FEATURE ARTICLE, JANUARY 2006

FINANCIAL FORECAST
A look at the hot markets and the trends in office lending and investment in Texas.
Lindsey Walker

With the new year underway, Texas Real Estate Business decided to speak with a few lenders to discuss the current state of financing office product in the Lone Star State. Michael Spoor of M.J. Spoor & Company, Bill Jackson of Commercial Mortgage Connection, Boyd Burton and David Tuttle of Marcus & Millichap Capital Corporation, and David Aaronson of Live Oak Capital reveal the hot markets, the current trends, and what to expect this year in office lending and investment in Texas.

TREB: What markets in Texas are hot right now? Which ones are struggling?

Spoor: From everything I know, Dallas is overbuilt in office. It's going to take them a long time to absorb all the space they have available.

Aaronson: I think Dallas' office market is still struggling. People may be paying good prices for the assets, but the absorption is not taking place. I think Corpus Christi is probably struggling. There's not a lot of growth over there. But, other than that, I think every other major Texas market is in expansion at this point.

Burton and Tuttle: In our opinion, Dallas is hot, especially Uptown and the Platinum Corridor (North Dallas up to Frisco). Austin is getting hot, Houston seems stagnate in the office sector, and San Antonio continues to have velocity.

Jackson: Austin/San Antonio, Dallas/Fort Worth and Houston are all hot. I wouldn't say ‘struggling,' but extreme south and west Texas are not exactly what I'd call anywhere near being healthy.

TREB: What is the office lending climate in your area?

Aaronson: It's very, very aggressive. It's a great time to be a borrower. There's capital for stabilized deals, and there's also capital for opportunistic acquisitions. Right now, I think Houston is right at the top of the heap. Business is very good. We're starting to see some real expansion in our office market.

Jackson: We have an ample supply of funding from a variety of local, regional and national lending institutions. The Dallas/Fort Worth market is very healthy, with the exception of downtown Dallas and Las Colinas. This area compares favorably with the other major metro areas in Texas, San Antonio-Austin and Houston. Though, our Texas markets are not nearly as strong as in California, Arizona, Florida and the Northeast.

Burton and Tuttle: In the state of Texas and the South/Southwest and Midwest regions, lending activity tends to remain somewhat aggressive for well-located, leased A and B properties, especially medical office. As with investment, certain corridors in Dallas are even more in demand, along with markets such as Austin. San Antonio appears to have some decent velocity while Houston is somewhat fragmented with certain areas even appearing stagnant (Galleria still appears strong).

Spoor: There have been a number of office buildings changing hands in Houston in the past 12 months, probably because the prices are relatively inexpensive compared to other parts of the country. People feel the Houston area's doing pretty well. There is some empty space in the downtown CBD. In some of the submarkets here in town and on the south side of town, vacancy for B buildings is down in the 7 percent range. Some submarkets are doing well, and there's declining vacancy and decreasing rental rates. There have been a number of medical office building announcements in the last year. There's some activity down in NASA Bay and Clear Lake, and there's some of that activity in the Medical Center and on the west side of town.

TREB: How is the investment climate in and around your area?

Aaronson: I'd say it's real aggressive in Houston right now. I think people are paying some extraordinary prices for some of the assets. But, it's really got everything to do with flow of capital into the real estate industry. I have clients telling me that, and this is unusual, the same comparable deal that you'd see in Dallas is now priced higher in Houston than it would be in Dallas.

Jackson: It is extremely healthy, especially in Fort Worth where RadioShack, Pier 1 Imports and D.R. Horton Homes have all either just completed new corporate headquarters buildings or have relocated to Class A space in the CBD, which, as a result, has seen a totally unprecedented spate of luxury high-rise, multifamily buildings (probably well over 1,000 units in all, with many more on the drawing board). Considering that we're a town of only a 500,000 population and there wasn't a single luxury unit available anywhere in the CBD just over a year ago, that's a pretty healthy influx of new, high-end product.

Burton and Tuttle: As it relates to office product, the Dallas/Fort Worth market is generally healthy. Cap rates remain stable, but Dallas/Fort Worth is submarket sensitive, so there are still some areas with significant vacancies. If absorption rates across the metroplex continue to remain positive, and if the investment climate remains strong, these specific submarkets will become more attractive to tenants who are still looking for an attractive lease rate, and this could help pick up these markets to more desirable occupancy levels.

TREB: What types of office properties are lenders interested in?

Spoor: I see fierce competition, certainly among the permanent lenders, for B, B+ or A- suburban buildings, multi-tenant. We just placed with one of our conduit lenders a couple of weeks ago, and I must have had 10 conduit lenders chasing that deal for me. There are really competitive spreads.

Aaronson: Lenders are interested in all kinds of properties: multi-tenant, single-tenant and owner-occupied, from $1 million to more than $100 million.

Burton and Tuttle: Permanent lenders are looking for properties that have a good tenant mix with staggered lease terms and solid cash flow. If the deal is a repositioning or turn-around opportunity, the market should be stronger than the property in order to provide a greater probability of positive performance. Deals that fit this criteria are increasingly commanding a premium compared to just a few years ago.

Jackson: Lenders mostly are interested in Class A and B office space (both single-level, campus-style and multi-story structures).

TREB: How did lending last year compare with lending in 2004?

Burton and Tuttle: Lenders remain aggressive on quality properties. Spreads remain strong. However, because of rising interest rates and aggressive spreads, the risk to the lenders is increasing. As a result, marginal deals that might have gotten funding in 2004 are either commanding larger spreads or lower LTVs.

Jackson: It is just as good, if not better. There's an awful lot of money (both debt and equity) chasing the same deals and there is a virtual flood of investors leaving the West Coast market bound for the Lone Star State. Ninety-five percent of my clients are from California, and I get several calls almost every day from California investors referred to my company by their West Coast brokers.

Spoor: For the office product, whether it's on the acquisition financing side or the permanent financing side, there are lots of lenders looking to do deals. I haven't seen any shrinkage in the appetite of the short-term or permanent lenders. There are lots of lenders out there who want to look at those sorts of transactions. I haven't seen anybody slowing down on the lending side. I don't know if there are more players this year than last year, but certainly there are lots of players.

Aaronson: I think everybody's had a really, really good year in every facet. I think that everyone's business is up 20 percent to 25 percent over 2004.

TREB: How do you think the lending environment will change during 2006?

Aaronson: I don't think that a year from now we'll be saying that business in 2006 was 25 percent better than in ‘05. I think we're starting to see some changes in what people will pay for assets because of higher interest rates, and so I expect to continue to see people wanting to invest in real estate, but with the higher interest rates, the returns they're going to be getting are less and they may not be willing to take those.

Spoor: Certainly, on the short-term lenders, I don't see any change at all. All these lenders have budgets they have to meet for production, so they have pretty good appetites.

Jackson: Unfortunately (as always), it's going to tend to level off, if not trend downwards, as we see rates continue to gradually move in one direction: up.

Burton and Tuttle: We believe that the trend that began with a slightly more conservative approach in 2005 will continue. Lenders are going to be more sensitive to market dynamics and the viability of the due diligence. Experience on the part of the borrowers will become more important. However, particularly in the stronger markets, we believe that there will remain a very strong market for top quality product and properties that have “yet to be realized” value.

TREB: Are there any other predictions regarding office lending in Texas?

Jackson: If the lenders don't literally flood the market with capital and keep their perspective (unlike in recent years past), the market should stay quite healthy, especially in the CBD and the nicer, more dense suburban areas.

Aaronson: I think that Houston and select markets will see new construction. I think you'll start to see it in Austin and San Antonio, but I don't think you'll really see any in Dallas.

Spoor: The locally owned and operated banks will continue to be active office lenders. In all, maybe with the exception of San Antonio, the major markets have existing usable space looking for tenants.  

Burton and Tuttle: Medical office, particularly those properties closely associated with medical campuses, will remain in strong demand. More lenders and equity sources appear to becoming more active in that sector, pushing continued development and lending activity. The lending options will continue to be strong. q

TREB: Discuss one office deal that was particularly challenging or significant.

Spoor: I arranged the acquisition financing in December 2004 for a 59,460-square-foot office building located in League City. When the building was acquired, it was 58 percent occupied. We found a bank that was willing to listen to the story that the property could be stabilized pretty quickly with local owners and local on-site leasing management. And that's exactly what the building owner did. He moved his office into the building, was there everyday, and there were a significant number of literally walk-in prospects who were looking for a small amount of space, in the 1,500-square-foot to 4,000-square-foot range. By being there in the building, he was able to talk to them and get the deals done very quickly. He currently has it 96 percent occupied. I was chosen to service the loan because I've known the owner, he's been a client, and it's just one of those things where when you have good relationships with clients, they call you when they need you.

Aaronson: We had a client acquire a Class B office building in West Houston that was 40 percent occupied at the time. The lender came in and provided an aggressive amount of loan proceeds to close the deal on a non-recourse basis as well as the money needed to get the building leased up. That was for RPD Catalysts, the owner of the building. We were chosen to service the loan because of the relationships that we have with the borrower and the capital markets as well as our expertise and knowledge of the capital markets.

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