COVER STORY, JANUARY 2008

FINANCING IN TEXAS
Experts discuss the lending outlook for several different property types in Texas.

MIXED-USE

There are many pockets of commercial real estate around Texas that reflect activity from various markets throughout the country. Overall, Texas is still a strong market for commercial real estate. Absorbing the market’s bumps while attempting to navigate through the current lending cycle, lenders of all shapes and sizes have been forced to go on a diet.

Commercial properties have taken the brunt of the lending scrutiny. Multifamily properties have seen a much slower change in lending guidelines. By association, mixed-use properties reap the benefit of this risk aversion. The commercial component allows some diversification while the residential portions still keep these deals low enough on risk to make them attractive to lenders.

Mixed-use properties are perceived as a multifamily cousin. Although there is typically a commercial component to the asset makeup (office or retail on the ground floor), the residential portion affords the asset and those vying for its ownership the benefit of multifamily mortgage risk and pricing.

These true mixed-use properties are relegated to the major cities of Texas (Dallas, Houston and Austin). A great deal of attention has been paid to this property type in the last 10 years thanks, in part, to developers and their drive to revitalize stale downtown warehouse districts. A new youthful infusion of this property type has been embraced as many of them have since stabilized and are even on their next round of market appearances.

Austin has always been a hot bed for real estate due to the large government and technology sectors. Dallas and Houston, two of the nation’s largest cities, will continue to have a steady stream of viable mixed-use deals. San Antonio and El Paso are large cities, but they have a smaller contingent of this property type. The smaller Texas markets and rural areas have little to no supply of mixed-use properties. As a result, the strong mixed-use activity will continue to remain in the major MSAs.

The desired loan products for these properties seem typical for the market cycle. As conduits continue to determine the gentle balance of their lending appetites, portfolio lenders and life insurance companies will continue to target multifamily and mixed-use properties. Short term financing is not currently a viable option, and pricing will continue to favor this property type more so than straight commercial. This alone will continue to make multifamily and mixed-use properties a preference of investors with strict rate-of-return requirements. However, long-term financing is still very aggressive and will remain strong for these investments.

The landscape of commercial Texas real estate will continue to be a top rung commodity. The mixed-use market, although not the strongest in the country, will fare better as the market continues to retract. Also, the young supply of properties will continue to be strong even as lenders tighten and shy away from riskier assets. In 2008, investors will continue to be able to find mixed-use investments and financing in Texas.

— Christopher Molina is a commercial loan specialist for KC Capital and responsible for originations in the West Texas and Southwest U.S. markets.

OFFICE

The aftershocks of last summer’s subprime lending meltdown are still reverberating throughout the commercial mortgage market. Liquidity has evaporated, most CMBS lenders have all but disappeared and prices reflect increased risks. With the debt markets still in turmoil, the seismic shifts have left investors and lenders wary and cautious.

How will these developments impact real estate business in Texas in 2008, specifically in regards to office properties? Clearly, the fact that some $40 billion to $50 billion worth of stale CMBS paper is now “warehoused” on balance sheets and credit facilities will dampen capital markets’ enthusiasm for deals. Yet because of its strong fundamentals, Texas real estate should continue to attract investor interest, particularly for quality office properties in major metro markets. The trend may be toward higher-quality assets such as Equastone’s acquisition of 13 Class A Dallas office buildings last July with a $333 million floating rate loan from GE Real Estate.

To a great extent, Texas is sheltered from the severe real estate upheavals other regions are now experiencing. Our property values — both residential and commercial — have not ballooned, and consequently are less vulnerable to drastic price erosion. Commercial office space is considerably less expensive here than in California or the East Coast — sometimes as much as 10 times less per square foot — and continues to attract value-conscious investors, including many from outside of the U.S. This cost savings is also a factor in attracting corporate relocations to Texas cities, as well as our low cost of living, no state income tax, transportation advantages and a highly educated workforce.

Fueled by the flourishing oil industry, the state’s economy also has spurred office investments and made risks more tolerable. Dallas/Fort Worth and Houston are two of the leading cities in the country in creating jobs, and Texas accounted for 14.6 percent of the nation’s job growth in October as our unemployment rate dropped to 4.1 percent — its lowest level in 31 years.

Despite all these positives, the uncertainty in capital markets will make 2008 a challenging year in Texas office real estate. With fewer lenders and heightened volatility, the amount of available leverage, as well as property values, are trending downward. Nationwide, commercial real estate prices fell 2.5 percent in the third quarter, the first drop in 4 years. These credit problems are no aberration. They make it more expensive for individuals to obtain mortgages and for businesses to expand.

However, demand for Texas office assets should not fall dramatically, given the favorable market fundamentals and the fact that Texas office developers did not overbuild during the recent boom years. Sellers, however, will need to lower their expectations, since buyers have less leverage and are paying higher costs for debt financing. Unless circumstances mandate otherwise, sellers who want premium value might be well advised to hold their properties for the near-term.

Borrowers will find it difficult, but not impossible, to obtain CMBS loans, and should consider working with lenders with strong balance sheets and on-book, multi-platform financing solutions. GE Real Estate, for example, has a flexible fixed-rate product that gives borrowers both rate-hike protection and prepayment flexibility.

When the debt market is in flux, a flight to quality is inevitable. Investors will gravitate toward first-class office properties in Dallas, Houston, San Antonio and Austin. Similarly, borrowers will seek out quality lenders able to provide the certainty of funding to close the deal. Although activity in the Texas office properties may slow down, especially in tertiary areas, the market has the quality attributes -— job growth, strong economy, location, high-value properties — that bode well for its continued success in uncertain times.

— Lance Wright is a regional director in the Dallas office of GE Real Estate.

MULTIFAMILY

The Texas multifamily lending climate is warming up after a cold summer. The chain of events that has caused a paradigm shift of tightened credit standards and more conservative underwriting also has increased interest rate spreads for multifamily housing in Texas. The winds of change blew out 10-year, interest-only (I/O), 1.15 debt service coverage (DCR), and market rents for proforma income as acceptable underwriting standards and blew in with 1- to 3-year I/O, 1.20 minimum DCR, and actual rental income annualized requirements. At its peak, spreads for multifamily financing were as much as 100 basis points over 2007 first quarter spreads. The Treasury rates have been accommodating of late with the 10-year Treasury hovering at historical lows of 4 percent. This has more than compensated the borrower by yielding a lower net all in rate. The upward re-pricing of risk will most likely be the long-term outcome for commercial real estate loans as the capital markets absorb the implications of the credit crunch.

In this lending climate, spreads will continue to be volatile with rate locks virtually nonexistent. The CMBS lenders will not take the rate risk and, thus, borrowers will take all the market rate risk until the loan is closed and funded. In some cases, lenders may add 10 basis points to the spread and lock the rate. If the borrower chooses this option, they must request that the “Material Adverse Change” paragraph be stricken from the loan commitment. This will give the borrower security in knowing there won’t be huge spread increases or re-pricing of the loan.

The major Texas markets of Houston, Dallas, Austin and San Antonio are currently experiencing strengthening economies as their economic drivers continue to expand. Employment in Texas is strong, the energy industry is running on all eight cylinders and unlike other U.S. cities, housing in Texas has not been overbuilt or overpriced. Subprime loans in Texas that may default are partly due to investor purchases, non-qualified first-time home buyers, and the move-up buyer who stretched too far on adjustable rate payment terms. When the rates on these loans reset, the payments may cause borrowers to lose their homes, creating a heightened demand on multifamily housing beyond what exists in the market today. As a result, in most areas of Texas, the multifamily rental market is the net beneficiary of the 2007 mid-year credit market disruptions that are being played out.

According to O’Connor & Associates’ third quarter market research, the four major markets of Texas have experienced increased absorption, higher occupancy and increasing rental rates over the second quarter. With a strong Texas economy, there is plenty of capital available for multifamily projects. Even though the commercial fundamentals are still in place, the capital providers have found it difficult to sell their mortgage-backed securities into the CMBS bond market. This has led mortgage brokers to navigate their borrowers toward portfolio lenders such as life companies and banks.

In the future, continued moderation of new construction should bode well for the incomes and values of existing multifamily properties and their supporting loans. The only caution is cap rates and interest spreads will slowly increase during the first half of 2008. Borrowers will require a professional mortgage banker to navigate the credit waters to secure the most advantageous loan terms.

— Paul Gardaphé is president and COO of iCap Realty Advisors in The Woodlands, Texas.

RETAIL

The credit market challenges of 2007 have presented the lending industry with some interesting challenges as it relates to financing retail properties. The market corrections occurring in August 2007 caused spreads on CMBS deals to widen out to levels not previously seen in prior stress periods occurring in October 1998 or September 2001. Certainty of execution became a main concern for everyone. Agile mortgage brokers soon realized that lenders with balance sheet portfolio lending capabilities were the answer. Suddenly, life insurance companies, local and foreign banks, and the government sponsored enterprises provided the best possible sources of capital. Wall Street is still an option, but there are no guarantees as to pricing. Yields on the treasuries are below 4 percent, but spreads approached 300 basis points, resulting in rates that essentially are only one-half percent below the prime rate.

The retail industry has been very strong during 2007 and should continue in 2008, with some caveats. The four major markets in Texas (Austin, Dallas/Fort Worth, Houston and San Antonio) have all had a great year.

The Austin retail market remains healthy, with almost 3 million square feet of new product coming on line in 2007. Noteworthy projects include the redevelopment of the Mueller Regional Airport and The Hill Country Galleria in west Austin. The coming year looks to be a good one for Austin, with perhaps another 2.5 million square feet of product being constructed. Austin’s economy is considered one of the strongest in the state. The technology sector is strong again, with added diversity of biotechnology and medical services. Hospitality, government, and manufacturing also are contributing to the mix.

An estimated 16 million square feet of retail space is being added to the Dallas market, making it the leading market in Texas for new space. Development is taking place throughout the area, with the Far North Dallas area leading the way. Three projects, each totaling 2 million square feet, are coming up in the Fairview/Allen area, Rayzor Ranch in Denton, and Alliance Town Center in Fort Worth.

Fueled by state-leading numbers in both job and population growth, the Houston retail market has seen as much as 13 million square feet of space added during 2007. The energy sector is benefiting from record oil prices, the Texas Medical Center continues to add space, Port of Houston is booming, and the future of space exploration has NASA excited again.

San Antonio has always managed to balance its demand and supply in the retail market. Its economy seems to be consistent, with no peaks or valleys. San Antonio is viewed favorably by corporate America, with its low energy costs, affordable cost of living, ready work force and increasing population base. With its military presence, tourism, and growing health care and high-tech industry segments, San Antonio should continue to do well economically. Overall occupancy is just above 90 percent. Northwest and North Central San Antonio is the focus of much of its retail expansion.

Texas is fortunate to be blessed with a strong economy providing job growth, which feeds our population growth. While the job growth may not continue at its impressive pace, Texas is expected to do well in 2008. The only concerns are the ill-conceived, unanchored projects that were built out in the far-reaching suburbs in anticipation of rooftops following. Cap rates on these assets should increase 75 to 100 basis points. The higher quality assets with strong tenancy, experienced sponsorship, and superior locations may see slight increases in their cap rates. We may see some tightening of underwriting standards and pricing that reflects leveraging debt beyond the 80 percent level on the capital stack. This in turn should keep the developments in check to counter any overbuilding of product.

Business may be sluggish during the first half of 2008 while the market makes adjustments. Look for interest rates to stay about the same, with the help of the Federal Reserve’s monetary policy. This year won’t add up to the volume done in 2007, but there will be a lot of maturing loans to refinance that were originated 10 years ago. Eventually the people with money will want to put it into play. Patience will be the key.

— Brandon Brown is senior associate/originations with LMI Capital in The Woodlands, Texas.

MANUFACTURED HOUSING

Texas is home to the most diversified types and classes of mobile home parks in the U.S. Financing options for these parks are equally as diverse.

Most believe that all mobile home parks are created equally and simply used as affordable housing. While this is true in many cases, the diversity of this property type must be understood in order to correctly identify financing and lead to a successful closing.

Retirement parks are prominent in the Texas Rio Grande Valley. The warm climate and proximity to Mexico make South Texas an ideal location for retirees. While these parks are often very nice, they present a specific challenge to lenders as their tenants are seasonal. Gross income in February will be much higher than in July. Many tenants also pay rent annually, at a discounted rate.

Another feature that makes these parks a challenge to finance is that several sites are often reserved for RV parking, as many retirees will come for just 3 to 6 months during the winter. 

The seasonal and transient natures of these parks are not acceptable to Fannie Mae lenders. Also, due to the current credit crunch in the capital markets, CMBS lenders are not lending on this property type.  Financing is available for these nice parks, but you must find a lender that understands the unique nature of the property and will retain that loan in their own portfolio versus wanting to sell off the loan. We expect to see this trend continue throughout 2008 and 2009.

Urban mobile home parks are among the most in-demand properties in the state.  They have public utilities, paved streets and typically strong occupancy levels. Fannie Mae will lend on the nicer parks, and the securitization lenders still have an appetite for them as well.  In many cases, a borrower can obtain up to 80 percent financing and aggressive rates equivalent to those offered on apartment buildings.

Most cities have very tight restrictions on mobile home parks, including moratoriums on new development. This limited supply combined with demand have driven urban park prices up and cap rates down in the last several years. Cap rates under 8 percent are not uncommon.

The challenge here lies in finding a lender and appraiser that can understand the value of these urban parks. Many appraisers that are not experts in the valuation of these properties will impose high cap rates on them, resulting in a low appraised value and a cut in loan dollars. Fortunately, there are lenders and appraisers that specialize in urban mobile home parks and understand their demand. Specifically inquire with your prospective lenders on the parks they have financed, where they are located, and the cap rates the appraiser used for each valuation.

Secondary and tertiary mobile home parks are the most abundant type of park in Texas. There is good demand for nicer parks in secondary markets. As you move away from the metropolitan areas into tertiary markets, you will typically see the park quality deteriorate. Items such as gravel roads, lack of public utilities and older mobile homes will limit the availability of competitive financing. We also see higher vacancy rates and park owned homes in these markets

Like most property types, mobile home parks in tertiary markets are a challenge to appraise due to lack of comparable sales. Many lenders are not currently lending on properties in tertiary markets due to the inability to accurately value the property and sell the loan. Some portfolio and higher risk securitization lenders however are still actively financing these parks.

Throughout 2008, we expect Fannie Mae to continue lending on nicer parks across the U.S.; however, very few parks in Texas meet their requirements. The conduit lenders will have limited financing activity due to the current credit crisis. Most parks in Texas will only find financing from portfolio lenders that specialize in mobile home park financing.

Urban parks will continue to be a popular investment among buyers, although we anticipate cap rates will slowly increase as more cautious investors will require higher returns.  The increase in single family foreclosures will lead to more houses being leased versus owned. Therefore, we do not anticipate a larger demand for mobile home sites than typical, nor do we believe that many new parks will be built in Texas.

— Todd Kuhlmann is the president and founder of Austin-based KC Capital.

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