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COVER STORY, SEPTEMBER 2007
BANKING ON THE WEST
The western lending environment is still on the go, but there is some ebb to the capital flow.
compiled by Brian A. Lee
Western Real Estate Business has the word on the latest lending trends in the region by going straight to the experts themselves — John C. Smeck III, principal/managing member for Johnson Capital in Phoenix; Jeffrey Wolfer, president and co-CEO for Kennedy Funding; Joe George, senior vice president for Countrywide Commercial; and Jeff Friedman, co-CEO at Los Angeles-based Mesa West Capital. Their keen insights on the current financial movements and preferences in the West follow.
WREB: What loan products are particularly popular right now?
Smeck: As of August 2007, the most popular loan product is one that will actually close! The disruption in the capital markets has pushed many fixed-rate lenders to the sidelines. The lenders who are still quoting fixed-rate loans are holding quotes for only a few hours. Floating-rate debt is still available and in the highest demand as owners seek to “hover” until the fixed-rate market finds stability and as owners who have historically been merchant builders try to warehouse assets until the investment sales market improves.
Wolfer: I would have to say that fixed-rate bridge loans are quite popular and are, in fact, becoming even more so of late, probably due to the inverted yield curve. When uncertain and/or fluctuating real estate trends make themselves felt, the banking industry traditionally tightens, making it more and more difficult to secure a loan from that sector. And this is, of course, when the private lenders experience an upsurge, as we represent the only true alternative to the conventional banking and credit-union interests.
George: We seem to be quoting more floaters now that the fixed-rate market has pushed back on deals that should have been executed as floaters.
Friedman: Floating-rate bridge loans on transitional and value-add projects are popular. The death of the 5-year, fixed-rate, interest-only CMBS permanent loan that was being used to finance the acquisition of transitional and value-add projects with limited or no cash flow has created an opportunity for the bridge lenders and other specialty finance shops to fill the void. This trend will continue in the immediate and middle term so long as the tightened rating agency and bond buyer standards persist (which will almost certainly be the case) and the yield curve stays normalized rather than inverted.
WREB: What property types are hot/not?
Smeck: The fundamentals — economic occupancy, rental rates, etc. — of all property types, except single-family residential, remain firm. Lenders still favor multifamily, office, industrial and retail properties, as well as seasoned hotel/lodging properties.
Wolfer: In our arena, land acquisition loans are always a hot item; small to midsized developers and speculators will always need to finance their land acquisitions. Office buildings and multifamily properties are still trading at record prices, with cap rates unheard of just 10 years ago. With condo conversions having dominated the past decade, hotels and rental apartments are reaping the benefits of the diminished inventory.
As for what’s not hot, that’s an easy one and has been for quite a while: high-rise condo developments. They’ve glutted the market and, to be blunt, it’s difficult to foresee a future in which that condition will change noticeably any time soon. It could take several years to absorb the existing inventory in that sector.
George: Everything is hot at the moment. We continue to see probably a larger amount of hospitality transactions than most of our competitors. Our industry is beginning to see healthcare deals again.
Friedman: Industrial, multifamily, retail (especially grocery-anchored and Class A malls) and full-service hotels continue to be red-hot, while residential condos and land (especially for residential development) are definitely not. Office is cooling and Class B malls and limited-service hotels in secondary and tertiary markets have become frosty. However, with the tremendous current flows of capital into real estate, even the cooling and no longer hot property types (with the exception of land and condos) are still experiencing substantial investment activity when viewed on a historical basis, but less so when compared to 6 to 24 months ago.
WREB: What markets of the West are hot right now?
Smeck: There are many hot markets in the West currently. Look at markets with continued strong population and employment growth and those are the markets that are the hottest — Phoenix, Las Vegas, most of southern California, Sacramento and Denver, to name a few. It has been reported that areas of the Northwest are experiencing good job growth as well.
Wolfer: The California market is probably the most active, with the San Diego area particularly busy and interesting. But the Inland Empire, in and around San Bernardino, is also very strong, and the fact is that most of the southern part of the state is experiencing activity far above the norm. Outside of California, Las Vegas and Phoenix are both robust, as is Idaho, Boise in particular. Keep your eye on all of these.
George: The San Francisco CBD is hot. Denver is continuing to turn around and emerge as a popular investment market.
Friedman: Seattle and the Pacific Northwest are especially hot markets currently. Continued job growth in aerospace and technology, together with the already firm markets and lack of new supply, have created strong market fundamentals, and these fundamentals are expected to continue. San Francisco and West Los Angeles continue to be sought after due to the relative strength of these markets and the lack of new supply. Similarly, there has been extensive investment activity in Silicon Valley, Denver and Phoenix, notwithstanding that these markets have seen only gradual market demand growth and supply constraint.
Portland, Albuquerque and Reno are markets that have been gaining in popularity and would be considered emerging, in part on a relative value basis as compared to the more primary markets in the Western U.S.
WREB: How do you think the lending environment will change during the rest of 2007?
Smeck: There will continue to be dynamic change in the capital markets. Underwriting standards will remain tight, and credit availability will continue to migrate toward higher-quality assets, locations, operational histories and sponsorships. Additionally, interest rates and spreads will continue to reflect great uncertainty in the market and remain highly volatile.
Wolfer: The fallout of the residential subprime meltdown has started a tightening among the large institutional lenders and Wall Street firms. So much of the real estate financing today is securitized and sold in the secondary markets that any uncertainty in that market causes most lenders to underwrite and price much more conservatively. It remains to be seen how long that uncertainty will last. It should continue to create opportunity for private lenders and others who didn’t sell their loans into the secondary markets.
George: The capital markets are volatile. There is still plenty of capital, however, the pricing of that capital is much more volatile now than at any time during the past several years. If a borrower has a quote from a lender, he should be sure to check that they will still honor the pricing and structure.
Friedman: On a macro-economic level, the economy has shown great resiliency to $80 oil, massive trade deficits with China, huge spending on the war in Iraq and, more recently, the residential softening and subprime meltdown. The bulls would say that this resiliency should continue, especially with an election year coming, but it would not be surprising to see the economy slow down at least in part and succumb to the slowdown in housing, potentially causing a commercial real estate correction.
In fact, the ongoing residential softening and subprime meltdown has already caused upheaval in commercial real estate CMBS markets, reducing liquidity in those markets and causing lenders to become more cautious. As the after-effects of the residential softening and subprime meltdown continue to work through the economy, the CMBS markets during the remainder of 2007 should continue to be impacted. Fixed-rate, interest-only loans will continue to be more of a rarity and available only for lower leverage financings on better quality properties. And CMBS lenders will continue to be more cautious and less likely to permit aggressive underwriting. This will reduce proceeds offered in the CMBS market and increase borrowing costs, providing an opportunity for the bridge lenders, mezzanine lenders and specialty financing shops such as Mesa West Capital to fill the void.
WREB: Does creative financing play a large role in your company’s growth strategy in the region?
Smeck: Providing expertise in capital advisory services has always been a hallmark of Johnson Capital. This expertise and experience will continue to be highly sought after by owners of commercial real estate. In fact, the turmoil within the capital markets only heightens the need and desire of owners of commercial real estate to seek the advice of trusted and highly experienced intermediaries, such as Johnson Capital.
Wolfer: Kennedy Funding was founded upon two basic tenets, one of them being creative financing and the other one being speed. Back when creative financing was a novelty, we were becoming experts at it, and today it’s an industry mainstay. It keeps getting better, too. There are more capital sources out there than ever, and there are any number of innovative ways of placing that capital. So financial creativity has gone from being a fad a decade or so ago to becoming one of the most popular and sought-after financing methodologies in use today. At Kennedy, we like to think we had a little something to do with that.
George: If we believe in the real estate and in the business plan, we will find a way to tailor a loan that mitigates our risk and yet delivers the product that our client wants. Countrywide consists of bricks-and-mortar folks who happen to be lenders.
Friedman: The focus of Mesa West Capital is providing creative and customized financings. In contrast to large traditional lending institutions, Mesa West Capital has an entrepreneurial approach and local Western U.S. decision-making, providing an ability to develop customized financing structures with its customers. This “hands-on” approach, combined with the institutional resources and deep experience of the principals, separates Mesa West Capital from its competitors and makes it a leading go-to commercial real estate finance source in the Western U.S.
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