FEATURE ARTICLE, OCTOBER 2005

CAPITAL FLOWS TOWARD FUNDAMENTALS
Strong property market fundamentals bode well for commercial real estate lending.
William Hughes

Hughes

The Federal Reserve will most likely continue its policy of modest rate increases to address potential inflationary pressures. This is likely for a number of reasons, including the current level of corporate earnings, the increasing cost of energy, improving employment numbers and consumer demand putting upward pressure on wages. While these issues clearly create upward pressure on interest rates, don't anticipate increases to the levels forecasted at the beginning of the year. Realistically, the 10-year Treasury could rise 20 to 50 basis points higher than its current level.

Of course, there are issues that could change this scenario. A bond rally in 2006 caused by decelerating inflation, a flat labor market and poor stock performance could occur. This could, effectively, slow down the Fed's march of interest rate increases. On the other hand, even if the Fed continues to push rates higher, there are factors that will hold yields within a reasonable range that still supports the current activity in the commercial real estate arena.

There was a period at the beginning of the year when the market was segregated by product type. The major property groups carried different spreads. For instance, the apartment sector, which has been the darling of the industry for a while now, was priced at the lower end of the scale, with hotels and motels priced at the higher end of the scale. Now there is a narrowing of the difference between the two prices. The difference between the primary groups — apartment, retail, office and industrial — has almost come together. There is little significant difference in pricing for these product types. Good quality real estate is being priced at somewhere between 100 and 115 basis points over corresponding Treasuries. Hotels and motels are certainly priced outside that category, but they have come in substantially from where they were at the beginning of the year.

Another trend in commercial real estate is the market share gain of conduit lenders. It's difficult to quantify the gains that conduits have made because different types of lenders are now acting as securitized lenders. Bank of America, for instance, is participating heavily in the commercial mortgage-backed securities arena when it comes to originating long-term fixed-rate mortgages. KeyBank, LaSalle Bank and other large lending institutions are following this path as well. A number of insurance companies are undertaking practices traditionally followed by commercial mortgage-backed securities lenders. Prudential, Hancock and other companies fall into this category. It's challenging to understand who is participating in the CMBS arena and who is not, but clearly the securitized product is taking a healthy bite out of other lenders' business. The reason for this increased market share is that securitized lenders now take in all product types. They enter tertiary markets. They are aggressive when it comes to pricing, and they are very competitive in terms of repayment schedules. And, finally, they are starting to create structures that allow them to be more flexible in the way they do deals.

In general, lenders have become more imaginative in their approach to transactions. They are all trying to do more business and some are pushing the envelope in terms of the deals they'll do. They are entering new markets and taking on new product types. They have, in effect, broadened their scope in order to compete for business and retain their lending positions. It is a competitive time for lenders, and they are moving outside of their traditional roles and markets. However, in most instances, they are not taking undue risk. Lenders are underwriting properly and, although they are somewhat out of their comfort zone, they are following sound underwriting principles.

In general, the outlook for commercial real estate lending in the mid-term is good. There are several reasons for this. The consistent flow of capital and a forecast of only moderate interest rate increases contribute to this positive outlook, as do a strengthening economy and improving real estate fundamentals. This is especially true for the western United States. With this said, it may be true that some commercial real estate investors will, from time to time, move to the sidelines to evaluate the market. Basic real estate fundamentals, however, are still strong, particularly in California. In the end, geographic constraints in the state will likely prevent any major fallback in values as the market moves into 2006 and beyond.

William Hughes is a managing director and senior vice president for Marcus & Millichap Capital Corporation.


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