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COVER STORY, SEPTEMBER 2006
LENDING IN THE WEST
Western markets are seeing more of the same, with a slowdown in the condo market but steady growth in other sectors.
Lara Fuller
As has been the case for the past few years, the outlook in the western lending market is generally positive. Certain areas, such as Southern California and Phoenix, have seen near-constant growth, contributing to the strength of the overall market. However, while the big picture looks good, there are a couple of property types that aren’t doing so well.
The condominium conversion market is no longer the hot ticket that it once was. While interest rates were low and demand was high, many developers jumped on the condo bandwagon. Now, however, the tide has changed and the condo market is quickly cooling. “More and more lenders seem to be either exiting the condo conversion business or more conservatively underwriting these opportunities,” says Jason Choulochas, regional director for the West in the Newport Beach, California, office of Chicago-based Wrightwood Capital.
Adds Geoff Arrobio, senior vice president with Johnson Capital in Los Angeles, “Condo projects are obviously overbuilt in some markets and money has dried up for these developments due to the ‘herd mentality’ of building these deals.”
The slowdown of the condo market is being seen in most major markets, with the exception of some Arizona cities. “Condominium conversions and development have cooled in most markets, although some areas of Arizona are still robust,” says Gary Bechtel, managing director of corporate initiatives and strategies with Meridian Capital Group in Los Angeles. “Condos, especially in Las Vegas, San Diego and Seattle, have taken a nosedive recently as their overheated markets have cooled off.”
In general, residential — excluding multifamily — is not the booming market it once was. There is significant overpricing and oversupply in the sector at the moment. “For-sale properties — whether single-family tract developments, condo construction or conversions — are difficult,” says Philip Powers, senior vice president and manager in the commercial real estate lending group of Security Pacific Bank in Los Angeles.
“Residential, non-multifamily, has taken a dive,” says James Fowler, principal with US Realty Capital in Newport Beach. “Home builders are providing significant discounts to get rid of excess inventories in certain markets. As a result, new land sales have slowed dramatically as contracts are being walked away from and new deals are hard to initiate.”
The prospects for other property types look much better. Growth is slower than it has been, but lenders aren’t overly concerned. “Since growth was so explosive in so many areas recently, it is normal to expect to see a bit of a slowdown and a return to normal development and absorption patters,” says Jim Clifford, executive vice president and chief credit officer with Minneapolis-based Marshall BankFirst Corp. “Within the next 9 to 18 months, we expect to see the market rebound.”
Adds Arrobio, “Most of the Pacific Southwest is enjoying solid growth, however, transaction volume is slowing down due to the lack of decent product (of a high quality) on the market for sale. It is very hard to make deals pencil today on a cash-on-cash basis when cap rates remain in the 6 percent range. Investors are looking for decent cash-on-cash returns year one, and if they can’t get it, properties sit on the market longer. An adjustment needs to happen and will happen over time.”
Retail, as usual, is one of the stronger property types. Developers have moved away from traditional developments and are looking at ways to keep retail properties current. “A new buzzword heard more and more often is the mixed-use, transit-oriented, urban-infill project,” says Fowler. “This is due to higher land costs requiring higher densities.”
Says Choulochas, “Ground-up and existing retail break-up plays are also popular now, with shopping centers being parceled and sold off to users in pieces. There is still a premium being paid by investors, particularly private investors, for net-leased retail projects with national or strong regional tenancies. We see this in both Phoenix and Southern California in particular.”
In terms of industrial, the strongest market is in Southern California. “In Southern California, we see continued strength in the industrial markets in both for-sale and for-lease, although increased construction costs and rising land prices may dampen the enthusiasm of developers for building new product,” says Choulochas.
Top Lenders and Popular Loan Products
Though many of the leading lenders in the West have experience in financing a range of property types with a number of loan products, they are still faced with challenging loans from time to time. With the changes in the market and the increase in interest rates, some companies have had to get creative in finding ways to provide financing for their clients.
Meridian Capital Group
Meridian Capital Group, based in New York, arranges financing for all property types, including multifamily, retail, office, industrial, manufactured housing, self-storage and hospitality. The Los Angeles office of Meridian covers most of the western states, including California, Arizona, Nevada, Utah, Oregon and Washington.
Meridian provides financing on a direct and indirect basis for a wide variety of loan structures. At the moment, the company is handling a number of permanent financing loans. “While there is a demand for most loan structures, the bulk of financing requests we are seeing is still in the permanent financing of properties with terms of 5 years or greater,” says Bechtel. “Mezzanine and multi-tiered loans are also very popular, as borrowers look to maximize their leverage, especially on acquisitions.”
Recently, Meridian provided a client with a multi-tiered capital structure, providing senior, mezzanine and equity components, bringing the total capitalization in excess of 90 percent loan-to-cost. “The client sought financing to acquire and convert an existing multifamily complex to condominiums in California, in a market where a number of new complexes had recently come online and where a high amount of leverage was requested by the client,” says Bechtel.
Security Pacific Bank
Security Pacific Bank does the majority of its business in California, Arizona and Nevada. The company provides floating-rate construction and bridge facilities for all property types and fixed-rate loans for multifamily properties.
A recent office transaction handled by the company shows its versatility. “We funded an acquisition loan in 3 weeks for a flex-office property being bought out of bankruptcy,” says Powers. “The first part of the loan funded the acquisition and was a combined first from the bank and second from Security Pacific Finance Co. for a total of 80 percent of cost. The second part of the loan, which closed 3 weeks later, funded the renovation, tenant improvements and other costs. The challenge was obtaining the highest level of capitalization in the least amount of time.”
Wrightwood Capital
Covering most of the western region from its offices in Newport Beach and San Francisco, Wrightwood Capital finances office, retail, multifamily and industrial properties.
The company provides structured senior financing, mezzanine and joint-venture equity financing in the $5 million to $50 million range. “Our primary focus today is in highly-customized, senior-debt positions in the $10 million to $50 million range for value-added business plans,” says Choulochas.
In Cupertino, California, Wrightwood Capital recently provided a $40.4 million first deed of trust loan to finance the acquisition of a three-building, 217,000-square-foot office portfolio. “Challenges in the deal included the property being 28 percent occupied at closing,” says Choulochas. “Further, our financing closed prior to all of the borrower’s equity being invested and prior to the borrower acquiring and merging the underlying leasehold estate with the fee-simple estate acquired at the initial closing.”
Wrightwood was able to structure a loan around these challenges by permitting funding at the initial closing as well as a subsequent disbursement to acquire the leasehold interest within 120 days of closing. “Wrightwood was also able to get comfortable in the Silicon Valley office market by underwriting and understanding the particular dynamics of the Cupertino submarket,” says Choulochas.
Johnson Capital
Office, retail, industrial, multifamily, hotel, mixed-use, medical and self-storage are the primary property types that Irvine, California-based Johnson Capital handles on a regular basis. The company provides permanent fixed, bridge, equity and mezzanine loans in all areas of the West. At the moment, Johnson Capital has seen an increase in the popularity of construction and bridge loans, as well as cheap, long-term acquisition debt with interest-only components.
A challenging deal that the company recently handled involved the 82,421-square-foot Rye Canyon office project in Santa Clarita, California. “We were looking for a non-recourse, office condo construction loan at a high loan-to-cost of 88 percent,” says Arrobio. The company searched for an aggressive, yet reputable lender who would be able to perform. “We found a solid, nationally-recognized firm, who has years of sound real estate experience and local market knowledge, to perform on the deal,” says Arrobio.
US Realty Capital
US Realty Capital finances all income-producing and residential projects in California, Nevada, Arizona, Washington, Oregon, Utah and New Mexico. The company provides land, A&D, construction, permanent, mezzanine and joint-venture equity loans. Lately, Fowler has seen a surge in the popularity of forward commitments (early rate locks) for permanent financing.
Recently, US Realty Capital handled a $90.5 million bridge loan to reposition a regional mall in Washington. It was a difficult deal because there was refinancing mid-stream during turnaround, and the borrower was given the ability to cash out equity in the early stages. “To handle the challenge, we assessed the appropriate capital source and helped to create a detailed monthly cash flow analysis to highlight and mitigate risks,” says Fowler.
Marshall BankFirst Corp.
“We finance a wide range of property types, including residential, multifamily, mixed-use, hospitality, senior living, healthcare, alternative energy, gaming, retail and industrial,” says Clifford. The Minneapolis-based company, which is a national lender, also has offices in Phoenix and Irvine. Marshall BankFirst provides a variety of loan types, including acquisition and bridge financing, construction, mini-perms and some term financing. “A large majority of our loans are based on a variable rate,” says Clifford. “We consider ourselves experts in construction lending for middle market (loans of $20 million to $100 million) developers.”
Recently, Marshall BankFirst financed properties in California, Nevada, Washington, Arizona, Hawaii, Idaho, Oregon and Utah. “Land acquisition and infrastructure development loans continue to lead the way as lending for residential development in a number of western markets continues to move along,” says Clifford.
The Remainder of 2006
Rising interest rates have had a negative effect on residential and condo conversion projects. They will also continue to affect other property types, but the extent of that effect has yet to be seen. “Interest rates have been and will continue to be the most important, yet unknown, variable in the equation,” says Fowler.
As of right now, it looks like interest rates will continue to cause a slight slowdown in most markets. “As rates continue to increase, income-producing property sellers’ expectations will become more unrealistic and the single-family and condo market will continue to suffer from oversupply and lack of affordability,” says Powers. “This will continue through the end of the year.”
Adds Clifford, “For developers, the larger the project and the longer the construction period, the more the interest rate means to them. Smaller projects that are completed within 12 to 18 months have less interest rate sensitivity than major, multi-story projects. For investors, the same holds true. For larger projects, they need a higher return on investment to cover their cost of fund. Rising rates mean they could potentially be looking at other asset classes for equal or better returns.”
No major changes are expected for the last few months of the year. The market is not as frothy as it was in 2005, but it is doing better than expected. “Given the current unrest in the Middle East, the continuing Iraqi conflict and the general strength of most markets in the country, I think we can look forward to more of the same through the balance of 2006,” says Bechtel.
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