COVER STORY, JANUARY 2007

FINANCING IN TEXAS

The state is seeing strong lending activity in the commercial real estate arena, particularly in urban centers such as Dallas, Houston, Austin and San Antonio. In this issue of Texas Real Estate Business, three experts discuss the lending environment in three sectors: hospitality, healthcare and multifamily.

HEALTHCARE

Once shunned by capital providers as being too specialized, healthcare properties are now the darling of the real estate industry. The reasons are obvious: the burgeoning and aging Texas population is driving demand for healthcare. Capital providers have become better educated on the intricacies of this sector. Moreover, the way healthcare services are delivered to the patient market has changed. These factors have created new development, investment and lending opportunities.

Historically, healthcare-oriented commercial real estate investments were limited to medical office buildings (MOBs) located on or near hospital campuses. Today, however, it is not unusual for an MOB to be located in a suburban market close to where patients live. Changes in healthcare reimbursement policy have motivated many hospitals to relocate what was perceived to be unprofitable services out of a hospital environment. This has created a new wave of development projects such as long-term acute care hospitals (LTACs), ambulatory surgery centers (ASCs) and specialized rehabilitation centers. All of these property types deliver highly specialized care not available in a conventional hospital and at a much lower cost for patient services, which is welcomed by the health insurance industry.

Whether a project is a MOB, a LTAC, a surgery center or rehab hospital, the underlying economics of each project is driven by the feasibility of the marketplace. Economic feasibility is often validated by various physician groups investing in either the real estate ownership or the operational ownership of the healthcare enterprise, which in turn comforts capital sources that the project will ultimately be successful if doctors have a financial incentive to send their patients to a particular facility. Furthermore, practically every healthcare project today is supported by long-term net leases from a medical service enterprise that usually has some aspect of physician sponsorship. Once a healthcare project is leased, there is usually very little turnover. Property ownership does not have to deal with constant ongoing tenant finish and leasing commission issues versus a conventional multi-tenant real estate property.

Long-term capital providers such as life insurance companies, 1031 exchange buyers and publicly traded REITs have all taken notice of the healthcare sector. Permanent lenders historically categorized healthcare as too specialized and were often frightened by the high cost of these projects (tenant finish alone often exceeds $100 per square foot). Permanent lenders are now educated and are willing to go much higher up the leverage curve (75 percent to 80 percent LTV). Healthcare properties are being aggressively priced by 1031 buyers and REITs all seeking the long-term consistent cash flow offered by this sector. It is not unusual to see a MOB or a rehab property trade at sub-7 percent cap rates in Texas.

Opportunities will continue to present themselves as various physician groups splinter from associations with conventional hospitals. The methodology by which healthcare services are delivered to the public continues to evolve. For now, the healthcare sector in Texas gets a clean bill of health.

— Scott Lynn is director/principal with Metropolitan Capital Advisors in Dallas.

HOSPITALITY

Lending activity has remained strong in Texas throughout the past year, particularly in the urban areas. Dallas, Houston, Austin and San Antonio are strong markets and will remain active in the upcoming year. The Texas coastal areas that were affected by hurricanes Katrina and Rita have also demonstrated an increase in both rehab and new construction activity. As a result, the coastal regions are also likely to remain hot markets for lending activity throughout the next year.

Texas, in general, has a significant amount of established properties that were built throughout the past 20 to 25 years. Many of these established properties, more specifically hotels, are now requiring substantial renovation and in many instances are being converted to another flag. Also, the replacement of a significant portion of the room supply along the Texas Gulf Coast lost as a result of Katrina and Rita has opened some markets for new development. Consequently, this has created a demand for shorter term, interest-only loans. Construction and mini-perm loans provide just such an opportunity and are ever increasing in their popularity and demand. 

Traditionally, banks were the standard source for short-term, adjustable rate, and full-recourse loans. However, now the banks must compete directly with Wall Street investors, life companies and other long-term lenders. In order to compete, banks have become more competitive, offering longer term loans (those over 5 years), with limited or no recourse, and fixed interest rates. Thus, not only will the Texas market continue to see a significant number of rehabs and conversions, but also, development of new properties due to the vast sources of construction funds at reasonable rates. In other words, the availability of the construction loans will drive some developers to build new properties versus the acquisition of existing ones, regardless of the continuing increase in construction costs.

Considering the strength of the economy and the aggressive lending market that we’ve experienced this year, 2007 will most likely continue at a similar or increased pace. Seasoned borrowers will take advantage of low interest rates while not over leveraging; and at the same time, history shows that first-time investors will typically over leverage their properties because money is available at low rates.

Additionally, for the first half of 2007, I believe that lending rates based upon Treasury and LIBOR will remain at slightly above their current levels, after which they will begin a slow climb. The accessibility of capital will continue to feed acquisitions, yet the availability of quality properties at reasonable cap rates will have a long-term effect on future acquisitions. If the economy continues to remain strong, and interest rates continue to remain at historically low levels, investors (new and old) will continue to develop at the same pace they have for past 2 years. In other words, it should be a happy New Year!

— Leonard Smith is senior vice president with Aries Capital.

MULTIFAMILY

In pursuit of aggressive growth strategies, both lenders and investors are awash in unprecedented levels of debt and equity capital, and they are finding a suitable home in Texas. However, it is not only the amount of capital available for investment, it is the variety of financing options that have been unique in 2006. This has been particularly evident in the multifamily sector, where investors have used innovative loan programs in order to take advantage of positive rental growth and declining vacancy rates in Texas metros.

Wall Street CMBS lenders, skilled at repackaging and transferring credit risk in the form of CMBS pools and collateralized debt obligations, have led the charge with annual securitization volume in the U.S. surpassing $175 billion through 11 months of 2006. According to REIS, Texas represented 5.1 percent of the overall loan count in the third quarter 2006, while Houston and Dallas ranked in the top four metros of CMBS issuance nationwide. Additionally, fixed-rate multifamily loans represented 17.3 percent of the total issuance for the third quarter, making it the second most favored asset type. As a result of this enhanced liquidity in the secondary market, innovative loan programs such as 5- and 10-year fixed-rate, interest-only loans, underwritten to debt service coverages as low as 1.20x (on an interest-only basis), have gained wider acceptance. Similarly, flexible prepayment options such as shorter lock-out periods, fixed percentage penalties and longer penalty-free periods also have become prevalent. These loan structures have allowed multifamily investors along the core-opportunity spectrum to preserve return requirements in a low cap rate environment and mitigate market risk by providing reversion flexibility.

Low interest rates also have encouraged investor demand for fixed-rate bridge loans, presenting opportunities for Lenders who have found liquidity in their CMBS pools or CDO offerings, or who are willing to use their balance sheet. With 5- and 10-year Treasury yields nearly 90 basis points lower than Libor, a 3- or 5-year fixed rate, interest-only structure with prepayment flexibility can be a better investment strategy than a traditional floating rate bridge loan. When comparing these bridge options, a conservatively priced 5-year fixed, interest-only rate of 6.50 percent represents only a 115 basis point premium over the current Libor rate of 5.35 percent. This is a below market spread for a traditional floating rate bridge lender. Plus, the additional .5 percent to 1 percent lender origination fee and the probable cost of a hedging derivative adds to the cost of the floating rate option. The fixed-rate bridge loan is a win-win situation for the lender and investor whereby the lender is able to charge a risk adjusted premium over Treasuries and the investor is given a low cost structure that protects against the volatility of Libor.

An alternative to a 3- or 5-year fixed-rate bridge loan is the 11-year loan, which has also gained importance in 2006. In this structure, the lender keeps the loan on its balance sheet for the first year at a fixed-rate interest-only payment, and then converts the loan to a standard 10-year deal that can be securitized, or bifurcated, in the secondary market. This is, in effect, a 1-year fixed-rate bridge loan, which gives the investor a shorter time period to maximize value. To ensure an exit, the lender will impose strict underwriting penalties if conventional CMBS underwriting criteria are not met within that 1-year bridge period. These penalties can range from springing recourse provisions to partial loan pay downs.

For lenders, the mantra for 2007 will be “liquidity, liquidity, liquidity” as they continue to transfer risk to the secondary markets. All of this is great news for multifamily investors that can use the resulting innovative financing structures for continued growth.

—  Jonathan Gilfillan is vice president with Live Oak Capital in Houston.

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