| COVER STORY, JULY 2005
COMMERCIAL LENDING UPDATE
Four lenders provide their insight on the office, industrial, retail and condominium markets in Texas.
Commercial real estate continues to be one of the strongest industries in Texas. As companies consider new projects, they look to lenders for loans and financing options. Lenders, in turn, are constantly coming up with new and creative loans to stay competitive. We asked four lenders to tell us about the lending environments with regard to the office, industrial, retail and condominium markets.
OFFICE MARKET
The capital markets’ love affair with real estate continues in 2005, and with many Texas office markets showing improving market fundamentals, lenders are carefully considering loans they avoided just a few years ago. However, the lenders will likely continue to underwrite office properties more conservatively than other major property types.
One reason for their caution is that economic indicators are still sending mixed signals, making projections difficult. On the plus side, job growth numbers are improving, and with demand for office space directly tied to job growth, 2005 should be the year recovery begins in the Texas office markets. The first quarter 2005 payroll numbers from the Dallas Federal Reserve show positive job growth in all five major metros. Houston and Dallas showed the biggest gains in jobs, and Austin’s growth rate leads the state at 3.75 percent. Additionally, positive changes in market fundamentals are already showing up in market surveys and are most dramatic in Austin and Dallas. Lenders are recognizing this improvement. However, the flattening yield curve, weaker trends in national economic indicators and tenant rep reports that clients are starting to delay expansion decisions may temper the speed of the recovery and scale back projections for continued occupancy increases and rent growth.
Despite those concerns, great loan terms are available for stabilized office properties. Loan amounts up to 80 percent of value (and over 90 percent with mezz debt), spreads in the 100 to 150 basis point range (and under 100 bps on low leverage deals), amortizations of 25 to 30 years (and a few years interest-only in many cases) — all combine to offer advantageous leverage. Banking on continued recovery, lenders are offering attractive financing on unstabilized properties. These bridge loans require higher equity (30 percent or more) and have spreads from 200 to 300 basis points over LIBOR. The typical 2- to 3-year loan terms are often interest-only and, for a fee, have extension options.
Office properties often present challenging underwriting issues and may require structured solutions to get lenders comfortable. The most common issues today are:
• The net operating income (NOI) may go down in the near future, not up, as the last of the older leases (with rents higher than the current market) expire.
• Cap rates may rise faster than the NOI. With cap rates compressing up to 300 basis points in the past 18 to 24 months, not all lenders accept that there has been a paradigm shift in the investor market and many are unwilling to underwrite a full loan.
Some of the ways lenders mitigate these concerns are to build up cash reserves for re-tenanting during periods of high rollover or shorten amortization schedules to help reduce the overall loan exposure on a quicker schedule.
In addition, lenders are offering new options that help meet borrower requests for more leverage. These include using “micro” market analysis (occupancy statistics for a small selected number of comparable buildings) that justifies underwriting a lower-than-market vacancy rate, offering longer interest-only terms to help support a higher loan amount until effective rents improve, and providing subordinate financing at historically low rates and low minimum coverage standards.
This borrower’s market looks like it will continue as mortgage investment in commercial real estate continues to provide relative value to alternative investment classes, like stocks and bonds. And as long as job growth and market fundamentals continue to improve in Texas, lender comfort levels for investment in office properties will also strengthen.
— John Morran, Senior Vice President/Branch Manager, GMAC Commercial Mortgage, Austin office
INDUSTRIAL
Industrial real estate enjoys a reputation as one of the most stable of the commercial real estate product types. While not as “sexy” as retail or office products, investment in distribution and manufacturing facilities produces returns that are continually attractive. But whether you are financing a shopping center, an office or an industrial building, real estate is a preferred asset class for all types of investors and there is no shortage of financing options.
In this current “borrowers market,” it is acutely important that lenders prioritize high underwriting standards. The margin and rate compression is acceptable given the price of the abundance of capital in the marketplace and the preference of real estate as an asset class. However, the strong pressure to accommodate borrowers in order to win transactions has resulted in unfortunate loan structuring modifications that are not necessarily good business decisions, and are not based on solid real estate fundamentals. To date, the acceleration of the markets has covered these transactions but borrowers and lenders beware: someone will be left standing when the music stops for these marginal transactions.
On a more positive note, the fierce competition for borrowers in the marketplace has led savvy capital providers to offer more sophisticated financing packages rather than simply compete on price alone. Specifically, borrowers have been looking for any product that provides forward rate lock protection and flexibility for prepayment and assumptions. By securing attractive financing they can financially engineer a project to be more attractive on the buy side.
Industrial properties have become particularly attractive to tenant-in-common (TIC) buyers. Not only has the participation by TIC investors in both interim and permanent lending increased, but TIC and 1031 exchange buyers have directly had an effect on the market based on the prices they have paid for various assets. Additionally, the increased usage of Commercial Mortgage Backed Securities (CMBS) and its stratification of risk are having a significant impact on the financial markets for industrial and all types of real estate.
Industrial real estate assets in Texas are attractive nationally for many reasons, one of which is the comparative replacement cost and cost basis. The cost per square foot in Texas is significantly lower than that of the West and East coasts. In fact, as the state demonstrates more attractive demographics and continued low costs of living and doing business, it is attracting more and more companies to conduct industrial business and to purchase or construct the facilities in Texas.
There may be some corrective moderation during the upcoming year due to a review of market conditions. However, well-located properties with experienced developers will not suffer. Trends suggest that interest rates will continue to experience moderate increases. However, while rates have increased, the compression in cap rates has mitigated any effect on the acquisition of real estate.
With these trends and conditions as a backdrop, successful lenders will differentiate themselves by offering value through innovative solutions. As the capital markets continue to mature, borrowers will increasingly value direct personal relationships with professional, experienced real estate companies and lenders.
— Rick Harsch, Senior Vice President, Houston Team Sales Leader, Houston office of Cleveland, Ohio-based KeyBank Real Estate Capital
RETAIL MARKET
As evidenced by the record attendance at the recent ICSC Convention in Las Vegas, retail continues to be a favored asset class in Texas and across the country. Despite the jobless economic recovery, consumer spending is causing retail to outperform other real estate categories like office and residential. Given the liquidity in the marketplace, retail anchored by grocery stores or big box investment grade tenants is priced aggressively by lenders. Lifestyle centers, which are typically mixed-use facilities with a high concentration of restaurants, clothing and specialty retailers, also are a current favorite among lenders. Occupancies at all of these properties continue to trend upward while rental rates hold steady near all-time highs across the major markets in Texas.
The current flat yield curve, in which there is little difference between short- and long-term interest rates, is causing most borrowers to seek long-term permanent financing priced over treasuries on stabilized properties. Many lenders now are willing to make fixed-rate loans of 80 percent LTV and greater on recently constructed, high-quality properties while the properties still are in lease-up. They are able to do this by either structuring the deal with a traditional earn-out, in which there is an initial funding based on in-place NOI and a future funding when the property achieves stabilization; by providing a reverse earn-out, in which a full loan is made based on a stabilized NOI and the borrower posts a Letter of Credit or a cash escrow equal to the loan amount attributed to the shortfall between the in-place NOI and stabilized NOI; or by “seasoning” the loan, in which the lender makes a full loan based on stabilized NOI and holds the loan on its balance sheet until the property’s NOI increases to the level required to support the loan made. Popular features on these loans include some interest-only period and the ability to add mezzanine debt at some future point during the loan term.
Another popular type of retail loan is a short-term floating rate loan to facilitate the financing of a property being redeveloped or in transition. These “bridge” loans are priced over the LIBOR rate and are primarily on assets that undergo a significant “repositioning” in their respective market. This typically involves upgrades to both the façade as well as the tenant roster. These assets normally are underperforming the market, need some time to stabilize, and are structured with proceeds allocated within the capital structure to fund both future capital expenditures and tenant improvement and leasing commissions. Given the upside in increasing the NOI at these assets, the borrower is looking for a loan with prepayment flexibility and specific dollars earmarked for executing their business plan.
Areas that are of most interest to lenders when making loans on these retail properties are the borrower’s expertise and track record, sales per square foot of the anchor and major tenants and the sustainability of these sales, construction and competition located near the property, and co-tenancy clauses and other specific features within the major tenants’ leases.
— Lance Wright, Regional Director, GE Commercial Finance – Real Estate, Addison, Texas
CONDOMINIUM MARKET
Low interest rates and the baby boom generation’s interest in a more carefree lifestyle are two of the primary drivers of Texas’ condominium market. There are so many projects being discussed that it is unlikely they all will be built. For construction lenders, the challenge is to determine which of the numerous proposed projects are really going to be successful.
Because there is a lot of money available to finance new condominium construction, developers with great projects are looking for banks that can be flexible and provide them with creative, tailor-made loans that suit their needs. Non-recourse and limited recourse structures are extremely popular as they enable project sponsors to minimize their downside risk and keep project liability off of their balance sheets.
In this development environment, senior financing for condominium projects can range from 75 to 85 percent of cost, depending upon the circumstances. Fremont recently closed the $82.8 million Azure condominium loan in Uptown Dallas at a loan-to-cost above 80 percent. Fremont is comfortable with this transaction because the project has a high level of presales, a great location and a very strong borrower.
The old real estate adage “location, location, location” has never been more true, and there are several hot spots in the Texas condominium market these days. Dallas’ Uptown area has become the new center of high-end residential, office and nightlife in Dallas. Numerous ground-up projects currently are underway, including Azure, The Ritz Carlton Hotel and Residences, and the W Hotel and Residences. Houston’s condominium market is also fairly active right now. Many new, luxury condominium projects have been announced, such as Orion, 2727 Kirby, Phase II of the Mercer and The Redstone project at the Houstonian. Several apartment-to-condominium conversion projects are also being planned. Austin’s condominium market is strong and the beach communities of Padre Island and Galveston have seen an explosion of planned condominium developments. Downtown Fort Worth, while smaller than the others, shows a healthy appetite for condominiums. Fremont has provided financing for The Tower at Sundance Square in Forth Worth and that project is now sold out.
Fremont expects the Texas condominium market will remain robust during the next year and then some, especially in the Dallas Uptown, Houston Galleria and beach areas. Lenders will continue to look at the numerous transactions proposed. It will become increasingly important for banks to have the ability to analyze the borrower’s business plan, looking for the viability of these developments prior to providing financing. Lenders and developers should pay close attention to the quality of what they are building and how that affects the sales prices that will be obtained. Lenders help to keep this in check by continuing to require a level of pre-sales that verifies the demand for the additional units. The key will be to have the right product in the right location.
— David Striph, Vice President and Regional Manager, Fremont Investment & Loan, Dallas
©2005 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints of
this article contact Barbara
Sherer at (630) 554-6054.
|
