FEATURE ARTICLE, AUGUST 2006

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

MULTIFAMILY MARKET

While single-family home sales in the Southeast area are beginning to see a downturn, the multifamily side is still expanding, with vacancy rates on the decline and rental growth gaining traction.

The markets’ health is due to four factors: strong economic and demographic trends; the condominium boom during the past several years; the current residential slowdown brought on by rising mortgage rates; and the relative restraint shown by developers in the weaker secondary and tertiary markets during the same time period.

The condo boom in some primary markets has removed rental supply via conversion and diverted developers’ projects from rental to condo, reducing the inventory in some already tight markets.  Although the boom has cooled or even stalled in some markets, its impact will continue to be felt during the next several years in multifamily markets throughout the Southeast. In fact, according to the National Association of Realtors, compared to last year, condo conversion activity will see as much as a 10 percent decline.

Two markets in particular impacted by condo development are Washington, D.C. and South Florida. The Washington metropolitan area (the District of Columbia, Northern Virginia, and Suburban Maryland) has one of the strongest economies in the country. According to the Bureau of Labor Statistics, 78,500 jobs were created in the last 12 months ending April 2006 and forecasters predict growth in the area of well more than 60,000 jobs during the next 3 years.

Rental vacancies in both markets are well below 5 percent. In addition to net absorption outstripping new deliveries, rental product during the past few years has been taken out of the market for condo conversions.

Last year, in Northern Virginia alone, there were twice as many units converted to condos as built for rental.  According to REIS, Inc., in Miami, that same ratio was 12 to 1. During the past 4 years, more than 34,000 units were removed from Miami’s rental inventory compared to roughly 5,500 units added from new construction. Strong rental growth is forecasted in both markets during the next 5 years. 

According to James Cahill, senior vice president of Bethesda, Maryland-based Ark Realty Capital, expectations need to be adjusted to reflect the current status of the condo conversion market.

“The rush to build or convert to condos drove land prices and multifamily properties up very quickly in both markets,” Cahill explains. “Converters were buying existing apartment projects at 3 percent cap rates (sometimes on next year’s NOI) with dreams of selling 30 units a month while raising prices 25 percent during the sell-out period. However, the slowdown in sales notwithstanding, there continues to be a disconnect between property owners and investors looking to buy existing multifamily projects.  The current owners still expect prices to reflect condo conversion potential and investors are seeking to acquire projects and maintain them as rentals.”  

Aggressive pricing for multifamily properties in primary markets nationwide have resulted in investors looking toward the secondary markets of Charlotte and Raleigh and tertiary markets like Greensboro. During the last downturn, these markets suffered job losses and continued rental construction, resulting in double-digit vacancies and hefty concessions.  In addition, these markets were particularly hard hit because of their high housing affordability. As mortgage rates fell, a large proportion of renters left to purchase homes and condos. 

A number of factors, however, have aided these markets’ recovery. Climbing interest rates over the past year have caused many potential homebuyers to remain in the rental pool. Steady job and population growth along with building restraint in the down years has also aided the markets’ recovery. As a result, vacancy rates have dropped below 10 percent again in all three markets and rents are beginning to rise modestly. 

Interest rates have increased substantially in the first half of 2006. With 1-month LIBOR currently exceeding Treasury Yields, many borrowers are forgoing floating rate acquisition financing and its interest rate risk and shifting toward permanent, fixed rate loans from the agencies and the conduits.  Although CMBS executions remain popular with borrowers, due to competitive rates and loan proceeds, a lot of borrowers are gravitating toward Agency (Fannie Mae and Freddie Mac) programs such as Early Rate Lock, Pre-Stabilization and Forward programs that allow them to lock in rates quickly.  Both Fannie Mae and Freddie Mac also have the advantage of offering supplemental loans to borrowers. 

Interest Only (IO) structures continue to be prevalent in the permanent market, particularly partial-term IO loans. There has been a gradual decrease in full-term IO periods, but those do remain available on loans with strong sponsors, markets and assets.  The Agencies and the Conduits allow IO structures.

The Southeast continues to be an active market for acquisitions and given the recent run-up in interest rates, many borrowers who are able to refinance with minimal or no prepayment penalties will choose to do so before rates edge up higher this year.

— Henry E. “Skip” Martinson is a director with Arbor Commercial Mortgage, LLC, in Charlotte, North Carolina.

RETAIL MARKET

The Southeast retail market continues to make strides and should remain solid into 2007.  Capital flows into Southeastern retail properties will remain strong during the next year, but lenders are beginning to tighten underwriting standards for some property types. In the single-tenant sector, lenders are imposing stricter debt-service coverage ratios depending on credit quality of the tenant or franchisee. Marketwide, CMBS issuance is expected to remain strong, but higher-yields on other fixed-rate income securities may lead to some widening in spreads. Competition among CMBS lenders is fierce, which may help keep control on the widening of spreads.

Energy prices, along with job and wage growth, will be watched closely in the months ahead. The bond market could shift on signs of greater inflation, pushing long-term rates up beyond current expectations.

The financing environment for retail properties in the Southeast remains highly favorable for borrowers. Lenders, especially the conduits and life companies, are attracted to the retail sector due to its strong fundamentals and the stability of property revenue. In fact, retail properties accounted for the greatest share of collateral in CMBS offerings last year. CMBS issuance is expected to rise as global investor demand for yield product holds strong.

Lenders are looking to finance all sectors of the retail market in the Southeast. Big box and lifestyle centers, as well as grocery-anchored centers and credit-rated single tenants, are especially favored. Unanchored centers in good locations still command premium pricing.

On the equity side, markets such as Atlanta, Fort Lauderdale, Miami, Charlotte, Nashville, Tampa, Jacksonville, Birmingham and other robust secondary and tertiary markets are increasingly on the radar screens of institutional and private investors looking for higher yields. This buyer group accounted for almost two-thirds of volume in the more than $5 million market during the past year, compared to 40 percent to 50 percent in the Southeast. Many investors from other regions, specifically the West, will continue looking for value deals in the Southeast. There are not as many investors from the West as in previous years, but there is still a lot of capital looking for good deals.

Although interest rates are rising, a number of factors are causing cap rates to remain low. TICs, REITs, and pension funds are battling for the well-located, Class A retail properties, while groups and individuals with 1031 funds are fiercely competing for many of the unanchored and single-tenant properties. Believe it or not, Marcus & Millichap has actually seen cap rates for retail assets in the Southeast fall slightly in the first 6 months of this year even with the increase in long-term interest rates.

Cities such as Fort Lauderdale, which is predicted to double in population during the next 20 years, will create more demand for retail space and will enhance the income and appreciation potential of well-located properties. After the condo market softened in much of Florida and other parts of the Southeast, many lenders are looking to the retail market to replace loans that were earmarked for condo development. 

Hurricane Katrina and the past 3 years of other devastating hurricanes have negatively impacted the Southeast. As a result, insurance premiums have risen significantly and show no signs of decreasing. Lenders are questioning the basis of their underwriting. On the positive side, many investors, developers and owners are purchasing and developing properties in hurricane-stricken areas that have potential for reconstruction and growth.

Lenders are competing to finance retail properties at a fervent pace. Two to 5 years of interest only is routinely offered, as is a longer amortization period of up to 35 years.  At the same time, lenders are utilizing creative methods to finance properties. Lower debt service coverages and lower tenant improvement and leasing commission reserves are helping lenders win deals. Higher leverage and mezzanine loans taking the permanent debt into the 85 percent to 90 percent loan to value are also available.

In short, the lending market for retail in the Southeast should remain stable for the rest of the year. Lenders, both construction and permanent, will continue to fight aggressively to win the retail business.

— David S. Akeman is senior director of Marcus & Millichap Capital Corporation in the Atlanta office.

©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.