COVER STORY, JANUARY 2011

LENDING IN THE RECOVERY
Access to capital has improved, but will it become more expensive?
Jaime Lackey

The new year brings with it optimism born of signs that commercial real estate’s falling values and faltering fundamentals are beginning to recover. With indications of stability in the market, transaction activity is beginning to increase — but will loan pricing continue to support a fledgling recovery?

“I think we will see a volatile interest rate market,” says Matt Rocco, senior vice president with Grandbridge Real Estate Capital. “I believe coupon interest rates will remain very attractive — in the mid-5 to low 6 percent range —  but I expect Treasuries to rise and investor spreads to decrease throughout 2011. At the end of the day, though, users of capital will still have the opportunity to obtain attractive financing.”

Ken Broussard agrees. “Long-term rates have been very attractive for a few years, however there is some concern that the general trend going forward could be in the other direction. The 10-year Treasury hit a low of 2.4 percent in mid-October, but was up almost 100 basis points a couple of months later. If economic data remains predominantly positive, it is likely that rates will trend upward in 2011. However, the spread overlong-term rates could decrease as more lenders enter the market,” says Broussard, senior vice president and regional executive for the Southeast with KeyBank Real Estate Capital.

“The CMBS market is slowly coming back to life,” Broussard adds. “Investors are looking at different options, and loans on stable real estate projects are being viewed more favorably — at the right asset value and capital structure. The market had to figure itself out, and, coming out of the recession, there was little doubt that loan structures would be fairly conservative.”

“Multifamily is by far the favored product,” Broussard says. “This is in part because Fannie Mae, Freddie Mac and FHA have kept the exit strategy for multifamily alive. From a short-term lender’s perspective, you need to have a place for performing loans to go in order to free up capital to make new loans.”

Multifamily market fundamentals also support the popularity of the multifamily product. Rocco says, “The multifamily market took a hit, but it is recovering faster than other asset classes. There is continuing demand from renters. Many people are still priced out of the homebuying market or cannot get a loan — and there has been a demographic shift where many people prefer the flexibility of renting versus owning.”

“Apartment fundamentals tend to track the broader economic market of a given region.  Continued economic recoveries suggest most [apartment] rent loss has been realized,” Rocco says.

Furthermore, there has not been much product delivered since 2008. “Arguably some apartment markets are not so much overbuilt as under-destroyed and need to have obsolete properties removed from the marketplace,” Rocco adds. “Continued improvement in economy and apartment fundamentals will afford select new development opportunities in the Southeast; however, financing will be reserved for only well-capitalized borrowers with established market demand for new product.”

On the multifamily acquisitions side, Rocco notes that the market is bifurcated.  “There is strong investor demand for high quality, well-located apartment properties,” he says. In late 2010, acquisition loans on such properties went up to 80 percent loan-to-value while refinance loans were up to 75 percent, with agency spreads of 190 to 210 basis points over the 10-year Treasuries.

On the other hand, it is very difficult to obtain financing for Class C properties, which often need significant capital improvements and repairs. “This year will continue to see defaults on low quality properties with high leverage,” Rocco says. “While we do not expect to see a huge wave of foreclosures, the recovery just is not dynamic enough to support all properties.”

Overall, Rocco expects to see significant recovery for apartment markets this year, while he expects industrial and retail markets to recover in 2 years and office markets to take 3 years for recovery following employment growth. However, he notes, “There will be continued issues working through low quality and locationally disadvantaged properties, which may trail the overall market recovery by an additional 1 to 2 years.”

Industrial markets continue to stabilize across the Southeast, Rocco says, except for pockets in southeast and southwest Florida, which consist of overbuilt incubator space where the recovery will parallel the construction trades. New construction will be limited to special use projects driven by major tenants. Lenders favor bulk and distribution facilities when it comes to acquisition and refinancing. In late 2010, loan-to-value ratios for industrial loans ranged from 65 to 70 percent with spreads around 225 basis points over the 10-year Treasury.

In retail markets, construction financing will be limited to projects where the majority of the debt service is covered by a major tenant, such as a grocer. These are also the properties in favor for acquisition and refinancing loans. Unanchored strip centers are more limited in their financing options. Stabilized, anchored centers can get up to 75 percent loan-to-value, while loans for unanchored centers typically top out at 70 percent loan-to-value, Rocco says. Pricing for stabilized assets averages 225 basis points over the 10-year Treasury, with 25- to 30-year amortizations.

Office construction financing is limited to build-to-suit and/or driven by special use opportunities, such as the Cox Communications project in Sandy Springs, just north of Atlanta, or projects for the U.S. General Services Administration.

Lenders prefer to finance office acquisitions over refinancing because of the new equity. Rocco adds that most lenders are underwriting to the local markets, where analysis focuses on vacancies, which hover around 20 percent in many Southeastern office markets. Underwriting is also careful to analyze current market rents versus in-place rents. For financeable product in late 2010, permanent 10-year fixed loans with 30-year amortization were available at 215 to 250 basis points over the 10-year Treasury.

The D.C. market has remained stable due in large part to growth in government jobs. According to Rocco, other stable Southeastern markets include Charlotte and the Research Triangle in North Carolina; Nashville and Chattanooga, Tennessee; Birmingham, Alabama; and coastal Virginia. While Atlanta has been hit hard with job losses, Rocco says the promise of a strong recovery looks good. He also believes the retiree demographic holds the long-term promise of recovery in Florida, which he calls “the boom and bust epicenter of the Southeast.”

While 2010 closed with positive indicators — such as signs of improving consumer confidence — many questions about the lending environment remain.

As Broussard notes, the U.S. is experiencing a fragile recovery. “The money pumped into the economy could prove to be inflationary, and that would impact asset values and loan pricing,” he says. “We have been experiencing mixed signals as the economy regains its footing, and look for 2011 to provide more clarity as to how the economy, commercial real estate and the real estate capital markets will recover this time around.”

On the upside, the current market has strong fundamentals that will support the commercial real estate market over the next few years. As Rocco says, “I’d much rather make a loan today when rents and values are at their lowest than to make a 75 percent LTV loan in 2007 where values dropped an average 35 percent in 3 years. We are underwriting in the trough, so to speak. The downturn brings market clarity. Lenders and investors can see the pluses and minuses of each building in the current environment. In 2011, we will write some of the best loans in 5 years.”

He adds, “The market today is significantly better than it was 1 year ago, and I expect it to be even better at the end of 2011.”

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