COVER STORY, SEPTEMBER 2004

MAKING SENSE OF DOLLARS
Lenders discuss lending trends in the West.
Brian A. Lee

With the lending industry expecting further increases in interest rates, borrowers in commercial real estate are taking advantage of the still-low cost of debt to lock in rates for longer terms. Most lenders agree that loan volumes will not be negatively affected as the amount of capital and level of demand in the West are still robust. The changing lending landscape will have an effect, however.

KeyBank Real Estate Capital provided financing for NorWood Development Group’s First & Main Town Center, a lifestyle center located in Colorado Springs, Colorado.

“While 2003 was a banner year for permanent loan financing due to historically low interest rates, the balance will shift for lending opportunities in [late] 2004 and 2005 back to more traditional and creative portfolio balance sheet loans that we experienced in 2001 and 2002,” says Tracy Edgers, senior vice president for KeyBank Real Estate Capital in Bellevue, Washington.

Of Products & Markets

Reacting to the dwindling supply of less expensive housing in Southern California, many developers are acquiring apartment communities with plans to redevelop them into for-sale condominiums. As a result, condo conversion and development loans are in great demand throughout the market, especially with the housing supply continuing to lag behind residential demand, says Tom Sherlock, executive vice president at Buchanan Street Partners. “Escalating prices relative to income, coupled with the difficulty in getting new development started, makes many conversions a profitable business plan,” he says. “While the going-in cap rates are extraordinarily low, the unit exit prices result in an attractive profit margin to the converter. As a result, we have seen apartments with a condominium map in place trade at cap rates in the 3 percent range.”

The current low interest rates on home loans have fueled the customer demand for condos with many first-time homebuyers entering the market. According to Gary Mozer, chief executive officer of George Smith Partners in Los Angeles, a similar thing is occurring on the commercial side: “Industrial condos are also very popular due to the same reasons — low interest rates, demand for product and ready access to financing. Developers are acquiring large single-tenant industrial buildings to redevelop into a building [featuring] several for-sale industrial condominiums. Many small companies are finding that low interest rates and SBA loans make acquiring space as affordable as leasing space.”

Edgers affirms that acquisition financing for such repositioning opportunities “necessitate 2- to 3-year interim-term bridge loans and often require a layer of mezzanine debt that remains in place until the property is stabilized. Exit strategies vary between a sale of the property or refinance, but loans are increasingly in need of intricate financial structures.”

In addition to the condo conversion financing, Mozer lists non-recourse construction loans, equity and mezzanine debt, quick-turnaround deals, and empty building loans as the more popular loan products in the West’s lending market. Freddie Mac tax-exempt floating rate bond credit enhancement and Fannie Mae DUS extended maturity options are popular loan vehicles for residential purchases, according to John Davis, executive managing director of Collateral Mortgage Capital.

John Loshbaugh, associate director for LaSalle Bank N.A. in Newport Beach, California, mentions retail first when asked what property types are the hottest in commercial lending in the West. He says that loan requests for office products are starting to pick up after an extended lull while hospitality continues to be a difficult asset class. As for the different western markets, the results vary per sector. “Office product in the Pacific Northwest and Phoenix market continues to have some pockets with higher vacancy rates, and there are certain multifamily areas in these markets where concessions need to be carefully addressed,” says Loshbaugh. Jay Rollins, senior vice president and managing director for Newman Financial Services in Denver, puts the retail and multifamily sectors at the top of the list, adding that office builders in markets other than Southern California continue to face challenges.

Edgers of KeyBank finds multifamily properties to be in greatest demand for those seeking capital for commercial real estate. “In fact, sellers of apartment properties are commanding capitalization rates of less than 6 percent,” he says, before acknowledging the strength of the aforementioned condo conversion trend on the for-sale side of the sector. “Retail properties in the greater Puget Sound region moved through the economic downturn with nary a hiccup in occupancy and performance, and remain solid investment and development opportunities.”

Leading Lenders

Lenders have arranged and closed many complex loans in the West. Their unique loan offerings, targeted to every facet of commercial real estate, have resulted in unique developments.

Buchanan Street Partners

Sherlock

Buchanan Street Partners finances office, retail, multifamily, industrial, hospitality and mixed-use properties across the West. The company, which has offices in Los Angeles, San Francisco and Newport Beach, California, provides equity and debt financing for permanent, construction, bridge and mezzanine loans as well as joint venture equity.

Staying on top of the condo conversion trend, Buchanan Street Partners recently advised ColRich Investments on the acquisition financing for its purchase of Haverhill at Highland Reserve in Roseville, California. The client plans a condo conversion of the 400-unit Class A complex. Buchanan Street structured a $55 million bridge loan, funded by PB Capital, that featured a $41 million funding at close of escrow and enabled another $14 million to fund future conversion costs.

Churchill Mortgage

Los Angeles-based Churchill Mortgage focuses mainly on financing office, industrial, retail and multifamily projects but has the flexibility and expertise to provide financing for such property types as hotels, self-storage and even marinas. Serving 11 western states with an emphasis on California, Arizona, Washington and Oregon, the company does the bulk of its business through Churchill’s life company and CMBS correspondents. Through these entities, Churchill provides long-term fixed- and floating-rate debt by way of construction, permanent bridge loans.

Earlier in the year, Churchill arranged a loan commitment on a large Class A apartment project. However, as the deal was being worked out, financing rates began to rise and forward rate premiums widened. Churchill leveraged its 35-year relationship with a New York lender to meet the borrower’s needs, getting the lender to lower the forward premium on the loan as well as provide additional funds for the rising construction costs.

Collateral Mortgage Capital LLC

Based in Birmingham, Alabama, Collateral Mortgage Capital provides financing for all property types across the nation, including western states California, Nevada, Arizona, Washington, Oregon and Idaho. A privately owned commercial mortgage banking firm, the company is a Fannie Mae DUS lender, a Freddie Mac Program Plus seller/servicer lender and a MAP-approved (Multifamily Accelerated Processing) FHA mortgagee and the exclusive correspondent for its affiliate, New South Federal Savings Bank. Collateral Mortgage Capital’s investor base includes insurance companies, conduits, pension fund advisors and commercial banks.

Davis

Collateral Mortgage Capital recently funded a $16.1 million first mortgage loan for the senior housing project, Aegis of Escondido, in Escondido, California. Funded through Fannie Mae, the financing was issued in two forms —a $14.34 million tax-exempt bond credit enhancement followed by a floating-rate discount mortgage-backed security (DMBS) of $1.76 million. Collateral Mortgage worked with Fannie Mae’s multifamily structured transaction group and Fannie Mae’s senior housing group to negotiate and issue the financing, which was a permanent take out on an existing construction loan.

“The deal was more complex than a standard, conventional transaction in that the property was added to an existing credit facility and included tax exempt bonds as well as conventional DMBS,” says Davis. “This required the coordination of a greater number of interested parties. The transaction closed on time and went very smoothly.” Collateral’s Seniors Housing Group is dedicated to financing senior housing facilities across the country.

George Smith Partners

A Los Angeles-based commercial mortgage brokerage firm, George Smith Partners specializes in arranging acquisition, construction and mezzanine loans along with joint-venture equity and highly leveraged participating debt. Since 1997, the firm has arranged financing in excess of $11 billion.

George Smith Partners recently arranged a 10-year, $71.5 million fixed-rate loan, at 65 percent loan-to-value, for a 1,000-room resort hotel and convention center in Southern California. According to Mozer, the firm placed a loan for the property owner more than 6 years ago and the balance at close was approximately $36 million. The defeasance cost was more than $6 million, but George Smith Partners still achieved a significant cash-out for its client. The firm’s hotel expertise, extensive capital market relationships and local knowledge were integral in closing the deal.

KeyBank Real Estate Capital

Edgers

Cleveland-based KeyBank Real Estate Capital finances all property types in California, Nevada, Arizona, Colorado and Utah. The company provides construction and interim loans; syndicated financing; commercial mortgages; market-rate equity and mezzanine debt; investment banking and advisory services. KeyBank is a full-service lender that finances projects requiring multiple loan types.

This year, KeyBank structured a complex $15.3 million financing package for the site acquisition and construction of Newberry Square, a mixed-use project in Lynnwood, Washington, located 20 miles north of Seattle. KeyBank had to deal with many challenges in this deal, including a development type unprecedented in the suburban market, stubbornly high vacancy rates and a project pre-leased only with developer-occupied space. Knowledge of the market and developer coupled with KeyBank’s robust portfolio of services enabled the project to go forward. Mezzanine debt was also needed to complete the project’s total capitalization.

LaSalle Bank N.A.

Loshbaugh

Based in Chicago, LaSalle Bank N.A. services all property types across the West with a range of products, including conduit facilities and fixed-rate, long-term (5-, 7-, 10-year terms) non-recourse loans. The company also offers amortizations up to 30 years and fully amortizing facilities up to 15 years as well as hybrid products like float-to-fixed loans, which offer floating rate debt for transitional properties nearing stabilization with a fixed-rate (conduit) exit.

This spring, LaSalle refinanced a 550,000-square-foot specialty-use office building in the Jewelry District of Los Angeles for $50 million. The deal featured many unique dynamics including the building setup, high rents, a substantial return of equity and a very large number of tenants, most of which were on short-term leases, raising rollover concerns. “LaSalle looked at the strong historical occupancy of the building, it’s location in a tight market, the very high quality building and the strength of the sponsorship in order to get comfortable with the financing,” says Loshbaugh, who maintains that tight underwriting of a loan can sometimes be mitigated by deals featuring strong experienced sponsorship, a property that serves a market need or an acquisition scenario where equity is coming into the deal.

Newman Financial Services

Rollins

Based in Denver, Newman Financial Services finances multifamily (both market and affordable), office, retail and industrial properties across the West. A division of GMAC Commercial Holding Capital Corp., Newman Financial Services is a national balance sheet lender providing short-term bridge, mezzanine and bridge/mezzanine combination. Rollins says that Newman’s typical loan is highly leveraged — up to 90 percent LTV — with a term of 1 to 3 years.

Newman recently closed an $84.1 million bridge and mezzanine loan for the acquisition and repositioning of Everett Mall, a 636,000-square-foot regional mall located in Everett, Washington. Newman provided the developer a portion of the loan through its New Markets Tax Credit (NMTC) program. Because the property is located in an area designated by the U.S. Treasury as a “hot zone” and a New Markets Tax Credit qualified community, Newman was able to utilize a portion of GMAC Commercial Holding Capital’s tax credit allocation to provide the mezzanine financing. “The use of these credits allowed a higher loan-to-value to be achieved and enabled the financing to be priced at a below-market rate,” says Rollins. “This combination of benefits provided by the use of the NMTC was instrumental to the financing structure placed on the project.”

Interested in Rates

The Federal Reserve has signaled its intent to gradually raise the Fed Fund Rate, and the rest of the lending community will follow suit. With interest rates of historically low proportions the past 2 years, few deals have been constrained by debt service coverage. “As rates rise, the cost of capital increases which will result in an upward pressure on capitalization rates as borrowers can no longer pay inflated prices for properties simply because they could borrow so cheaply,” says Davis. “Debt service coverage will become more of a factor in sizing loans as NOIs stay the same but annual debt service increases.”

However, Sherlock maintains that short-term interest rates are so low that the expected increases in the next 12 to 18 months will have little impact on the pace of development. “The expected increases will result in rates that prudent underwriters have already been factoring into their analysis,” he says. “The greater developer concern is at what point will cost increases — whether cost of capital or cost of materials — erode profit margins, rather than be passed on to the end user.” Edgers says that, in most cases, the limiting factor for determining available loan amounts has not been the traditional loan-to-value equation, but rather a determination that there will be cash flow available to service debt.

As for long-term rates, new lenders are still entering the conduit loan business despite some significant increases, suggesting that institutions expect continued growth in overall demand in advance of the refinance wave projected to begin in 2005 or 2006. “In the CMBS world, 2005 will be bolstered by a wave of refinancings as conduit deals from the mid-1990s will begin to come to maturity,” says Loshbaugh.

Gary Nelson, president of Churchill Mortgage in Los Angeles, says that, with rates low but expected to rise during the next few months, many borrowers are looking for higher leverage and longer terms. Rollins calls it “one-stop shopping” for the developer — the high leverage, first-trust loans that can cover up to 85 to 90 percent of the capital structure. Mozer says that long-term fixed-rate capital allows the borrower to take advantage of the current low interest rate environment for an extended period of time. Many of these loans contain interest-only components ranging from 1 to 5 years, he adds. Says Loshbaugh of LaSalle Bank, “There is a general perception in the market that the fall elections will generate significant volatility in interest rates, and I think people are eager to lock in what are still very low rates.”

Davis does deliver the “universal message” from lenders that unprecedented amounts of capital will still be available for commercial real estate lending during the rest of the year. “It is a borrower’s market with lenders jumping over each other to land solid deals,” he says. “Spreads have been thin for good deals and structure has often won out. Lenders will continue to flood the market with funds, and, if rates rise, fewer deals will pencil out. The end result will be continued intense competition between lenders for the transactions that do work.”

Mozer points out that rising interest rates will spur an erosion in property values, as cap rates adjust higher, and the placement of lower-performing properties on the market due to the fact that, as interest rates rise, these properties cause a greater financial strain on the owners. Rollins contends that rising interest rates will “actually help the value-added lending business from a quality of transaction perspective. Transactions in a rising-rate environment will need to create real value, rather than relying on interest rate arbitrage for an exit strategy.”

Looking through 2005, Davis says the lending environment will continue to feel the pinch of higher interest rates. An improving economy and the re-emerging appeal of the stock markets will cause lenders, in particular life companies, to re-evaluate their allocations of investment funds. “Additionally, the buyers of mortgage-backed securities will have other appealing investment options to get the returns they desire, resulting in less capital available for commercial real estate lending,” he says. “This should work to the advantage of Fannie Mae and Freddie Mac lenders… as the recent hyper-competition for multifamily product will not continue to flood the market with cheap debt. The other change that will occur is that real estate fundamentals will continue to improve following the overall economy. This will result in more deals that work, as occupancy levels will gradually improve across the board and concessions will burn off. Lenders still have the gold, and they will get back to making the rules.”

©2004 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.