COVER STORY, JULY 2008

COMMERCIAL LENDING IN 2008:
HOW WILL TEXAS FARE?

With all of the news circulating about the state of our nation’s economy and the credit crunch, it would be easy to think that there’s no hope for commercial real estate growth in 2008. However, where there are challenges, there always are opportunities — especially in a state like Texas, where the economy is strong and the job market is still on the rise. In this issue of Texas Real Estate Business, we spoke with three commercial lending experts in Texas to see how they believe the year will wrap up and what next year will hold. Interviewees included: Todd Kuhlmann, president and CEO of Austin, Texas-based KC Capital; Dave Striph, senior managing director of Dallas-based Westmount Structured Finance; and Ross Jones, senior vice president – finance for Dallas-based RM Crowe.

TREB: How is the current economic climate and credit crunch affecting your business in Texas?

Kuhlmann: Even though the climate for the majority of the United States has become more challenging, Texas remains an excellent and stable market for KC Capital. Because of the diversity of industry in Texas, our unemployment rate has actually been falling and is at a record low of 4.1 percent.

Striph

Striph: As a private structured finance company, the credit crunch has created more opportunity as there is a large need to fill in the gaps in the capital stack that were left behind as many lenders left the market and underwriting standards have tightened.

Jones: We are not as active in the office market, which has been our core business for years. There seems to be fewer transactions being completed and more people waiting to see how things play out over the next few months.

TREB: How long do you believe this credit crunch will last?

Kuhlmann: We believe — based on our experience and association with industry leaders — the current credit crunch will not begin to subside until early 2009. That said, portfolio and agency loans continue to provide plenty of capital for sound commercial and multifamily property.

Striph: While liquidity is slowly creeping back into the market, we believe there is still a major lack of confidence among investors that will be here for the foreseeable future.

Jones: I wish I knew, but hopefully things get better toward the end of the year.

TREB: In the meantime, how is it affecting the cost and underwriting standards for commercial loans?

Striph: Conservative underwriting is now the common theme among lenders, and costs have risen.

Kuhlmann: At the beginning of the credit crunch, there was a rapid flight to quality by the lenders that were still actively lending. Now that the dust has settled, most active lenders have refined their parameters and set lending guidelines. Commercial lenders have reverted back to the fundamentals of underwriting the property and the borrower in order to make good lending decisions.

Jones

Jones: Spreads have certainly widened from 1 or 2 years ago, more equity is required and recourse is becoming more common. Lenders are becoming more selective as there are few lenders competing, and certainly the long-term, interest-only loans no longer are being considered.

TREB: Are investors and property owners getting discouraged? Are you still seeing interest for new developments?

Jones: The real estate fundamentals have remained fairly strong, so I would describe the attitude as more cautious than discouraged.

Kuhlmann: We are seeing investors reentering the market, looking for purchase opportunities with better returns. Some sellers are a bit discouraged that appraised values are flattening and declining in some areas, as capitalization rates become more realistic for the investment risk.

Striph: There has been a gradual acceptance among property owners that the market will not revert to pre-credit crunch pricing; however, we still are seeing interest for new developments.

TREB: What advice would you give owners and investors in terms of how to approach getting a commercial loan at this time?

Kuhlmann

Kuhlmann: As always, owners and investors should research the lender with which they plan to work. If someone is offering you terms that are too good to be true, then proceed with caution. A good lender will do a thorough evaluation of the loan upfront, to avoid or minimize the loan changing during or at the end of the process.

Striph: Dealing with experienced structured finance professionals is the best way to approach this market. In this environment, an investor needs a financial partner who understands structured transactions and is willing to tailor creative capital solutions for complex business plans.

Jones: Expect the process to take longer, expect to invest more equity, and expect to consider recourse to get the best pricing.

TREB: What property types are getting hit hardest? What parts of the state?

Striph: New condo developments as well as new residential lot developments are seeing the most stress all across the state.

Jones: I haven’t noticed much of a geographical difference across the state or significant difference by property type, though I would say there is probably more of an emphasis on core-type assets in general. Overall, cap rates have increased slightly from a year ago, but, as I mentioned before, the properties are not suffering like the capital markets situation would lead you to believe.

TREB: Is the condo market being affected in the same way as single-family housing in Texas?

Striph: We believe the market for condos is under more stress than the single-family housing market.

TREB: Do you believe business in Texas is suffering as much as elsewhere in the U.S.? Why or why not?

Kuhlmann: Texas has a strong economy. The state is growing at a rapid, yet healthy, pace. Texas did not see the huge increase in property values that the East and West coasts experienced, as well as areas like Las Vegas and Phoenix. Because of this and a great employment base, Texas is a great place to invest right now.

Striph: We believe Texas is much better off than many areas of the country. The energy and agriculture industries are booming and we have seen good population growth over the past years. Additionally, Texas did not have a massive run-up in home prices like other areas of the country.

Jones: It does not seem to be as affected as other areas in the country. Houston is strong with the energy market, but, in general, I don’t think Texas came back as quickly after 2001 as other parts of the country, which probably has helped.

TREB: How do you think the lending environment will change during the remainder of 2008? What about next year?

Kuhlmann: Just a few months ago, it was common to obtain 80 percent financing on apartments and commercial properties. Now, 75 percent is the maximum LTV for commercial deals, with many limiting the LTV to just 70 percent. Fannie Mae even has changed its debt coverage requirement from 1.20 to 1.25. These underwriting changes translate into more equity and more money down that a buyer will need in order to purchase a property. Agency and portfolio lenders are taking a closer look at the credit worthiness of all borrowers. Even on non-recourse loans, borrowers with credit scores below 680 are finding it more and more difficult to obtain financing.

Striph: We believe conservative lending standards will be here for a while.

Jones: Obviously, it’s hard to judge at this point, but I would doubt the environment changes much before the end of 2008 or early part of 2009.

TREB: Are there any other predictions or comments you’d like to make regarding lending in the commercial real estate arena?

Kuhlmann: Contrary to popular opinion, there is still money out there for good investments if you understand the current lending market and can structure your deal to fit. Appraisers are applying higher cap rates to the income analyses in their reports, resulting in lower appraised values from just 6 months ago. This trend is likely to continue. If a lender is financing a property being sold at a low cap rate, they will have to ensure that the borrower is prepared to put more equity in the deal or confirm that the seller is willing to negotiate if the value comes in lower than the sales price.

Non-recourse loans are becoming difficult to find for many commercial properties. When non-recourse is simply not available, we recommend our clients close on a short 3- to 5-year fixed loan with flexible prepayment options and recourse until the conduits start lending again. This way the borrower can re-evaluate their loan options in just 2 or 3 years and be able to refinance with a non-recourse loan at that time — with little to no penalty. Some of the highest default rates among commercial loans are from borrowers purchasing properties in out-of-state markets in which they do not have experience. Because of this, inexperienced out-of-state borrowers are having a greater difficulty in finding financing than local and experienced borrowers. It is not believed that conduit lenders will be lending again for at least another year, hopefully by mid 2009. Because of the huge demand created by the absence of the conduit lenders, banks and life companies are seeing a lot of deals, which allows them to be very picky on what they will lend on. There are, however, still plenty of financing opportunities available for credit worthy borrowers financing fundamentally sound real estate investments.

©2008 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.