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COVER STORY, JANUARY 2007
FINANCIAL FORECAST FOR 2007
As investment prices continue to rise, lenders rise to the occasion with various deal structures.
David Koepf and Roberta Fuhr
As 2006 came to a close, developers, investors and lenders alike were wondering what the future would hold for commercial real estate in the West. Interest rates and energy prices are the big unknowns that no lender can ignore — or predict. Despite these uncertainties, some of the commercial real estate finance trends that emerged in recent years are likely to continue to permeate the western region, with some common macro-level trends affecting markets from San Diego to Seattle, Burbank to Bellingham.
Residential Cause – Commercial Effect
Although interest rates appeared to be holding steady in late 2006, the increases of 2006 had a dampening affect on housing markets nationwide. Conversely, this created many home runs for investors lucky enough to find multifamily investment properties. The challenge in the apartment sector continued to be finding the deals, since construction and land costs continued to affect the economic viability of many sites. Many multifamly financings have involved joint ventures with land and longtime owners. Investment sale pricing has reached record-high levels for the opportunities that are out there where the numbers work and sometime even where they don’t. Cap rates keep decreasing, with many deals in the 4-percent range and some sub-4’s beginning to show up on the radar screen. In 2007, expect construction costs to plateau, which may spur additional new development and take the pressure off the sales of existing assets in the market.
One way to approach the shortage of land for multifamily product is to approach projects not just as apartment deals, but as mixed-use developments. The shortage of new development sites in high-density, mature regions, combined with burgeoning public interest in “smart growth” planning, has opened the door to some exciting mixed-use developments and community investment programs. While sometimes challenging to finance, especially where public-private partnerships are concerned, such projects have the potential to create additional redevelopment and property investment opportunities in the surrounding communities.
Retail, Office and Industrial – the new “ROI”?
Beyond the apartment sector, other commercial property types are also going strong as investment vehicles. You might say a good way to achieve ROI is to invest by the letters — in Retail, Office and Industrial.
In the retail sector, lenders continue to look favorably on neighborhood shopping centers and lifestyle centers, while keeping a close eye on the retail industry as a whole. The best financing terms are available for properties that are well located and leased, reflecting lenders’ commitment to strong underwriting on construction and permanent loans. In particular, lenders are scrutinizing grocery-anchored centers more closely than in the past and are reluctant to finance properties anchored by grocers that may not flourish and keep the rent checks coming in — i.e., a grocer that does not fill a very specific niche is likely to be acquired or is not dominant in the local market.
In the office sector, property values continue to appreciate at a record pace. Again, finding the deals is the challenge, particularly if you are looking at major coastal markets. Many investors are looking at secondary and tertiary markets because they are priced out of major metropolitan areas. For example, properties in Sacramento are providing an investment forum for those looking for a San Francisco alternative. In Washington, the communities of Spokane, Tacoma and Olympia are seeing investor interest from entities that previously looked mainly in Seattle. As the competition for deals remains high, lenders are being extremely careful in underwriting each transaction, while offering new deal structures that make the numbers work for those with strong credit.
New Financing Structures
The need to compete by offering new deal structures is behind one of the most significant trends in recent years: the ever-increasing sophistication of commercial real estate financing and the subsequent increase in financing options available to developers and investors. Developers involved in new construction or redevelopment of older properties can gain a competitive advantage over their peers if they educate themselves in the emerging financing structures designed to maximize return on investment.
In today’s world, a developer does not necessarily need to secure separate loans for interim and permanent project financing. Those with a proven track record and a strong credit rating may be able to pre-negotiate financial packages that include both interim and permanent financing for new construction or redevelopment.
Increasingly, savvy developers are not only locking in interest rates for permanent financing before a shovel hits the ground, but also are able to concentrate on the business of development with the long-term financial details already in place.
Structured Finance on the Rise
The recent era of low interest rates and aggressive loan-to-value ratios has led to greatly increased use of mezzanine debt and equity. As interest rates fell to record lows in the past few years, borrowers’ appetites for mezzanine debt naturally increased exponentially as a means of closing the equity gap with affordable capital. Since some first mortgage contracts prohibit the use of mezzanine debt, borrowers also have turned to preferred equity. Formerly the province of specialized investment firms, preferred equity today is available through a wide range of capital sources, including commercial banks.
Investors in small retail centers or multiple apartment properties, for example, are finding that the use of preferred equity can increase the number of properties in which the borrowers can invest because their equity is not tied up in a single project. In addition, some lenders are willing to combine preferred equity financing with a developer’s cash equity to enable the borrower to undertake a significantly larger project. In this manner, the borrower can increase its return on investment by a proportional amount and all for the same upfront commitment of funds.
Conversely, as interest rates rose last year, thus reducing the loan amount a borrower could receive on a first mortgage, lenders have sought other ways to replace lost leverage through complex structured transactions. This challenge has led to the emergence of collateralized debt obligations (CDOs), in which the lender uses short-term debt instruments as collateral and replaces them with new collateral as borrowers pay on those assets. As an alternative to CMBS loans, CDOs will likely play an increasingly important role in commercial real estate financing in the coming year. Whole loans and transitional assets can also be placed in the CDO providing lenders and borrowers with more flexibility in financing.
Big-picture Financing
In addition to adopting sophisticated new project financing techniques, developers also are learning to address their short- and long-term financial goals with holistic solutions that some lenders are now able to provide. For instance, the developer may find that a line of credit, rather than simply seeking project-by-project funding, is the best way to support a national expansion program. Some developers and acquirers are also boosting the bottom line through technology-based treasury management programs that expedite deposits and vendor payments, incrementally increasing returns on interest-bearing accounts.
New & Improved CMBS
As the CMBS market has matured over the past decade, conduit lenders have learned how to meet the needs of investors and mortgage borrowers alike with more flexible programs than in the past. While the “plain vanilla” conduit loan is still the norm, even the simplest transactions tend to not be quite as status quo as they once were. The market’s increased ability to rate and sell CMBS traunches has allowed conduit lenders to finance transactions more aggressively than before and still find CMBS investors.
As a result, today’s conduits can securitize floating-rate balloon loans, construction loans, mezzanine loans and loans with interest-only periods followed by below-the-line amortization, defeasance requirements or prepayment penalty fees and other loan variations far beyond the traditional fixed-rate, long-term mortgage. This new flexibility is enabling developers and property investors to pursue their business plans more cost-effectively than ever before, while addressing the inherent risks of commercial real estate investment.
Roberta Fuhr is senior vice president and northwest regional manager for KeyBank Real Estate Capital in Seattle. Dave Koepf is senior vice president and team sales leader overseeing Orange County and San Diego for KeyBank Real Estate Capital.
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