FEATURE ARTICLE, MARCH 2006

LAY OF THE LENDING
Do commercial lenders in the West see an ebb or continued flow from the region's capital hill?
Ned O'Hearn

Previously, investors might get jittery about prices slipping from the jagged peaks seen recently in most western markets, but now lenders are typically exercising caution. To get a less emotional and hence more reliable reading on even subtle changes in the investment climate, lenders are the ones to talk to.

The good news for investors in several key markets throughout the West is that lenders remain confident that there's nothing of concern on the immediate horizon. But that doesn't mean they're not keeping watch.

“Given the momentum of our economy and the tremendous population growth, I see the overall market remaining strong in all sectors for the next couple of years,” says Greg Steinhilber of L.J. Melody Capital Markets in Phoenix. “Lenders are eager to lend on anything that makes sense.”

To Steinhilber and others serving the frenetically busy Phoenix investment market, there really aren't any product types that don't make sense. When surveyed about product types that remain in “strong demand,” the boxes for office, industrial, retail, multifamily and land all got checked. No sector was identified as “weakening.”

That's probably because cap rates have yet to creep upward, something that has surprised market observers like Steinhilber. “Watch for cap rates to start inching higher,” he cautions, “especially if interest rates continue to rise.”

Sandy Throop scans the market from his perch as director of asset/fund management for Hanover Financial Company in Los Angeles. “When asked about general market conditions I always say, ‘It depends,'” he says, tempering his generally optimistic outlook. “We are seeing continued strength in the West Coast apartment markets, with plenty of buyers. Similarly, there's a great deal of strength in the owner/user market for smaller office and industrial buildings.”

“Weak buyer demand is an oxymoron in the present climate,” adds Jeff Teetsel, vice president and regional manager for Fremont Investment & Loan. Like a frontier days cattle driver, Teetsel's perspective cuts a wide swath across the west, covering properties in Arizona, Colorado, Idaho, Montana, Nevada, Utah and Wyoming. And, again like a cowboy in a McMurtry novel, Teetsel is struck by all the land speculation going on.

“Land speculation is rampant,” he observes. “Some buyers in 2006 will be proven to have made the wrong bet, but good deals still exist and fundamentals remain strong in markets like Phoenix.” He regards interest rates in the manner he'd eye wolves around a herd. “Interest rate increases will at some point have to temper cap rates, but I don't see much evidence that it's happened yet.”

In addition to keeping a close eye on interest rates, some lenders are increasingly guarded about markets where the rise in appreciation has been staggering. “The key is to be wary of markets that have experienced rapid appreciation,” says John Kutac, business development officer for Western Capital Partners in Denver. “Buyers looking to get in now have probably missed the ramp up and will be overpaying in markets where a lot of inventory will be coming online.”

Kutac acknowledges, however, that generalizations shouldn't guide investment decisions and that the viability of different product types varies from one market to another. “Dallas is a poor apartment market and Denver is just emerging from a terrible office run,” maintains Kutac, whose broad focus encompasses the entire West. And, like Teetsel, Kutac is uneasy about the land market, stating that “speculative buying has created a cautious approach to land from most lenders.”

One portion of our random interviews with lenders in western markets sought advice for investors “who purchased property in the past 2 years and might be growing concerned about value slippage.” The majority of respondents favored holding those properties for the long term. “If the fundamentals on your real estate investment are sound, I recommend holding for the long term,” says L.J. Melody's Steinhilber. “Growth and migration trends continue to favor Sunbelt cities, and that's not going to change. As these cities mature, owners of well-located and fundamentally sound investment properties will reap the benefits.”

Hanover's Throop provides an additional thought for investors — holding assets that are snuggly within one's “core areas of competency.” “It's too costly to replace similar assets,” he contends, adding that there's so much capital waiting on the sidelines for markets to decline that competition for replacement assets will be fierce.

Western Capital's Kutac does envision scenarios where investors might consider unloading properties. “If the property is income producing, owners should understand that current cap rates are truly unprecedented and, without a long-term hold strategy, they should consider capitalizing on them.”

Dan Nillen, vice president of Commercial Real Estate at M&I Bank in Phoenix agrees. “The bubble hysteria appears to be more media driven than anything,” he contends. “That being said, there's nothing wrong with putting some money in your pocket!”

Fremont's Teetsel would go one step further in advising investors. “If you've got a buyer willing to pay you for the upside that's not yet materialized, and you are in at a basis from a couple of years ago, then the easy money is selling soon.”

One subject mentioned in the survey that caused our lenders to sigh, if not gasp, was the frenetic pace of condo conversions in markets throughout the West. Lenders are decidedly growing concerned over the number of hotels and apartments being snapped up for conversion purposes.

Curtis Hansen, senior vice president at the National Bank of Arizona feels that the Phoenix condo-conversion market is definitely oversaturated and that lenders are now very cautious in making loans. Phoenix's Steinhilber and Denver's Kutac observe a weakening condo-conversion market where lenders are “exercising more caution” on loans. “Lenders need to be careful with condominium conversions since there's been such a dramatic increase in inventory,” warns Kutac. Again, however, he tempers that generalization by citing “considerable opportunities in newly emerging markets, as well as select existing markets, like Los Angeles.”

Steinhilber's caution is rooted in market depth. “Everyone is curious to see if all these condo units sell,” he pointedly observes.

Southern California might represent the exception. David Braga with Scripps Investments & Loans in La Jolla, California complains of a “lack of supply,” adding that lenders are most willing to make condo-conversion loans in his area.

The lenders contacted were generally sanguine about the overall state of the investment market. “It's a truly great time to borrow,” exudes Steinhilber. “Treasury yields remain close to an all-time low, and the spread over Treasuries that lenders charge is about as tight as it has ever been.” But even such unabashed enthusiasm has a caveat.

“If there's any economic shift that leads to defaults, or if mortgage-backed securities suddenly fall out of favor with investors, we'll see an immediate widening of spreads. If that happens, all bets are off!”

Betting on the investment market is something that most investors thrive on, from those who have proven to be savvy to those who have proven not to be. But, the best sense of the gambler's risk isn't gained by watching how investors play. The best sense comes from the lenders behind them, and, for now at least, most of them are smiling.

Ned O'Hearn is a principal with Scottsdale, Arizona-based Boulders Realty Advisors.


©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.