COVER STORY, APRIL 2006

SOUTHEAST COMMERCIAL LENDING REPORT
A lender’s perspective of the money markets for some major property types in the Southeast.

The actions and attitudes of the lending community can be a solid indicator of the state of property types in local markets. Southeast Real Estate Business asked for lending professionals to provide insight into what financing products are hot for the different property types and a glimpse towards how lenders feel towards certain markets. The industry professionals that participated were Tim Perry and Van Wehr with Atlanta-based CBRE|Melody (Retail); Vince Hughes with the Atlanta office of iCap Realty Advisors (Industrial); Howard W. Smith with Bethesda, Maryland-based Green Park Financial (Multifamily); and Michael Brown in the Boca Raton, Florida, office of Meridian Capital Group.

Multifamily Market

While the Southeast is generally a strong multifamily region across the board, the diversity of the markets is nothing short of astounding. From the speculation along the Gulf Coast to the condominium fever in Florida and Washington, D.C. to the steady markets in the central South, the Southeast has it all.

The Gulf Coast, excluding Florida for the moment, will be a top story for this year. Developers and owners are uncertain as to the future availability of insurance, the future building standards, and — possibly most of all — the impact of another active hurricane season.

Despite the uncertainty, hot markets draw speculators. With rents now on the rise as much as 15 percent, concessions all but gone, and vacancy as low as 0.1 percent in some areas, developers are hard at work. Most are replenishing lost stock, especially affordable housing, and betting on new properties slightly further from the beachfront in impacted Gulf Coast markets.

Brian Andrews, president of Andrews Commercial Mortgage, does business along the Gulf Coast from Texas to Florida. Andrews, and his multifamily clients, are expecting to see a record year this year and again in 2007. He is finding 20 percent increases in proforma NOIs and big, national players coming to the area in search of portfolio transactions.

Andrews claims that loan preferences in the region have shifted from CMBS to Fannie Mae. “Everyone wants Fannie Mae because of the 30-year fully amortizing product and the ability to include multiple supplemental loans down the road,” Andrews says. “Fannie Mae is doing a great job with our B and C properties as well, which is critical as we build up affordable housing and bring back our local workforce.”

Florida will be another top Gulf Coast story. The story is similar across the Florida markets – healthy employment growth combined with low vacancies, due in part to inventory reductions through condo conversions, will help keep Florida an active market.

While the condo craze is beginning to cool, many apartment owners still have heightened expectations and are taking the time to shop their properties to condo converters. If the for-sale housing market slows and smaller condo converters exit the market, these same apartment owners may be looking for refinancing or selling to more traditional buyers.

Washington, D.C. has been another hot market for condos. The conversion rate is expected to slow, and lenders are becoming more selective on the deals and sponsors that they are willing to finance. Unlike speculative markets such as South Florida and Las Vegas, however, end users are the primary buyers of Washington D.C.-area condos, giving the D.C. market added stability.

The nation’s capital will maintain strong job growth, but the large number of units coming online — more than 8,000 — will keep the area’s multifamily market from getting overly tight.  Within the District itself, new, mandatory affordable housing zoning policy will change the way developers view the D.C. market and should help make affordable-focused financing popular in that market.

“We’re beginning to see lenders become selective with respect to condo financing,” says J. Tyler Blue, executive vice president of Walker & Dunlop. “At the same time, there exists significant capacity for construction, mezzanine, and equity financing within our market. Popular products in this year will include forward commitment structures and construction permanent financing.”

The remainder of the Southeast tends to have a mix of markets, with some, such as Birmingham, getting a good push from Katrina. Atlanta also received temporary benefit from Katrina, but as a large market with many units coming online in the near future, the impact of the hurricane season was not as prominent as other Gulf Coast markets.   Urbanization continues to be the trend in Atlanta, including several large redevelopment projects. And the Raleigh and Memphis markets are expected to be solid performers in this year as well.

Across all of the Southeast markets, the continuing low interest rate will drive a high volume of refinancing. In addition, almost all of the Southeast markets will need affordable housing – each market for its own reasons. Florida and Washington, D.C. have a need to offset skyrocketing home prices, and the Gulf Coast needs affordable housing to help attract workers and bring back its displaced residents.

Overall, the Southeast should be a strong region this year with something for just about everyone. The lending environment will continue to be competitive, but transaction volume is expected to be as good or better than last year.

— Howard W. Smith, III is executive vice president and chief operating officer of Green Park Financial in Bethesda, Maryland.

Office Market

Although the office market has certainly reflected the slowing economy during the past few years, last year brought evidence of recovery in many of the Florida markets. Vacancy rates of 15 to 20 percent in the state’s largest office markets are showing significant improvement in many submarkets. Contributing to this trend is the improvement of the employment rate in Florida. According to the Florida Agency for Workforce Innovation, Florida’s unemployment rate in January was 3 percent, the lowest rate reported since the data series began in 1976. This rate was down 1.2 percentage points from 4.2 percent in January of last year.

Multifamily prices that have soared to the point where most local investors have chosen to sell their properties or refinance and pull out excess equity have driven increased demand for office product among other property types. More money is chasing office properties, and coincidentally, many of the office submarkets have begun to improve in terms of vacancy and rents.

The destructive hurricane seasons of the past 2 years have had a huge impact on the demand for office space. Many buildings were either seriously damaged or completely demolished and have required work to be rebuilt. A lot of the older office properties have benefited from the hurricanes, as many of the taller Class A towers experienced damage, requiring tenants to vacate into whatever space was available — which was generally the lower quality buildings.

The huge vacancy created by the dot-com bust has now been absorbed and requests for construction loans for office buildings are being heard for the first time in several years. In fact, since January of last year, more than 55,900 jobs have been added to the construction industry in Florida, leading the state in the rate of job growth. This is a clear reflection of the lower interest rates and the strong demand resulting from two busy hurricane seasons.

Just 2 years ago, a Meridian client was looking for space in Palm Beach County and had the ability to rent in any building with at least some duration of free rent and other concessions. Now, this client has outgrown their space, is struggling to find space in any building, and will likely not get any duration of free rent or other concessions.

A newer trend that is becoming more common across the state is the concept of the office condo. More upscale small business professionals are choosing to buy rather than lease so that they can get a return on their investment and asset protection as well. Numerous end users have opted to stay in their space as owners, hoping for eventual appreciation. The office condo market should set the trend of all different forms of commercial condominiums.

To summarize, recovery should continue in most markets as average vacancy rates are decreasing and there are signs of new construction in nearly all markets that had none for the past several years. Lenders are re-examining their appetites for office product, which will likely result in more available loan dollars. Rehabilitation deals, as well as office condominium conversions, should increase as more bridge money is also becoming available for the product.

— Michael Brown is a managing director with Meridian Capital Group’s Boca Raton, Florida office.

Retail Market

Success fuels growth, and coming off last year’s inferno of product and capital, lenders and investors alike are aiming higher this year. Concerns abound about enough product being traded; or enough product being developed; about how rising interest rates will affect cap rates; and how will lenders continue to adapt their products to increase capital flow? However, there is little doubt that retail real estate will continue to thrive as the Southeast maintains real job growth, fueling the economy as Americans have proven they are not afraid to spend.

The hunt for product has continued to segment the investment market as property owners look for opportunities. The influx of West Coast capital into the Southeast, along with aggressive 1031 exchange capital, is keeping the desire for small retail very strong. Cap rates and values for NNN properties are still at record numbers, and the market for small, unanchored retail has seen cap rates continue to fall as some investors seek rent growth potential. Anchored retail has also continued to be bid as REITs, pension funds, TIC sponsors and syndicators battle it out for the top properties. Likewise, others are seeking rehab projects ranging from backfilling vacant boxes to complete redevelopment.

Feeding the frenzy are the lenders. With every drop in cap rate, high leverage need, high rollover issue, or redevelopment — lenders have found ways to adapt and provide borrowers the tools to make the deals work. Whether through interest only periods, lack of reserves, extended forward rate locks, or making a commitment to hold loans longer, the lending community has over performed in propping up real estate values and upside, even in an upward rate environment.

In the retail sector, investors seem very concerned with maintaining yields on either future development or acquisitions. These concerns are met with a flat-yield curve and lenders offering programs that will fix interest rates 12 to 24 months in advance of funding on either a one-off basis or as lines of credit. This effectively offers the real estate market a capital market hedge with relatively little forward premium — even going so far as to share any upside profit in the hedge should rates rise and the facility be unwound. On a more conventional basis, loans are being priced to the brink of unprofitability in almost every aspect — larger lenders are now focusing even more on volume as margins continue to be squeezed. Loans are also becoming less intrusive and on strong assets, the majority of loan requirements, such as escrows or lease approvals, are often waived or considerably limited.

Construction/Perm loans are the new black. If volume is the game, lenders are now attacking the loans that are still in blueprints. With short-term interest rates dangerously close to inverting the yield curve, fixed-rate construction loans are now priced lower than traditional floating rate loans. Lenders have developed programs that make sense for developer/owners who seek to keep their property or for a developer/seller who can essentially pass on a rate hedge to the future buyer or current presale market.  Permanent debt can also be increased at stabilization for a buyer at the same rate as the construction period. 

Likewise, the redevelopment play is also becoming a hotly contested market. Non-recourse, high leverage lenders are betting on great locations and low prices to perform better than usual this year. These players are poaching on the niche in the capital stack historically dominated by high net-worth individuals with a pension for risk. Country Club equity has become too expensive compared to the institutional or fund equity that is aggressively looking for product. Besides the numbers of players, the largest change in this segment has been the push for smaller deals. For the past several years there were numerous programs available for large projects, leaving the small big box redevelopment to local banks and private equity. Now there are numerous lenders seeking loans below $8 million and very effectively competing with the local bank and local equity partner for business.

In 9 months, the market will know whether the year lived up to the hype, but expect little change in the overall lending or capital market for retail property in the southeast. Lenders will find ways to help investors maintain yield, developers hedge cap rates and profit, and will continue to find creative ways to get in front of business earlier.

— Tim Perry and Van Wehr are directors in Atlanta with CBRE|Melody that focus on retail capitalization throughout the Southeast.

Industrial Market

As a real estate asset class, industrial properties have been considered a stable investment characterized by low occupancy volatility, minimal management requirements, and predictable capital and operating expenses. Because of these features, it has been a favored portfolio investment for owners and lenders alike and has helped to balance earnings through economic uncertainty.

Sub-categories of industrial properties include bulk, distribution, flex and office showroom. Each has appeal to different types of users as well as lenders. Because bulk facilities often lack tenant diversity and are subject to the temporary risk of high vacancies, they are less appealing to conduit lenders and are best suited to life insurance companies or portfolio lenders. These lenders are able to accept vacancy risk that conduit lenders are not, since they are not bound to securitization standards in their loan underwriting.

The multi-tenant distribution, flex and show room properties have broad appeal to most lenders and are actively pursued by them in all markets. Loan-to-values range from a high of 80 percent with current interest rate spreads ranging from 110 to 125 basis points depending on location, tenant mix, quality and age of the property. Single tenant properties are a challenge to finance unless the tenant is investment grade, or, at a minimum, a leader in the market.

With respect to flex space, if the office configuration reflects a standard layout, lenders will not usually penalize the loan underwriting with excessive future tenant improvement costs. If the lender perception is that the space is special-purpose, be prepared to have a capital reserve that will adequately address that issue.

In the past decade, ownership of bulk storage properties has shifted toward institutional ownership and development. Because of this shift, lenders have found it difficult to find willing borrowers since many of the owners have no need for secured financing. Instead, the properties are financed through unsecured corporate borrowings or are owned outright by pension or real estate investment funds. Although lending opportunities for bulk storage are not found in abundance, lenders have actively competed for these loans when given the chance. Interest rates have ranged from a low of 85 basis points over comparable term Treasuries to a high of 125 basis points. Terms of 10, 20 and 30 years have been available depending upon the strength of the tenant, length of the lease and the market area of the property. Most lenders have favored multi-tenant properties but have considered single tenants when the financial strength of the tenant outweighs the potential risk of a tenant default.

The bulk storage markets of Atlanta and Memphis are the leading locations for this sub-property type because of the critical mass of properties, road systems and strategic location to major distribution markets. In some cases, investors are choosing properties that are located across the river from Memphis, in Mississippi, due to state tax incentives.

To be competitive, lenders know that bulk properties need to have a minimum ceiling height of 32 feet, ESFR (early suppression, fast response) fire systems, truck courts of at least 185 feet, and, more recently, trailer storage. Trailer storage has become more important due to changes in federal regulations that have reduced the amount of time a driver can log in a day. This has caused a shortage of drivers and an increased demand by their employers that they not be delayed waiting to load and unload freight. Storing trailers on site helps to reduce driver turnaround time and keeps them on the road.

Long Beach, California shipping terminals continue to be a bottleneck in the logistic pipeline. Because of this issue more container companies are shipping to the East Coast via the Suez Canal. The beneficiaries of this shift are the eastern ports and the on-site providers of long-term and transient storage. The Southeastern ports continue to see a rise in demand and development activity is brisk.

Competition among investors to purchase industrial properties is intense. Capital is abundant and institutional; and TIC buyers are bidding down cap rates to unprecedented lows for both large and small properties. Low interest rates as well as interest-only loans have helped fuel activity, but if rates rise precipitously borrowers could face negative leverage, which will have a potentially dampening effect on the market. Increased interest rates along with the substantially higher costs of construction may force rents upward if investors hope to maintain acceptable yields.

So what does this mean for investors, lenders or borrowers? That it is a good time to be any one of these. Demand for space by tenants remains good and lenders are eager to find product.

—  Vince Hughes, Sr. is a director with iCap Realty Advisors based in Atlanta, Georgia.

©2006 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.