital.
He says, “Entering 2010, I don’t see much change from 2009. A lot of lending sources are playing the waiting game to see how bad defaults will get. As a clearer picture emerges, lenders will be less hesitant to pull the trigger. Underwriting standards will remain tighter in the foreseeable future. Leverage will slowly return, but I don’t expect DSCR [debt-service coverage ratio] to be back at 1.2x for quite some time.”
There are some improvements in commercial lending versus a year ago. As Reese says, lenders are more willing to consider loan-to-value ratios up to 65 percent, and interest rates are significantly below early 2009 levels. (Average LTVs in early 2009 were 50 percent, and interest rates were in the 8 percent range.)
However, Reese says, “Today’s underwriting will primarily focus on trailing operating histories and current rent in place, with little to no credit given to optimistic forecast projections. I believe it will take another 1 to 2 years before we will return to traditional underwriting guidelines and only after we have clear economic signs of stabilization and overall improvement.”
Gardaphe agrees. “Underwriting will remain conservative. Due diligence will be the key to getting a loan approved,” he says. “Global cash flow schedules will be in vogue. Lenders will not just analyze the assets in question — they will fully analyze the borrowers’ and principals’ global cash flow. If other investments are causing a cash-drain, lenders may forego financing the performing asset.”
Difficult Situations
The most challenging financing situations today are over-leveraged loans that will mature in 2010, Reese says. “This list includes a significant amount of the $250 million+ in CMBS maturities as well as bank construction loans and life company loans held within their portfolios.”
He explains, “Many of the CMBS maturing loans were initially underwritten with aggressive rent and cap rate assumptions, resulting in high leverage levels. Today’s underwriting assumptions are much more conservative resulting in lower valuations and difficulty in refinancing existing debt levels. Stronger borrowers will be able to pay down the principal and finance at lower leverage levels, but cash-strapped borrowers will be subject to the lenders’ willingness to negotiate extensions and/or loan modifications.”
Behanick agrees that refinancing will require cash. He says, “Lenders are overcompensating for bad lending practices of the past. Loan-to-value ratios have dropped from 80+ percent to 65 percent. This, along with rising cap rates, makes it virtually impossible to refinance without bringing cash to the table.”
According to Gardaphe, hospitality assets and land held for condo or residential development will be the two most difficult asset classes to finance in the near term.
Government Role in Recovery
Everyone has an opinion about the government bail out programs. How are these programs helping commercial real estate?
“For the most part the Feds have ignored the commercial real estate loan situation,” Gardaphe says. “PPIP [Public-Private Investment Program] is just getting underway. The banks need to get the toxic loans off their books before they are able to restart their commercial real estate lending. PPIP should have been implemented in mid-2009 so the banks and servicers of the CMBS pools could rid themselves of the troubled commercial real estate loans. This would have been the start of the capital thaw, but for now we are still frozen in time.”
PPIP was announced in March 2009. The federal government plans to spend up to $100 billion of capital from the Troubled Asset Relief Program (TARP) and private investors to help fund the purchase of legacy assets — including pools of loans — from banks. Basically, private investors bid for the assets, and PPIP money funds 50 percent of the equity requirement for the purchase.
Reese says, “It is my opinion that the bulk of the government stimulus and bail out programs to date will only offer a short-term solution. I believe we have delayed the inevitable and that the taxpayer will ultimately bear the burden of these programs.”
Reese says there is an ample supply of private capital looking for an opportunity to invest, however, investors are waiting until market fundamentals improve. Occupancies, rents and cap rates need to stabilize, providing an appropriate return relative to perceived risk.
What is in Store?
Gardaphe says, “Currently commercial real estate loans have a 6 percent default rate. Some of these defaults are technical in nature. For example, a loan has matured or the asset value has fallen to a point that the LTV covenant is busted. Commercial real estate loans will continue to default if the capital market does not thaw this spring. Banks alone cannot refinance the watershed of maturing CMBS loans. The volume of maturing CMBS loans has caused a bottleneck for the special servicers handling loan extensions and modification.”
Reese says, “I believe that the commercial real estate market will suffer greatly without the return of a CMBS capital source to refinance the billions of dollars in maturing loans over the next 3 to 5 years. This can only be accomplished assuming appropriate yield returns for the respective risk. Until we have an established capital source for these maturing loans, we can continue to expect defaults, loan modifications, discounted note sales and potential foreclosures.”
Which Texas Properties Will Lenders Favor in 2010?
Multifamily is still the preferred asset class due to consistent availability of FNMA / Freddie Mac, which provides reliable financing options for acquisition or refinancing. With the housing market still in turmoil, apartments should maintain stable occupancies and rents. However, some multifamily markets could experience softness due to an over-supply of failed condos turned to rentals.
— Ronald Reese, senior vice president and managing director with the Dallas office of Northmarq
The hierarchy of commercial real estate product that will find financing and a place at the closing table in 2010 will be: medical office; industrial; office with in-place, long-term leases and strong tenant profile; well-located multifamily that is well maintained; retail with minimal short-term lease rollover, and high occupancy; and, lastly, hospitality — if you can find a hotel lender that will provide the debt.
— Paul Gardaphe, senior vice president with The Woodlands-based Q10 | Amegy Mortgage Capital |
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