FEATURE ARTICLE, FEBRUARY 2006

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

OFFICE MARKET

Hagwood

Even though there was only a marginal improvement in vacancy rates, investment sales activity in Atlanta, like many markets in the Southeast, was brisk. More than 90 properties changed ownership in Atlanta during last year. The median sales prices per square foot increased approximately 6.8 percent to $131 last year from $122 per square foot in 2004. As net rental income growth was stagnant overall, capitalization rates—or internal return on an investment, which is derived by dividing the net operating income by the purchase price—continued to decline on average. According to Realpoint Research, cap rates averaged approximately 7.65 percent for the city as a whole, a decline of more than 70 basis points from the beginning of 2004. This means the same (or less) net income is supporting higher prices—a fact that continues to give many investors cause for concern.  

The ultimate risk to investors and lenders alike is that interest rates could continue to increase. This will eventually have an upward impact on cap rates, resulting in lower property values in coming years—a situation not seen since the late 1980s and early 1990s. With many of the highly leveraged deals closed in the past year, there is a strong chance that some of them may face a payment default risk or a refinance risk; that is, the value of the property may not support enough loan proceeds to retire the existing mortgage when it balloons. Interestingly enough, CMBS mortgage delinquencies actually declined during the past 12 months to .16 percent from .25 percent for office properties nationally.

While office owners face a number of obstacles, finding favorable financing for their properties is not one of them. The past 2 years were excellent times for office borrowing. The 10-year U.S. Treasury Note, the primary index used by lenders in pricing permanent loans, remained close to its historical lows.   However, early last September, the 10-year Treasury began a march north. Yields increased nearly almost 55 basis points, from 4.1 percent, to a high of 4.64 percent. Fortunately for borrowers, interest rate spreads charged by permanent lenders have remained relatively flat (at press time), thus weakening the blow of the treasuries and providing some relief to the recent increase in long-term rates.

Still, the run-up in long-term interest rates places enormous pressure on lenders to become more creative with the permanent-financing deals they offer to office owners. Lenders are still offering loan packages that cover upward of 90 percent of the property's value through a combination of first mortgage debt and mezzanine debt—floating rate debt secured by the equity interest of the borrowing entity rather than the property. These options have become essential as increasing prices mean that borrowers need more cash to purchase assets.    

Recently lenders have lessened their willingness to offer interest-only payments during the early years of the loan term, which could further depress a borrower's initial cash flow during the first several years. Without batting an eye many lenders are still offering amortizations of up to 30 years, even on older properties. The recent rate increases have slowed new loan originations, and lenders are aggressively on the hunt for quality properties to finance. Therefore, property owners will continue to have a captive lender audience. Permanent debt capital is abundant from all sources including life companies, pension funds and, of course, CMBS issuers. There are plenty of good deals to be found for each of the office markets, and there is strong interest from the lending community in the Southeast because of the long-term economic upside in the region.   

—  Chad Thomas Hagwood is a senior vice president and branch manager of the Alabama office of GMAC Commercial Mortgage Corporation.

MULTIFAMILY MARKET

Walsh

Most Southeast multifamily markets saw economic occupancies plummet from 2001 to 2002. The two main factors contributing to this downswing were slower job growth and record-low single-family mortgage rates, which enabled many apartment dwellers to become homeowners. These factors contributed to a decrease in demand for apartments. Additionally, there was a continued introduction of new units to the market—even after market problems were readily apparent. Luckily, most new developments were financed with floating-rate loans resulting in extremely low carrying costs that allowed most owners/borrowers to survive.

Tapie

“Both Fannie Mae and Freddie Mac are facing strong competition in all product lines, perhaps more competition than at any time in history,” says Jerry Johnson, GSE chief underwriter with Atlanta-based Collateral Mortgage Capital. “They have been forced to make many changes to remain competitive, but they have adapted well and continue to enjoy a healthy share of the multifamily finance market.”  

The first key to recovery is to impede the downward trend. The Southeast has accomplished that, but those looking for a quick recovery will be disappointed. Recovery has been steady but slow, and will likely continue along a similar path. In spite of the sluggish recovery, buyers continue to actively seek multifamily properties in the Southeast. Unprecedented low cap rates in some West Coast and East Coast markets have had an effect in the Southeast.

First, sellers flush with equity have increased the capital flow into the Southeast as they seek more favorable cap rates. This has reduced cap rates in Southeastern markets to unprecedented levels, but still 1.5 percent to 2 percent higher than in the hottest markets. This has turned many Southeastern owners into net sellers in order to take advantage of the low cap rate environment.   The odd combination of buyers who believe cap rates are abnormally high and sellers who think cap rates are strangely low seems to benefit both sides, but the true result of this phenomenon will not be known until the time comes to sell these same properties once again.

The unprecedented low cap rates and proliferation of out-of-town buyers has created challenges for multifamily lenders in the Southeast. Lenders are often unable to lend the expected 75 percent to 80 percent of the purchase price because of other underwriting constraints, especially when the buyer's analysis is based on improving economics. In these cases borrowers are forced to inject more equity into deals or use alternative financing sources. Additionally, many out-of-town buyers bring their own financing, making it doubly difficult for Southeastern lenders to compete for their business, and forcing many to take a more national approach to their business.

Given those conditions, positives still remain in the market. Fixed mortgage rates have avoided the hikes experienced in the floating-rate market, remaining at favorable levels around 5.5 percent for 10-year terms. The larger Southeast markets, such as Atlanta, Charlotte, and Raleigh-Durham, are slowly recovering, and condominium conversions, while slowing in some markets, continue to keep the apartment unit supply in check.

No area has seen condominium conversions impact the local multifamily market more than South Florida. According to the REIS Observer, 15,500 South Florida units have been converted since 2003, including 5,145 in the past 6 months alone. At the same time, new multifamily development has been slow, allowing for solid rental growth and a vacancy rate less than 4 percent, as low as any market in the country. These unique aspects of the South Florida market have affected financing activity. Even in a favorable fixed-rate environment, many apartment owners seek flexible financing that allows for early prepayment should the property be converted. Lower Class B and C complexes continue to attract traditional financing, as they are not highly sought after for conversion.  

With New Orleans suffering severe damage due to Hurricane Katrina, many its area residents fled to other Southeastern cities, which boosted those apartment markets but left a large housing void in the New Orleans and Mississippi Gulf Coast region. Now, many lenders are dealing with insurance problems and questions that lack precedent. The silver lining for area apartment owners and lenders is that housing is in high demand, and any livable vacant unit is currently occupied. Even though some lenders and investors are bullish, the turnaround in that region will not happen overnight. It may be years before the impact of Katrina is accurately defined. But, as jobs and people move back into what was previously a city with 500,000 residents, the immediate demand for reasonable living accommodations will almost inevitably rise.

— Tom Walsh is director and Alan Tapie is assistant vice president in the Atlanta office of Collateral Mortgage Capital, LLC.

SENIOR HOUSING MARKET

As the nature of senior housing evolves, so does the financing of senior housing projects. In fact, different levels of medical services and amenities that are offered at senior housing   properties drive different underwriting and financing requirements. As methods of financing for senior housing become increasingly sophisticated and as the older adult population continues to grow, a rising number of commercial real estate developers have identified a need to develop not just housing options for older adults, but corresponding continuing care options, as well.

Traditional senior housing developments may be very specific to the senior citizen population in their design and marketing, but in the nature of their business, they are simply real estate developments with a specialized set of building features and amenities. However, senior housing developments that are owned and/or operated by a healthcare provider entity — and even those that simply incorporate a continuing care component — must be underwritten considering both the real estate and healthcare business issues. Much like a bank would underwrite credit for a new hospital, it must approach the underwriting of a senior housing and care facility based on its operating business model — not as a traditional real estate development or asset.

For experienced senior housing developers in the Southeast, financing the housing needed by the many new residents of this region should be an uncomplicated process: secure equity, request development financing, build the units, then apply for permanent finance once the revenue stream is in place. However, the ‘amenity' of on-site medical care is often one that can vastly change the landscape for financing the project.

The demand for care is where developers need to make careful choices regarding the components of any new real estate project being designed for and marketed to the senior population. If a new development is owned or operated by a hospital or other healthcare provider, the developer needs to turn to a full-service institution that can offer not just real estate finance, but corporate financing, as well. Both the interim and permanent finance of this type of facility will be underwritten by the borrower's ability to operate a successful business — not merely on the value of its real estate and ability to construct a project and pay back the loan. By working with a full-service lender whose healthcare lending and real estate groups work in tandem with one another, the borrower will ensure that the project breaks ground.

Unfortunately, in many financial institutions, turf battles between commercial/ healthcare banking and the real estate groups might prevent the lending process from moving forward smoothly.   This should not have to occur. In fact, working together with the client, the lender should be able to analyze and underwrite the healthcare and real estate aspects of the business concurrently, and complete the process in the same expected timeframe.

— Philip Carroll is senior vice president, Southeast regional executive, and Jack Boudler is vice president, with KeyBank Real Estate Capital – Healthcare Finance.

©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.