COVER STORY, JANUARY 2006

FINANCIAL FORECAST
Lenders remain positive about markets in 2006.
Daniel Beaird

Looking ahead to 2006, lenders across the Southeast are cautiously optimistic about the future lending environment. The economy is steadily improving from the 2001 recession and lenders are more positive today than they have been forecasting the previous 2 years. Commercial real estate lending continues to be a buyer's market and remains very competitive, but lenders are witnessing the craze of condominium conversions and the conclusion of the 1990's 10-year fixed-rate loans somewhat balance the scale.

Multifamily loans, especially conversion loans, have become popular in many Southeastern markets. Condominium conversions have taken off, especially in Florida. “Everything is a condominium conversion,” says Faron Thompson, managing director of the income property capital group at Primary Capital. “Recently, I've heard of only one deal in southeast Florida in which the new owner intended the property as a rental.” And if the past two tumultuous hurricane seasons have slowed new construction in Florida, they have not slowed down the conversion market. After a hurricane, permitting activity is limited to correcting the related damages, causing new projects to possibly face setbacks of an estimated 3 to 9 months. The Florida conversion market, on the other hand, has avoided any type of slowdown. “It just doesn't seem like it has affected it at all,” says Brian MacKay, founder of M&A Financial, an intermediary lender located in Clearwater, Florida. “If you can find the right property and you are not overpaying for it, there is such a margin between what it costs to build or convert and what you can get for it if it's on the waterfront.” This has lent itself to more conversion loans as well as structured finance, mezzanine and construction loans in Florida.

According to MacKay, though, the conversion market will slow down when the sellers begin to price their product so the converter cannot make any money. “They are getting harder to find because the sellers are pricing them so that there isn't any money left when they convert,” MacKay says. Howard Smith III, executive vice president and chief operating officer at Green Park Financial, agrees, “The boom in the condominium industry has had a dramatic impact on the perception of value within the multifamily market.”

Grocery-anchored retail loans remain strong in Florida, and across the Southeast, as well. “If you stay with the top two or three chains in a particular market, depending on how large that market is, it is usually a safe bet,” Thompson says. Getting involved with a new grocery chain player might make a lender more cautious. “If a new grocer is trying to break into a market, the developer is probably getting a rent from that grocer that is more than he could get from the top two chains,” Thompson says. “So, there is some incentive for the developer to make that deal, but staying with the tried and true is good business.”

In Washington, D.C., job growth, primarily due, to the growth of government entitlements and companies providing services to the government, has led to the nation's capital to become one of the top markets in the nation for office financing as well as multifamily financing. The market has witnessed job growth in both the private and public sectors. “The Southeast appears to demonstrate continued strong population and employment growth, but especially Washington, D.C.,” Smith says.

The rise in interest rates during the past year doesn't damper the lenders' enthusiasm for the Southeast. “Looking at interest rates in the past, over a long term like 15 or 20 years, today's interest rates are still very attractive,” Thompson says. “If rates continue to march upward, the first thing you'll see is cap rates go up some.” Fannie Mae's London Interbank Offered Rates (LIBOR) has risen from historical lows at a little more than 1 to more than 4 during the past year and a half. “So, you are talking about 6 or 7 percent money as opposed to 3 or 4 percent a year and a half ago,” MacKay says. “But, deals always worked at 7 or 8 percent in the past, so they should work now if they are good deals.”

The 10-year fixed-rate boom of the middle to late 1990's locked in many borrowers at a 9 and a half to full-term yield maintenance. As the condominium converters came along in the early 2000's, offering copious amounts of money to convert, borrowers were stuck with years still remaining on their 10-year fixed-rate loans and facing pre-payment penalties of up to 20 percent of their balance. A yield maintenance fee is designed to reimburse the lender for the present value of the difference between the interest income the lender would have earned during the life of the fixed-rate loan and the interest earned at the reinvestment rate in effect at the time of the payoff.

Most of the 10-year fixed-rate activity occurred from 1995 up to the conduit crash of 1998. During the next three years, the refinance window will open, which will bring more business to the financing institutions, especially on the multifamily side as some deals have come open in 2005 and already been sold to condominium converters. It is a phenomenon that will affect everything around it, according to Thompson, and the next few years will offer lenders an opportunity to become more creative with short-term loans as the 1990's fixed-rate loans will close out. “Some momentum will get away from traditional yield maintenance and defeasance,” Thompson says. “Lenders will begin to get more creative and target pre-payment flexibility.” Flexibility being the key word there because without a pre-payment penalty, if interest rates go up, the borrower has an advantage, and if interest rates go down, the borrower has an advantage, after he refinances. So, lenders will have to get creative to avoid such a one-sided proposition.

Recent years have seen a very favorable interest rate environment for real estate investors and developers. Today, LIBOR has risen and interest rates have risen to 6 to 7 percent. “But, you have to look at the economics of it, you know when the NASDAQ was going through the roof, it was going to come back at some point,” MacKay says. So, lenders remain cautiously optimistic about 2006.

Overall, the Southeast lending environment looks relatively stronger than it did a year ago. Lenders look at monthly cash flows as it pertains to the trailing 3 months. If the market has held firm during that time period, it's good; and if the market has gone up, it's better. “Most mortgages in the Southeast are showing vitality, especially compared to other regions of the country,” Thompson says. Lenders anticipate the Southeastern market will be competitive and active in 2006, so understanding and targeting the appropriate Southeastern submarkets is an important factor to lenders' success.

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