COVER STORY, JANUARY 2007

2007 NORTHEAST FINANCIAL FORECAST
It is all about adding value to this complicated and vibrant market.
Stephanie Mayhew

Despite threats of rising interest rates, higher energy costs and the weakening of the U.S. currency, the economy continues to grow. Bolstered by strong corporate profits and higher stock prices, the commercial real estate industry should continue to see financial gains in 2007. The overall state of the economy, interest rates and development costs all affect future development, acquisitions, lending and leasing activity in the Northeast. Northeast Real Estate Business sat down with David Cohen, the regional director of the Northeast for GE Real Estate’s North American Lending division, to discuss the lending environment for 2007.

Northeast Markets

Lenders continue to be bullish on the major markets in the Northeast and markets such as New York City, New Jersey, Boston, Philadelphia, Westchester County, New York; Stamford, Connecticut; and Long Island, New York, continually captivate the attention of developers, investors and lenders because they exhibit the drivers that exude constant economic growth. “Markets such as New York City are exhibiting declining vacancies and strong rent growth; thus, bolstering investment sales activity,” notes Cohen. In addition, secondary drivers such as an influx of tourism, strong demographics, the home to major corporations and Fortune 500 companies and the strength of the financial sector help drive the New York market.

In turn, the overwhelming success in markets like New York City can have positive effects on surrounding markets. For example, the vacancy rates for the Midtown Manhattan office market are declining and rents are growing,

but there is a limitation on large blocks of space. The growing demand for more space will push into surrounding markets such as Downtown Manhattan, Long Island, Westchester County and northern and central New Jersey. “When there is limited or no office space available, companies are going to look for the next best alternative and that is going to be those surrounding markets. These markets are starting to thrive off the general parameters or drivers that are present in New York City right now,” observes Cohen. 

Of course, there are always areas and pockets throughout the Northeast that are struggling, but according to Cohen there are no specific areas in the Northeast that lenders are shying away from. “Lenders will often be cautious in tertiary or soft secondary markets, but it is hard to generalize and pinpoint struggling markets in the Northeast. A lender will look at the drivers and trends in that particular submarket, the property type characteristics and class, who the sponsor is and what their execution plan is,” says Cohen. For example, because of the departure of some of the insurance business in the eastern Connecticut/Hartford area, this office market has been struggling somewhat and has not been as quick to recover as a major market like New York City would. However, a prudent lender will look very carefully at the market and transaction characteristics before turning away from it.

“We don’t want to exclude a particular market or submarket. If you look at what is happening in Hartford, it depends on a number of factors and what is being financed,” says Cohen. Is it a grocery anchored retail center with good sales in a strong suburban submarket or is it a large office building in the Hartford central business district with tenants with short-term leases and above market rents? “The analyses on these two properties would be completely different. The right deal may be a 50 percent loan-to-value (LTV) in Hartford and the wrong deal may be a 90 percent LTV in Hartford, again depending upon the transaction characteristics and all of the variables. It really comes down to all of the different variables in terms of where we want to lend and whether we want to make a particular loan,” maintains Cohen.

Property Types

Despite concerns regarding the U.S. housing market, there are no specific property types that are struggling in the Northeast. According to Cohen, GE is lending across the board on all sectors. “It comes down to the market, the sponsor and characteristics such as the class of that particular property type. For example, the New York City market has all of the right trends for each sector. We might have sensitivities to office in other markets because that market might be flat in terms of vacancy trends or we don’t see the same type of rent growth or upside, but GE is a real value-added lender, so for our on-book loan products we look for those types of deals,” says Cohen.

Office

The office market continues to be the strongest in 24-hour type cities, and rehabbed and repositioned office product are very favorable among lenders as any type of upgrade or enhancement will increase rents and drive revenue. “As a lender, it is important to look at all of the factors present in the market and the property,” remarks Cohen.

According to Newmark Knight Frank’s 2007 National Office Market Outlook, the office market has been quite favorable throughout the Northeast. The overall availability rate in the New York City office market is 9 percent, and in pockets such as Midtown and Midtown South, the availability rate is sitting at approximately 8 percent with a vacancy rate of about 5 percent. Newmark also reported that vacancy rates were sitting at approximately 13 percent in New Jersey, and vacancy rates in the Long Island and Westchester/southern Connecticut office markets have been steady, but asking rents have been trending up. The Boston office market absorbed approximately 5 million square feet of space  in 2006 and close to 3 million square feet is currently under construction. 

Retail

Retail continues to be strong, especially in New York City. Barriers to entry such as increasing land prices, rising development costs and tedious approval processes have kept vacancy rates low and sustained rent growth. Cohen notes that lenders focus on strong anchored centers in viable locations with particularly good demographics. Per a recent retail report from The Goldstein Group for the Route 17 corridor in New Jersey, the area is showing an extremely low vacancy rate of 1.52 percent with limited available space. The report also forecasted limited available space well into 2007.

Multifamily

The multifamily sector continues to be strong throughout the Northeast, and despite the struggling condominium market, this sector should continue to remain strong throughout 2007. According to a report from Marcus & Millichap, the northern New Jersey multifamily market has enjoyed robust renter demand due to the strong job market in New York City. Along with a 2.8 percent average increase in asking rents this past year, the median sales price was up by 4 percent. Increased job growth and limited for-sale housing affordability in the Brooklyn market is also currently driving rental demand.

Marcus & Millichap is forecasting an increase of 6.3 percent in rental rates, and noted that approximately 4,500 units were set to come online in Brooklyn at year-end 2006. Activity was brisk in the other boroughs as well. Marcus & Millichap reported that owners in Manhattan raised asking and effective rents by 7 percent in 2006, owners in the Bronx raised asking rents by 2.7 percent and effective rents by 2.6 percent, and a sizeable portion of new construction came online and was quickly absorbed in Queens in 2006.

Other Sectors

As in the other sectors, location is key; therefore, the industrial sector continues to remain strong in the Northeast region due to its ports, coastal shipping lanes and strong transportation hubs. Self-storage is another hot sector that has been capturing the attention of lenders in the Northeast region. The hospitality sector can often be one of the most volatile sectors, but lenders continue to look favorably upon this property type. “Lenders tend to go with the name brand flags and they also look at the demographics of where the hotel is located. Hotels in a big city where there is a high level of tourism is what lenders look for. You want to lean away from tertiary cities in general and the lower-class type of hotels,” says Cohen.

Loan Products

As the market continues to tighten in the Northeast region, lenders have been focusing on flexible financing and creative deals. Loan products such as CMBS, bridge, mezzanine and B-Note loans are very popular, but Cohen notes that the most popular loan structures today involve those lending programs where the borrower can benefit from creating value at a property. “The most popular lending programs that we have right now are our value-added on-book bridge program and our value-added on-book fixed-rate program, which is called our flexible fixed-rate financing,” says Cohen.

According to Cohen, the reason this type of loan is so popular with their clients is because it offers 3-, 5- and 7-year fixed-rate terms, GE will lend at 85 percent LTV and will go higher for the right product, it allows collateral substitution for portfolios and it is interest only for up to 5 years. “This type of loan product also offers prepayment flexibility as opposed to yield maintenance or defeasance, so it is a much more economical prepayment formula,” notes Cohen.

In addition, the loan does not require an appraisal because it is all based on a discounted cash flow valuation, plus the program is asset managed by GE and is structured to allow for earnouts based on performance and facilities for “good news” (tenant improvements and leasing commissions) and capital expenses. “Earnouts are so important for the borrower because there is no negative arbitrage because we are not funding an escrow at day one,” asserts Cohen.

“It comes down to being creative and flexible for our clients so they can buy a property, come in with a higher LTV and be rewarded with earnouts as their properties create value-added returns,” says Cohen. “In today’s market you can’t buy revenue streams because of the compressed cap rates, so borrowers need to  create income streams and the on-book value added lending programs work out perfectly for the borrower in these situations.”

Most sponsors are creating value at their properties through leasing or asset enhancement programs. GE recently closed a $27.15 million on-book loan for Vision Equities and its partner Grosvenor Investment Management in just 21 days for the purchase of Parkway 120, a Class A office building in the Metropark area of Monmouth County, New Jersey. According to Cohen, the going in debt-service coverage on this loan was sub-.50x and it was less than 50 percent leased. The loan was structured with an initial funding of approximately $23 million and the balance up to $27.15 million was a result of additional collateralization, i.e. interest reserve, and also a good news facility of about $4 million. “The risk we took was in the lease-up. To mitigate that risk we made sure it was a solid value creation deal. We have a very good sponsor with a property in a very good location. They are going to create value by accelerating the lease-up by focusing on the asset and working to lease it up over a 3-year period,” remarks Cohen.

Keys to Success

Value-added deals such as the one mentioned above will become even more prevalent in the 2007 lending environment. In order to compete in the current real estate market, lenders need to be prudent in their underwriting and lending, but at the same time be creative and assure certainty of execution to clients in a timely manner. “There is only so much creativity you can create in a loan under a securitized product, so the creativity has to come with the on-book portfolio type products,” says Cohen.

However, despite such a tight market, there is a great amount of room for growth in the Northeast. “As older leases are coming due, a tenant that might have signed a $25 per square foot lease 5 years ago may now be looking at $42 per square foot. This is the value creation we like to see,” says Cohen. As sponsors recognize the rent growth capabilities in their properties, they will be able to create value, and with loans such as GE’s on-book portfolio of loans, they can receive earnouts based on performance.

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