COVER STORY, FEBRUARY 2006
WESTERN LENDING ACTIVITY
Are lenders banking on any big changes in western capital markets in the new year?
As the country adjusts to a new year, so do the banking and lending industries. While many of the factors and conditions that were present in the last quarter of 2005 will carry through to the new year, there will be changes as well. Many markets, especially retail, continue to bustle with new activity, while others, such as segments of multifamily, are slowing down.
Warming (And Cooling) Trends
One area in which big change is predicted is the condominium-conversion market. Towards the end of 2005, the formerly ‘hot' condominium conversion market began to cool off, with many developers and lenders taking a step back. “Capital market interest in condominium conversions appears to be waning across the board,” says Jason Choulochas, regional director for the West with Wrightwood Capital in Chicago. “More and more lenders seem to be either exiting the business or more conservatively underwriting these opportunities.”
Scott Wicken, a senior analyst with Mountain Funding in Newport Beach, California, sees a similar situation with the condo market. “Most people are becoming a bit picky on condo projects and have adopted a ‘wait-and-see' attitude because of the boom in recent years in condo conversions and developments.”
Adds Jacob Wurzburger, managing director with Meridian Capital in Los Angeles, “Due to lenders' eagerness to lend on construction and condo development projects and historically low interest rates in the past few years, the condominium and construction market has been over-speculated in many regions such as Las Vegas and Phoenix.”
The retail market continues to be a popular property type in most areas, particularly Southern California. “There is still a premium being paid by investors, particularly private investors, for net-leased retail projects with national or strong regional tenancies,” says Choulochas. “We see this in both Phoenix and Southern California.”
San Diego is one of the hotter areas of Southern California, with one of the lowest vacancy rates in the nation, says Leo Morales, senior marketing specialist with Imperial Capital Bank in La Jolla, California.
In addition, while retail is doing well in Southern California, so are most other property types. For several years running, the region has been able to maintain strong growth almost across the board. “Generally speaking, the commercial real estate market remains strong in Southern California, despite rising interest rates,” says Wurzburger.
Joseph Milanowski, president with USA Capital, also sees Southern California, as well as areas of Arizona and Nevada, as active areas. “The markets that are hot right now [include] Southern California and the Sacramento/ Central Valley region,” he adds.
Adds Choulochas, “In Southern California, we see continued strength in the industrial markets both for-sale and for-lease, although increased construction costs may dampen the enthusiasm of developers for building new product.”
Timothy Ballard, chief investment officer and managing partner, and Thomas Sherlock, managing partner, with Buchanan Street Partners see the same trend in both office and industrial markets. “All office in Southern California is hot,” they say. “Industrial is hot, too, especially near ports.”
In Northern California, there is also a lot of interest in office properties, especially in the Silicon Valley. “The capital markets anticipated improving property fundamentals in the Bay Area, and some of those predictions are now coming true,” says Choulochas. “We are seeing local investors stepping up and taking on projects with significant lease-up risk in anticipation of improving market fundamentals.”
Office, even outside of California, is starting improve. Wicken with Mountain Funding has seen the office markets in many cities begin to rebound with vacancy rates dropping.
LEADING LENDERS IN 2006
Strong lending companies are able to ride the ups and downs of the market, while continuously providing their clients the loans they need. While what the market does or does not do is important, being able to adapt to the changes in the economy is most important for a successful lending firm.
Mountain Funding, headquartered in Charlotte, North Carolina, finances a full range of commercial real estate properties, including office, retail, multifamily and industrial, in all areas of the West. The company provides high leverage debt and mezzanine loans, in addition to equity, residential and commercial land loans, and hard money and bridge loans. At the moment, the most popular loan products among Mountain Funding clients are land acquisition and development, high leverage debt, commercial respositionings, and quick closing bridge and hard money loans.
The company recently handled a $25 million land bridge loan in California. “The deal was challenging because of the quick closing period (3 weeks), two unsubordinated ground leases and a very complicated underwriting and closing,” says Wicken. Mountain Funding was chosen to handle the loan because of the company's development expertise, quick closing capabilities and flexibility.
Greystone Servicing Corporation
While New York-based Greystone can work in any state in the West, the company primarily finances properties in California, Washington and Nevada. The company handles mostly multifamily and senior-living properties, but also small office, retail and industrial. “We are a Fannie Mae delegated underwriter and servicer and we provide largely fixed-rate long-term debt (10-, 7- and 5-year terms), but we can also provide adjustable mortgages, and we have a very strong FHA product line which includes amortizations up to 30 years,” says Toby Lieberman, managing director with Greystone in Mountain View, California. “We also have the capability to early ratelock for extended periods of time in order to preserve low rates in this rising interest rate environment.”
Greystone recently completed a $40 million transaction in the Silicon Valley area of California. The project had been purchased for cash and the company was ready to finance it. The biggest challenge was that 25 percent of the units at the project had been leased to a local university and all of the leases were expiring right around the date the loan was to close. In addition, the leases were not going to be renewed. Because of the strength of the borrower, Greystone was able to accept a corporate guaranty to cover the temporary dip in income and were then able to fund the entire loan. “Greystone was very creative in getting comfortable with the guaranty, rather than holding back a portion of the loan for a very short period of time while the property was restabilized,” says Lieberman.
Imperial Capital Bank
Imperial Capital Bank (ICB), which provides construction, bridge/interim and permanent loans, covers all western states, with the exception of Hawaii. The company provides financing for most income property types including office, retail, mixed-use, multifamily and light industrial. Additional special use and owner-occupied properties are considered on a case-by-case basis. The company's strongest products include the structured finance and bridge to stabilization programs. “We are uniquely able to understand transactions that need additional due diligence that other institutions are unwilling to provide,” says Morales.
ICB recently provided construction funds of $10 million to facilitate the repositioning of the former Sequoia Health Club and Conference Center in Buena Park, California, into a 34,000-square-foot, multi-tenant retail center, shadow-anchored by a new Target. “Challenges to the request included the constant changes in the tenant mix as well as in the overall size of the center while the loan was being appraised, underwritten and while under construction due diligence,” says Morales. By drawing on the strengths of different members of the ICB team, the company was able to close the loan. “The borrower was impressed with the ICB team's ability to adapt to constant change, and I am confident there will be future business for ICB with this customer,” says Morales.
Wrightwood Capital is based in Chicago, with offices in Newport Beach and San Francisco, California. In the West, the company primarily finances office, retail, multifamily and industrial properties. Loan types include structured senior financing, mezzanine and joint-venture equity financing in the $5 million to $50 million range. “Our primary focus today is in senior debt positions in the $10 to $50 million range for value-added business plans,” says Choulochas. At the moment, the company is seeing a strong demand for bridge loans for value-added business plans for office, multifamily and retail projects with some income in place. “Also, our non-recourse construction loan product is attracting a lot of interest from developers of industrial and retail properties,” says Choulochas.
In Long Beach, California, Wrightwood Capital provided a $29.5 million first deed of trust loan to finance the acquisition and repositioning of a 193,998-square-foot mid-rise office building. The repositioning included building out 7,500 square feet of speculative space into smaller 1,500-square-foot units and making significant capital improvements. Wrightwood was able to structure a 36-month term non-recourse acquisition loan which floated over the 30-day LIBOR interest rate index. “We were able to provide a financing package combining both aggressive pricing and leverage competitive with other lenders in our peer group,” says Choulochas.
Meridian Capital, based in New York, is active in all of the western states. The company arranges financing for multifamily, office, retail, industrial, co-op, hospitality, mixed-use and self-storage properties. Meridian also arranges fixed-rate, floating-rate, construction, mezzanine, bridge, forward-commitment and renovation/repositioning loans.
Recently, the company handled the $38 million financing of the Bay Club Apartments in Marina Del Rey, California. The property, which includes 205 apartments and 253 boat slips, is located on ground leased by the county of Los Angeles, and the remaining term on the ground lease was shorter than the term of the requested loan. Though challenging, Meridian Capital was able to deliver the best terms and service. “Upon discussions between Meridian's lender and the client, the lender was extremely impressed with the sponsor's market knowledge, due diligence, expertise and was sufficiently confident that the ground lease concern would be mitigated and offered very aggressive terms,” says Wurzburger.
Buchanan Street Partners
Newport Beach, California-based Buchanan Street Partners provides permanent, bridge, construction, jv equity, mezzanine, forward-commitment and pre-sales loans in all areas of the West. A recent transaction that the company handled was $61 million of debt and equity financing for the acquisition of three Class A office buildings, totaling 323,000 square feet, in Ontario, California. The client, CIP Real Estate, was looking to recapitalize their venture through a sale to a new entity controlled by CIP. CIP acquired the assets in phases and was looking to replace its partner with a more passive long-term partner. “The main challenge was sourcing a long-term equity partner on an off-market transaction to meet CIP's goals of holding onto the asset and at the same time realize the gains from original acquisition,” say Ballard and Sherlock of Buchanan Street. “The secondary challenge was to establish the purchase price balancing the needs of the seller and original investors as well as the new long-term equity.”
Buchanan Street Partners had worked with CIP on many previous transactions and was therefore able to capitalize on its knowledge of the asset and CIP's future goals.
Johnson Capital provides financing for a wide variety of property types including multifamily, retail, office, industrial, manufactured housing, self-storage, and flagged and non-flagged hotels. Johnson Capital is based in Irvine, California, and has offices all across the country. The company provides all loan types including bridge, mezzanine, permanent, equity and construction.
Recently, Johnson Capital was retained to provide financing for the acquisition and conversion of a Southern California class A apartment complex into condos. “The borrower's goal was maximum leverage under a short timeframe,” says Gary Bechtel, managing director with Johnson Capital. “The borrower was requesting maximum leverage of up to 100 percent of the total project costs.” Johnson Capital was able to provide a package using a combination of bridge, mezzanine and equity components that produced a 97 capitalization structure. “We had an outstanding relationship with the borrower and have been involved in the placement of a number of these types of financing that gave us credibility with the client as well as the capital markets community,” says Bechtel.
Las Vegas-based USA Capital finances residential, industrial, office, retail and multifamily properties in California, Nevada, Arizona, New Mexico and Washington. The company provides all types of loans including short-term and permanent financing for acquisition, development and construction.
USA Capital recently provided more than $36 million in funds to Marlton Square Associates to purchase the existing Santa Barbara Plaza in order to demolish the center and prepare the site for resale to separate developers for construction of 140 single-family homes, 150 condominium units, 180 senior housing units and 116,000 square feet of retail space. The city of Los Angeles also committed to a package of incentives in order to encourage the redevelopment. “Our biggest challenge was acquiring the land from multiple property owners and assembling it into the deal to meet the Los Angeles city government's criteria for releasing redevelopment funds for the project,” says Milanowski. Because USA Capital has significant experience in working on redevelopment projects and those that involve government funding, it was able to provide the flexibility needed to allow the acquisition within its collateral requirements.
In 2006, there will be changes in both the interest rates and cap rates, though these changes have been predicted for a while. Since the changes are expected by most in the industry, there shouldn't be any drastic changes in the lending environment. “We do not believe the gradual rise in interest rates will have a dramatic effect on the market,” says Wicken. “Some markets will gradually soften and lending criteria will become a bit more conservative. Despite this there will still exist a strong overall market as well as continued demand for financing and development.”
Bechtel at Johnson Capital also believes that 2006 will be another good year for the financing of commercial real estate, though not as “frothy” as 2005. “The continued/potential increase in interest rates will not have a great effect on the amount of transactions that are financed, especially given the amount of loan products available today that were not in existence 5 to 10 years ago when a number of the loans that will be maturing were originated,” says Bechtel.
Say Ballard and Sherlock, “Assuming interest rate increases are in line with the ‘blue chip' economic forecast, then rising rates should have little influence on the supply of capital flowing into real estate. We believe the compression of cap rates will end and rising interest rates may cause a moderate increase in the cap rate environment.”
Choulochas sees a continued increase in interest rates, but at a slower rate than has been seen over the previous year. “Short term rates will continue to rise, although the pace of increases will abate,” he says. “Strong demand for properties with cash flow has kept cap rates in check.”
Says Lieberman, “As in the past, I think that the increase in interest rates will cause a temporary slow down in real estate financing. However, there is a record number of refinances that will be coming up in the next 2 or 3 years, and I believe we will see more refinancing activity than purchase activity.”
Milanowski also predicts a slow down in certain areas, due to the rising interest rates. “Rising interest rates will slow down absorption of certain product types, especially residential as they slow sales of homes,” he says.
As the changes in the market are not surprising, banks and lending institutions have modified their businesses accordingly. “We find lenders have adjusted their underwriting criteria,” says Wurzburger. “Some are very comfortable with the market and are still aggressive while others have tightened somewhat. There is still so much money chasing real estate deals that while there may be some adjustment to allow for higher interest rates, the market will probably adjust to reality without a significant downturn.”
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