COVER STORY, NOVEMBER 2011

CAUTIOUS CAPITAL MARKETS
As the recovery slows, how will lending be affected?
By Jaime Lackey

The black cloud of the European debt crisis has dimmed the economic outlook in the United States. Combined with lingering questions about our own long-term debt issues and lack of job growth, the uncertainty has slowed our economic recovery. What does this mean for the capital markets?

For more insight, Northeast Real Estate Business talked with Joshua Messier, vice president of New York City-based Centerline Capital; David Casden, who runs Centerline’s Mortgage Pricing Desk; Spencer Garfield, managing director with New York City-based Hudson Realty Capital; David Henrich, a senior vice president with the Philadelphia office of NorthMarq; Greg Haines, vice president with Jersey City, New Jersey-based Provident Bank; and Melissa Farrell, managing director with Prudential Mortgage Capital Company.

Capital is crucial in commercial real estate. So, what is going on with the economy — and what is the state of lending? As Garfield says, “Some people think that the world is coming to an end, while others think we are in a recovery — though no one could call it a robust recovery.”

NREB: What factors could affect the capital markets?

Casden: The global economy as a whole and most specifically the European debt crisis can and will affect the capital markets. If the crisis overseas does not contain itself, eventually credit will dry up between lenders and we will find ourselves in a situation we experienced a few years ago where finding loans at underwriting standards acceptable to the consumer was almost impossible.

David Henrich, senior vice president, NorthMarq

Henrich: The two most pressing issues affecting the capital markets are the possibility that the U.S. and European economies will experience a double dip recession and that the eurozone will not be able to solve its persistent debt crisis. Falling into a second recession will cause real estate lenders and investors to be much more cautious. Underwriting guidelines will tighten as investors will be concerned about falling valuations, rising vacancies, and lower rents. Demand for space will decline as well. Potential tenants will hesitate in taking additional space and may even decide to take less. Lease terms will be shorter and owners may need to offer rent concessions to keep tenants from leaving.

The debt crisis in Europe is all about contagion. What will happen if Greece defaults? Can the effects be contained to Europe? What effect will it have on U.S. banks? Whatever happens, the flow of capital will be altered. Already the flow of money between banks on the continent has been restricted, as some banks won’t make loans to other banks. Until the crisis is resolved, the results will be less capital and higher costs. The Commercial Mortgage-Backed Securities (CMBS) market experienced this during the summer months when investors, reacting to events in Europe, demanded higher returns to purchase certain securities that were being sold in the secondary market. While the CMBS market is trying to recover, their costs are still above market.

Spencer Garfield, managing director, Hudson Realty Capital

Garfield: At a minimum, political uncertainty makes people nervous. Any eurozone bank issues can affect lending in the U.S. If Greece defaults, it will impact banks. Dexia Bank is in the process of being bailed out. Any losses would have an impact. These factors probably will not diminish the capital available; the question is how long before we see a meaningful increase in the availability of capital? Where is the securitization market is and when it will come back? When it comes back, it will provide liquidity, which is good for real estate. But it needs to be smart money and not come back too aggressively because that will create more of the same problems we had.

Haines: The resolution of the European debt crisis could be significant. But we also have issues here in the U.S. that will continue to affect the economy. For example, problems in the housing market, fuel cost, continued unemployment and underemployment.

NREB: What are your expectations with regard to the availability of capital for the next year?

Farrell: Generally speaking, the Northeast is one of the strongest markets in the country. For quality properties in quality locations, there is definitely capital available today.

Garfield: If you have a quality sponsor with a stable property in a top-tier market, there is tremendous capital available. But if the sponsor is not strong, if the asset is not stable or if the asset is located in a tertiary market, the availability of capital drops dramatically.

Henrich: There seems to be plenty of capital in the market to finance existing income-producing properties. Life companies, Freddie Mac and Fannie Mae, banks, private funds, and equity investors have all participated this year. Conduits, on the other hand, have had an up and down year. This group was very active and competitive during the first half of the year. Their presence was very good for the overall market as they provided additional liquidity. The second half of the year has been a different story. Conduits rely on the capital markets to sell the loans they originate into the secondary market. This market broke down in early summer when the European debt crisis heated up and the rating agencies began to criticize and question their aggressive underwriting structures. They are slowly coming back into the market but pricing remains above market.

Josh Messier, vice president, Centerline Capital

Messier: I expect capital to remain accessible for borrowers looking to acquire or refinance properties. The government-sponsored enterprises will continue to capture the lion’s share of the multifamily market for permanent debt. Balance sheet lenders like life insurance companies and banks will be active and conduit lenders will also be a factor, however the CMBS market remains volatile. The construction debt market has slowly returned with a conservative approach to lending. Multifamily construction parameters remain more aggressive than office, retail and industrial due to the availability of permanent debt take-outs from the agencies. On the equity front, I expect institutional investors to continue their flight to quality in primary markets as development projects seem to be attractive to investors who would rather develop to a 6 cap than buy at a 4 cap. Smaller investors who are getting pushed out of larger markets are creatively finding deals in secondary markets.

Haines: Permanent financing is easier to obtain because there is a track record for the income stream. Construction lending is always a challenge because it requires analysis of the sponsor’s ability to construct the property on time and on budget, as well as potential lease-up risk.

Henrich: Banks, which provide most of the construction dollars, are still working through the loans they made during the height of the market. The story needs to be compelling to have any chance of having a bank commit to this loan type.

Garfield: HUD is one of the few options to finance ground-up development. Otherwise, all the stars must line up for construction financing from a conventional source. You must have an established sponsor of the highest quality, a tremendous amount of equity, a top-quality asset, and a strong location.

NREB: What do you expect in terms of interest rates? How does this compare with the interest rates seen in the last couple of years?

Casden: For the near term, or 18 to 24 months, I expect long-term interest rates to remain at historic lows as the economic recovery from the recession continues at an extremely slow pace. With unemployment expected to remain historically high, and GDP expected to grow slowly, we see no real reason that the investor community would retreat from the safe haven of U.S. Treasury securities. This will continue to translate into historically low mortgage rates for the foreseeable future.

Greg Haines, vice president, Provident Bank

Haines: The Federal Reserve has indicated that it is committed to keeping short-term rates low in order to simulate the economy and produce jobs. This should keep long-term rates low as well. We may see rates fluctuate a little, maybe a 35-basis point increase, but nothing that will significantly affect capital available for commercial real estate financing.

Farrell: The Fed has indicated that it expects to keep interest rates low for the next few years. Borrowers have heard that loud and clear. They expect low rates will be available through the next year.

Henrich: The Federal Reserve has flooded the financial system with liquidity since the financial crisis in order to help the economy to recover and to make borrowing more affordable. There is no indication at this time that the Fed’s policy will change. However, the policy could change if the U.S. and other world economies begin a strong, steady recovery and the European debt crisis is resolved.

NREB: Underwriting requirements for commercial property loans changed dramatically during the recession. Have things continued to evolve?

Garfield: When the recession hit, the knee-jerk reaction was to tighten underwriting beyond what was reasonable. Underwriting has loosened a bit but it is still much stricter than we saw in 2006 and 2007.

Haines: Banks will continue to require higher levels of equity from qualified sponsors over the next few years, and most financial institutions will continue to require higher levels of pre-leasing for construction projects than required before the recession.

Farrell: We’ve seen a decline in cap rates used for underwriting, and loan-to-value ratios have increased from their lowest point. On the life company side, I don’t feel that we are becoming too aggressive. I do think life companies, which are moderate leverage lenders, are becoming slightly more aggressive with lending on Class A properties.

NREB: What is happening with distressed properties in the Northeast these days?

Messier: Although much of the Northeast hasn’t seen the volume of distressed assets prevalent in other parts of the country, there is a niche for lenders offering bridge-to-permanent financing programs, particularly for multifamily properties. The perm is often in the form of an agency takeout and these programs are ideal for properties in performing markets that have been mismanaged or are in need of slight to moderate rehab in order to achieve market rents.

Garfield: This market offers a tremendous opportunity for an opportunity fund like Hudson. In general, we do $30 to $40 million in bridge financing each quarter. Seventy percent of that is in the Northeast. Typically, we’re working with properties that need to be renovated or leased up, or we are financing discounted debt acquisitions.

Many people expected a landslide of distressed debt to hit the market, but this has not occurred. There has been a steady flow of distressed assets coming to market and this should continue. Low interest rates have allowed lenders to extend and modify loans, and continued low interest rates will allow lenders to continue working with borrowers. However, as modified and extended loans come due, there may be an increase of distressed assets hitting the markets. Lenders that do not see a viable exit may choose to sell debt at a discount.

Melissa Farrell, managing director, Prudential Mortgage Capital

Farrell: While it is difficult to predict how many distressed assets will hit the market, there is certainly appetite for these assets among investors, particularly in the Northeast, which is one of the strongest markets in the country. Overleveraged buildings are being recapitalized, especially in New York.

Haines: In terms of office and retail properties, quite a few sponsors have been injecting cash and may be running out of reserves. There is a higher risk of distress in secondary locations. During the recession, we saw a rapid decline in property values. That has leveled off. We do not expect to see a continued dramatic drop in values. Occupancy levels will rebound slowly. In the meantime, tenants are still in the driver’s seat and they are pushing for higher tenant allowances and favorable lease terms — which will continue to keep property values flat.

NREB: Which property types will lenders favor in the Northeast in 2012? Why?

Henrich: Clearly, the hottest market is the apartment sector, followed by grocery-anchored retail. The apartment market has recovered nicely in most markets around the country. Rents and occupancy levels are rising with rent concessions almost non-existent. Thanks to the federal agencies, Freddie Mac and Fannie Mae, capital is readily available — and at very low rates. Driving this market is the weak economy and the for-sale housing market. Some of today’s renters are concerned about the unstable labor market, persistent declining home prices and high credit standards needed to obtain a residential mortgage loan. Grocery-anchored retail centers with a dominant grocery store operator on a long-term lease make up a highly desirable asset class in this market. Capital providers are attracted because of the stability the grocery store provides.

Messier: I expect the multifamily asset class to remain favorable among lenders in the Northeast heading into 2012. The combination of increasing occupancy rates and decreasing cap rates in the region’s core markets make multifamily assets very attractive. Other asset classes could benefit from increased lender appetite assuming there’s a low cost of capital.

Garfield: Outside of the multifamily market, lenders are tripping over each other to finance core assets in top-tier markets. Lenders are hesitant to loan on suburban hospitality, office and retail that isn’t anchored by a grocer.

Farrell: Lenders are often not willing to close loans for CBD office properties — and will continue to shy away from these assets until job growth returns. Hotels are also difficult to finance due to the volatility of one-day leases, where both business and pleasure travel depend on the economy.

Haines: Acquisition of properly priced real estate continues to be attractive provided the asset is acquired at today’s value and not on an anticipated value in the future. The tremendous amount of product that will be maturing in the collateralized market will provide such continuing opportunities.

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