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COVER STORY, FEBRUARY 2010
COMMERCIAL LENDING UPDATE
Experts discuss the critical financial factors in the West.
compiled by Brian A. Lee
The performance of the capital markets is obviously a big thing to watch this year as most western commercial real estate sectors look for stability. Western Real Estate Business contacted three Los Angeles-based financial executives — Ryan Krauch, a principal at Mesa West Capital; Wayne Brandt, a managing director at Buchanan Street Partners; and Gary Mozer, a principal/managing director at George Smith Partners — for their expert commercial lending views on 2010.
WREB: How do you see the commercial lending/financial market this year?
Krauch: The capital markets will still be severely constrained on a relative basis in 2010, but will see some increased liquidity in certain areas. Certain life-insurance companies will have increased allocations, the securitization market will see a few deals executed and potentially some of the limited capital that has been raised both privately and publicly will begin to get deployed. In all cases, the lending criteria will be very strict and limited to higher quality assets in top markets with reputable borrowers. For some of the best quality assets, there may even be a mini-capital bubble since any capital source that is active will want to pursue these assets, which will result in good pricing for the borrower.
Brandt: 2010 will be a big year for determining the direction of commercial real estate. The most difficult part of the downturn is behind us: the equity and bond markets have pretty well stabilized, in real estate and otherwise, and the big banks have made great strides in de-leveraging and stabilizing their portfolios. Most importantly, buyers and sellers have begun to capitulate, which results in transactions. The byproduct of increased transactions is price discovery, which thaws investment channels for both debt and equity. Despite all that, there is still very little efficiency within the debt markets as weaker banks continue to fail and consolidate, spooking investors. So the question that remains is how long until things stabilize and what does stabilization look like. That remains to be seen, but 2010 certainly marks the beginning of that road to recovery.
A rebound will be driven by increased transaction volume, which doesn’t happen until investors and banks alike fix their existing problems, have success raising additional capital, and can find adequate financing to generate acceptable returns — probably in that order. Fundamentally, in a predominantly consumer economy, job growth will help stoke space demand and consumption, which directly benefits office, industrial and retail sectors of real estate. Additionally, as public policy allows for banks to extend distressed loans without any consequences for the banks or the investors, this will continue to limit access to debt and prohibits establishing reliable pricing for buyers. So, for these assets that are 100 percent or more leveraged, either the bank or the owners will need to shoulder the distress so the market can move on.
Mozer: Assuming no exogenous events panic the system, we see a continued improvement in the capital markets. Capital has been on the sideline for nearly 2 years. Meanwhile, the Fed is infusing liquidity like never before. The big banks are quickly earning their way through losses with record profits based on the low cost of capital and are looking for new opportunities. Strong demand for high-quality bond paper among fixed-income buyers is driving yields down, thereby increasing the appeal of commercial real estate lending for pension funds and life companies. Opportunity and hedge funds are popping up every week with capital to place, often with a dividend obligation that forces them to deploy capital. So there is a lot of money around.
WREB: Is there a sweet spot where you feel comfortable lending in today’s environment? What criteria must deals hold today to garner your attention?
Krauch: We have always focused on institutional-grade assets throughout the western United States, typically between $10 million and $50 million in size. We support borrowers that have expertise in both the asset’s product type and geography. Often our borrowers are seeking to add value to the property through a renovation or lease-up program, though in today’s environment many are simply seeking capital for more stabilized property types or to recapitalize an existing capital stack. Most of our borrowers realize that long-term options in this environment are not ideal while loan proceeds are down against depressed values and rates are up. We are able to provide borrowers flexible pre-payment structures that will allow them the opportunity to refinance as soon as the capital markets recover.
Brandt: We are finding opportunity in distress as well as healthy, stable assets. But generally speaking, in order for us to feel comfortable in this environment, our loan must be able to stand on its own, meaning that the asset produces adequate cash flow to support the debt service on the loan. As rents and occupancies decline, reducing the levels of finance-able cash flows, we can still manage to find comfort in the loan by focusing on basis and market fundamentals.
Mozer: Underwriting and credit are back to fundamentals; conservative assumptions, simple structures and strong cash flows. Capital prefers quality over yield. The easiest transactions are Class A, with respect to asset, tenant, market and sponsor. That said, we look for transactions with a defined need. Users of capital will only accept the pain of transitioning from 2006 to 2010 underwriting if a forcing mechanism exists. Old paradigm capital is an asset that we usually advise our clients to hold on to.
WREB: Do you find in this market that you are focusing more locally, regionally or nationally? Why?
Krauch: Given the lack of liquidity throughout the system, there is widespread demand for our product throughout the country. We are focused on what our clients need, and their needs are not limited by geography. Fortunately, although we have a large western United States presence, we are well versed in markets throughout the country and have been able to deliver for our borrowers from coast to coast.
Brandt: Naturally, we have an advantage in markets where we have presence as it relates to market intelligence, branding, banking and developer relationships, etc. However, our focus is not limited to a particular region; we are working to find the best local operators in the top markets around the country.
Mozer: Good real estate is good real estate, and we work nationally. But as a Los Angeles-based firm, we have more experience in the western United States and emphasize that geography in our business development. Real estate is a regional industry. Corner-by-corner expertise makes the deal. So we are focusing on the markets we know best. The only recent change for us is deemphasizing tertiary locations, as they are particularly difficult to finance today.
WREB: What commercial property type should stand out the most during 2010 and why?
Krauch: Hospitality will be the sector to watch. It was the hardest and earliest hit, but it is generally the first to recover as well. How this sector performs in 2010 will be a good harbinger for the performance of the other product types.
Brandt: Depending on how fundamentals fare, particularly job growth, office may continue to experience significant deterioration in cash flows as leases done in the boom years expire and reset to market rates. Also, higher unemployment will result in less demand for space, leaving large vacancies, irrespective of market or asset quality. This has the potential to significantly depress cash flows and values for office product.
The corporate level and bankruptcy concerns for retailers appear to have eased, so provided that consumption returns to normal levels and consumers again have reasonable access to credit, retail could potentially present some exciting opportunities.
Mozer: Multifamily and credit-tenant real estate will benefit from advantageous financing and therefore show higher values/lower cap rates. Multifamily assets benefit from subsidized agency money. The private sector is picking up the slack left by the Treasury’s reduced GSE bond buying, and the Treasury will probably increase its activity if demand weakens; agency paper will continue to prop up multifamily values. Bonds dominated 2009 debt markets, as capital looked for quality; a record $146.5 billion in high-yield bonds were issued according to Thomson Reuters LPC. Credit tenant leases allow real estate investors to access the fixed-income capital market directly and will continue to enjoy strong relative liquidity and low costs.
WREB: What is the biggest concern or demand you’re hearing now from commercial developer and investor clients?
Krauch: Clients are looking for capital that can help them either de-leverage existing product or take advantage of some of the distressed product that is and will become available. They are looking for capital sources that can move quickly when needed to exploit these opportunities and can also provide flexibility in terms of pre-payment and structure.
Brandt: Nobody wants to be the first one back in the game for fear of getting burned again, but specifically, both developers and investors are worried about inflation, valuation and access to affordable debt in the face of approaching loan maturities.
Mozer: Most of our sources are behaving as if we have turned the corner on the credit crisis, but general economics are less certain so we are still waiting to call a bottom on the ongoing deterioration in fundamentals — rents, occupancy and absorption. Most of our clients are focused on managing interest-rate exposure, as recent policies will ultimately drive long-term rates higher. But looming maturities that cannot be refinanced are the most immediate and significant risk to the health of the capital markets themselves.
WREB: What’s the biggest or most unique financial trend you’re seeing within the distressed real estate segment in the West?
Krauch: The discounted payoff (DPO). We are finally starting to see lenders willing to part with assets at a reasonable discount to par, though mostly with existing borrowers as opposed to third-party buyers. We are able to finance the DPOs for our clients, which creates a great win-win for everyone involved.
Brandt: I am not sure this is unique to the West, but capital has completely evaporated in overbuilt markets like Phoenix, the Inland Empire and Las Vegas. However, multiple capital options exist for good product in more stable markets like San Francisco and Los Angeles.
Mozer: We are excited about 2010 — the transactional world is improving. The bid-ask spread is narrowing from both sides. Lenders are gaining confidence in their work-out decisions and increasingly willing to foreclose. Capital is returning to the system.
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