FEATURE ARTICLE, JANUARY 2007

CONSTANTS IN A SEA OF UNCERTAINTY
While interest rates and energy prices keep us all guessing, strong fundamentals never change.
John Manginelli

As 2006 was coming to a close, developers, investors and lenders alike were wondering what the future would hold for commercial real estate in the Northeast. Interest rates and energy prices, of course, are the big unknowns that no lender can ignore — or predict. Despite these uncertainties, some of the commercial real estate finance trends that emerged in recent years are likely to continue to permeate the New York-New Jersey markets. 

Market Trends

Although interest rates appeared to be holding steady in late 2006, the increases of 2006 had a dampening affect on housing markets nationwide. In the Northeast, existing home sales declined by 12 percent by July 2006, compared to the same period in 2005. Given the chronic housing shortages in major markets such as New York City, however, demand for both rental and purchased property remains at healthy levels. However, nonetheless, some New York and New Jersey condominium projects have changed course as developers — and their lenders — have become concerned about the rising inventory of condominium units.  Many institutions are limiting this financing to primarily an existing client base and/or transactions with significant positive economics and equity. 

On the rental side, New York City continues to be among the highest-priced rental apartment markets in the nation, and thus, a very strong market for real estate developers and investors. Some of the challenges for this product type remain construction and land costs versus economic viability. Many of our apartment rental financings have involved joint ventures with land owners, longtime owners, or transactions subject to a ground lease. Investment sales pricing has reached record-high levels, with Midtown West, the West Village and Lower Manhattan being particularly active. Meanwhile, high rents and the high cost of ownership have motivated consumers to migrate to such Brooklyn neighborhoods as Williamsburg, Brooklyn Heights and Cobble Hill, creating new opportunities for enterprising rehabbers and developers. Retailers are following suit, with Nordstrom and Trader Joe’s among the latest new entrants to Brooklyn.

Outside of Manhattan, the strong investor interest is benefiting many of New York’s and New Jersey’s established communities.The shortage of new development sites in this high-density, mature region, combined with burgeoning public interest in smart growth planning, has opened the door to some exciting mixed-use developments and community investment programs. The City of Newark, for example, is revitalizing an underserved area on the city’s Western edge with the new Home Depot Shopping Center, to include retail and residential components. In Asbury Park, New Jersey, Westminster Communities has developed the 35,000-square-foot Wesley Grove retail center and is planning additional retail and residential components as part of the waterfront’s ongoing revitalization. While sometimes challenging to finance, especially where public-private partnerships are concerned, such projects have the potential to create additional redevelopment and property investment opportunities in the surrounding communities.

Lenders continue to look favorably on neighborhood shopping centers and lifestyle centers, while keeping a close eye on the retail industry as a whole.  The best financing terms are available only for properties that are well located and leased, reflecting lenders’ uncertainty about the future commitment to strong underwriting on construction and permanent loans. In particular, lenders are scrutinizing grocery-anchored centers more closely than in the past and are reluctant to finance properties anchored by a grocery that may not flourish and keep the rent checks coming in — i.e., a grocer that does not fill a very specific niche, is likely to be acquired or is not dominant in the local market.

Like looking at trends in specific areas of retailing, lenders also are looking closely at macro-economic trends. Another lender concern is whether energy prices and interest rates will dampen consumer spending and put retail center profits at risk. Some shopping center owners may face a challenge if they need to refinance their mortgages to fund property improvements to stay competitive, trading yesterday’s low-cost financing for today’s higher interest rates.

New Financing Structures

To deal with the challenges ahead, lenders have become more innovative than ever before. On the financing front, one of the most significant trends in recent years is the ever-increasing sophistication of commercial real estate financing, and the subsequent increase in financing options available to developers and investors. Developers involved in new construction or redevelopment of older properties — a common occurrence in high-density New York-New Jersey submarkets — can gain a competitive advantage over their peers if they educate themselves in the emerging financing structures designed to maximize return on investment.

In today’s world, a developer does not necessarily need to secure separate loans for interim and permanent project financing. Those with a proven track record and a strong credit rating are now looking to pre-negotiate financial packages that include both interim and permanent finance for new construction or redevelopment.

For example, KeyBank Real Estate Capital recently closed an $83.3 million credit facility for a Rhode Island-based investor group. The credit facility includes a letter of credit, a construction loan and a Freddie Mac forward commitment for permanent credit enhancement for the Groves at Johnston, a 300-unit multifamily property. In another deal, KeyBank recently offered an owner a forward rate lock of $95 million on a multifamily rental property in New Jersey and also provided a $75 million construction loan.    

Increasingly, savvy developers are not only locking in interest rates for the permanent finance before a shovel hits the ground, but they are also concentrating on the business of development with the long-term financial details already in place. For those who have been developing real estate for years, it is a highly advantageous method of financing. New investors may also find that this strategy is available to them, if they serve as financial partners of developers with more experience in the business.

Structured Finance On The Rise

The recent era of low interest rates and conservative aggressive loan-to-value ratios has led to greatly increased use of mezzanine debt and equity. As interest rates fell to record lows in the past few years, borrowers’ appetite for mezzanine debt naturally increased exponentially as a means of closing the equity gap with affordable capital. Since some first mortgage contracts prohibit the use of mezzanine debt, borrowers also have turned to preferred equity offered by KeyBank and others. Formerly the province of specialized investment firms, preferred equity today is available through a wide range of capital sources, including commercial banks.

Investors in small retail centers or multiple apartment properties, for example, are finding that the use of preferred equity can increase the number of properties in which the borrower can invest because their equity is not tied up in a single project. In addition, some lenders are willing to combine preferred equity financing with a developer’s cash equity to enable the borrower to undertake a significantly larger project. In this manner, the borrower company can increase its return on investment by a proportional amount and all for the same up-front commitment of funds.

Conversely, as interest rates rose last year, reducing the loan amount a borrower could receive on a first mortgage, lenders have sought other ways to replace lost leverage through complex structured transactions. This challenge has led to the emergence of collateralized debt obligations (CDOs), in which the lender uses short-term debt instruments as collateral and replaces them with new collateral as borrowers pay off on those assets. As an alternative to CMBS loans, CDOs will likely play an increasingly important role in commercial real estate financing in the coming year. Whole loans and transitional assets can also be placed in the CDO — providing lenders and borrowers with more flexibility in financings.

Big-Picture Financing

In addition to adopting sophisticated new project financing techniques, developers also are learning to address their short- and long-term financial goals with holistic solutions that some lenders are now able to provide. For instance, the developer may find that a line of credit, rather than simply seeking project-by-project funding, is the best way to support a national expansion program. Some developers and acquirers also are boosting the bottom line through technology-based treasury management programs that expedite deposits and vendor payments, incrementally increasing returns on interest-bearing accounts.

New and Improved CMBS

As the CMBS market has matured over the past decade, conduit lenders have learned how to meet the needs of investors and mortgage borrowers alike with more flexible programs than in the past. While the plain vanilla conduit loan is still the norm, even the simplest transactions tend to not be quite as plain as they once were. The market’s increased ability to rate and sell CMBS traunches has allowed conduit lenders to finance transactions more aggressively than before and still find CMBS investors.

As a result, today’s conduits can securitize floating-rate balloon loans, construction loans, mezzanine loans, loans with interest-only periods followed by below-the-line amortization, defeasance requirements or prepayment penalty fees and other loan variations far beyond the traditional fixed-rate, long-term mortgage. This new flexibility is enabling developers and property investors to pursue their business plans more cost effectively than ever before, while addressing the inherent risks of commercial real estate investment.  

Constants in a Sea of Change

Whether interest rates and energy prices rise or fall, what will never change is one fundamental aspect of the Northeast in general — the barriers to entry for new construction. Population growth in the Northeast is lagging behind the rest of the nation partly because many Northeast markets already are mature and well established, especially along the Philadelphia-Boston-New Jersey-New York corridor along the coast. Yet, the lack of fresh developable land sites in an already heavily populated region has helped keep the market in balance and will likely continue to do so. In New York and New Jersey, today’s high-density development will continue to provide opportunities for creative developers and the lenders able to provide the right strategic solutions in the current environment of uncertainty.

John Manginelli is senior vice president and district manager, New York and New Jersey, for KeyBank Real Estate Capital.

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