COVER STORY, FEBRUARY 2012

FINANCIAL FORECAST
From interest rates to CMBS, lenders weigh in on factors that will shape the debt financing market in 2012.
Savannah Duncan

Heading into 2012, there are a lot of uncertainties in the financial arena. Southeast Real Estate Business magazine asked three lenders to weigh in on hot button topics including The European debt crisis, the CMBS market and the Dodd-Frank financial regulation reform. The lenders included: Chad Hagwood, executive vice president of originations based in Beech Street Capital’s Birmingham, Alabama, office; Joe Tilley, chief operating and financial officer of Phillips Realty Capital’s Bethesda, Maryland office; and Bob Stout, president and CEO of Q10 Capital’s Nashville, Tennessee office.

SREB: The 10-year Treasury yield is hovering around 2 percent, near a record low. Do you expect the 10-year yield to remain in this extremely low territory in 2012 (2 percent to 2.5 percent)?

Tilley: I do expect the 10-year Treasury to remain below 2.5 percent during 2012. The current economic data just doesn’t support a scenario in which the economy accelerates its growth and pressures the federal government to raise rates. Additionally, until the equity markets stabilize, Treasuries will continue to be a “flight to safety” investment choice.

Hagwood: I expect the 10-year Treasury to remain fairly low through the balance of the election cycle, but if the outcome with Europe’s financial situation is bad, then all bets are off.

SREB: Is the real issue today for most commercial real estate borrowers in the Southeast the cost of funds or the ability to obtain them at all, or both?

Hagwood: Rates are extremely attractive today — that isn’t the problem. The problem is a borrower securing credit, in other words, finding funds. Lending remains tight for many borrowers and many property types. That isn’t going to change anytime soon.

Stout: The cost of funds continues to really be at historic lows, they are not an issue for borrowers today. It’s really more a challenge to get a high enough loan-to-value to refinance existing loans that are maturing. The second real challenge is it’s still a very difficult lending market for people that are trying to build new projects. Construction lending continues to be very constrained.

Tilley: The challenge will not be the cost of funds, but rather the ample supply of funds that allow the borrower to accomplish its objectives. Falling rents and increasing vacancies have an adverse effect on property valuations, which limit the amount of leverage that a borrower can obtain. Furthermore, where capital is available, it is being funded at more conservative levels. Given the combined consequence of these factors, many borrowers will find that they will need to add equity simply to refinance their current debt.

SREB: Are lenders getting nervous that so many investors in commercial real estate want to buy apartments, particularly Class-A apartments in top-notch locations?

Tilley: Yes, lenders are beginning to fill their “buckets” for this property type. Hopefully Fannie Mae and Freddie Mac can help supply capital. In the Washington, D.C. market, there continues to be a huge demand for multifamily. In fact, during 2011, we worked on more multifamily construction assignments than any of us can recall.

Stout: If you own a quality, Class A multifamily property in a solid market anywhere in the country, particularly in the Southeast, there will continue to be to be a lot of demand from investors to buy those properties, and there’s going to be plenty of capital available to finance those acquisitions.

Hagwood: The concern is that cap rates are artificially low because of low interest rates. Multifamily is considered a safer harbor right now because the fundamentals and trends work in its favor, and investors are naturally going to flock to that property type.

SREB: True or false: Until the CMBS market heals, the lending market for commercial real estate will remain choppy.

Stout: The CMBS market is really dependent on the health of the bond market. Until the global economic issues are resolved, particularly with the European debt crisis, and until there’s some confidence that the U.S. government has our federal spending and deficit under control, the bond market is going to continue to be choppy, which again is going to impact the CMBS market. There are plenty of CMBS lenders with capital available. The key is that they just have to be able to sell those loans eventually in the bond market.

Tilley: True. While there were obvious underlying issues, the involvement of CMBS in the mid-2000s created very efficient markets. In certain markets throughout the country, CMBS is already playing a big role in providing capital to commercial real estate. Having said that, we all need a thriving CMBS market by 2013.

Hagwood: False. The commercial real estate market will remain choppy until there is real growth with employment and people feel a lot more certain and confident in our federal government and our banking system.

SREB: Where is the industry at on the continuum of working through the problems of distressed real estate in the Southeast?

Tilley: Banks in the Washington, D.C. area have benefitted from “extend and pretend” due to the strength of our market. Interestingly, it has been far easier for borrowers to work with special servicers in other parts of the country than it has been here. Given the strength of our market, special servicers are unlikely to restructure or modify debt — they would prefer to own the property themselves.

Hagwood: We are certainly going to see more REO properties come to market. I don’t know if we will necessarily see more than we did last year, but the sales of distressed and REO properties are far from over.

SREB: Much has been made of the Dodd-Frank financial reform regulation and the uncertainty it brings to our industry. What are your thoughts?

Tilley: It seems to be affecting the debt REITs and bigger banks. The macro affects of Dodd-Frank have not been realized yet because it is being phased in over several years. Dodd-Frank will cause some inefficiencies in the market, leading to opportunity for the right people.

Stout: There is an awful lot of concern and criticism from the industry, but the criticism is really just about the uncertainty this has created. It’s causing a lot of lenders to be less aggressive than they might otherwise be because they are just unsure how the legislation is going to impact their business. I hear from a lot of our life insurance company lenders that they are expecting that the requirements are going to be increased substantially, which is going to cost more. That, in turn, will impact mortgage bankers and service for those life companies.

SREB: Is speed of execution more important, less important or about the same in lending as it was during the height of the commercial real estate boom in 2005-2007?

Hagwood: Speed is, has been and always will be important. It is even more important today than it was from 2005 to 2007 because people are far more nervous today than they were in 2005. Everyone is expecting the next big piece of bad news to hit, and they don’t want it to affect their deal negatively. So, they want things done quickly, and as it was advertised upfront.

Tilley: Speed to execute is always important. While we continue to enjoy success in the Washington, D.C., markets, every transaction takes longer than it used to. Time kills deals and consequently every transaction is more fragile. We need the re-entrance of CMBS to accelerate transaction speed.

SREB: As you prepare for the annual MBA show in Atlanta, what do you think will be the big questions at the show that will be addressed and need to be addressed?

Tilley: Life insurance companies will only generate $50 billion or so in financing. Banks will provide their fair share as well. However, from 2005 to 2007, CMBS was providing $200 to 250 billion in debt annually. CMBS did less than $30 billion in 2011. Also, what forms of capital will allow borrowers to finance 75 percent loan-to-value deals?

Hagwood: The biggest and most asked questions will be the same as they have been for the past couple of years: What will happen to the agencies Fannie Mae and Freddie Mac? When is CMBS going to be fully operational? How much longer until we see real economic recovery? Unfortunately, the real answer has remained exactly the same — we just don’t know.

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