FEATURE ARTICLE, SEPTEMBER 2006

NORTHEAST COMMERCIAL LENDING REPORT
Lending experts provide a glimpse into the current lending environment in the northeast.

The actions and appetites of the lending community are often an excellent barometer of the overall health of an industry. Northeast Real Estate Business asked several lending professionals to provide insight into the current trends of the lending environment for five different property types in the Northeast.  James P. Houlihan, partner of Houlihan Parnes-iCap Realty Advisors, LLC and founding member and president of iCap Realty Advisors, LLC, provided a glimpse into the office market. Joseph LaVita, sales director for Silver Hill Financial, LLC, and Thomas F. Welch, vice president in Meredith & Grew’s Capital Markets group contributed to the retail section. The multifamily portion was covered by Thomas Economou, senior vice president of The Park Avenue Bank. Paul Braungart of Regional Capital Group provided his expertise for the industrial market, and  Gregg Wolfer, the co-CEO of  Kennedy Funding, Inc., provided his thoughts for the hospitality portion.

Office

James P. Houlihan, Houlihan Parnes-iCap Realty Advisors, LLC

Currently, capital markets are aggressively financing permanent, interim, construction, mezzanine and equity loans. Because of the inverted yield curve and the sharp increase in short term rates; owners are replacing interim loans with long-term fixed rate loans. For instance, as of Monday, July 17, 2006, with the 30-day Libor at 5.37 percent and prime at 8.25 percent, in most cases, it is actually cheaper to borrow money long-term at lower spreads over indicative treasuries. As of the same date, 10-year treasuries were at 5.07 percent, the 7-year interpolated treasury was 5.05 percent, and a 5-year treasury was 5.04 percent. Recently, shorter-term treasuries have been higher than long-term treasuries.

Money is available at spreads over indicative treasuries from the high double-digit range to spreads of up to +125 from the CMBS market. The range of spread is based on the quality of the product and issues such as credit of the tenants, debt coverage ratio, rollover risk, and loan to value ratios. Typically, financing is available for up to 80 percent of appraised value or acquisition cost without having a negative effect on the spread. For lower leverage loans in the 60 to 70 percent range, spreads can be 10 to 15 basis points cheaper for the same product. 

Cap rates have been pushed to an all time low over the last 40 years. Most properties qualify on loan to value ratios. In addition, lenders have been more innovative and aggressive in order to win the frequent fierce competitions. Terms previously offered that have not been previously available include 10-year interest only terms or interest only for the initial 3 to 5 years on 10-year fixed rate loans. Thirty-year amortization schedules are common, and in rare cases longer schedules are available. Additionally, lenders are more flexible with TI’s, leasing commission requirements, and repair reserve requirements. As the CMBS market has matured, loan documents have become more borrower friendly. Loans are available on a par basis and quotes for third party reports and caps on legal fees are available. 

Borrowers have experienced difficulties dealing with servicers who are slow to respond and can attempt to hold up borrowers for additional fees above and beyond the standard .5 percent to 1 percent transfer fee. Brokers and borrowers have become more sophisticated in negotiating language to protect themselves.

Savings banks, insurance companies, credit companies and foreign lenders have all exhibited an abundant appetite for office products. Low to non-existing default rates and continued strength in the economy coupled with constant or increasing demand for space have placed office product at a heightened level of favor. Obviously, this is tempered by geographic region and also specific markets and sub-markets.

In the Northeast, the New York market has been extremely strong and the strength of midtown market has spilled over to surrounding suburban markets. As local economies continue to percolate, most suburban markets have continued to show declining vacancy rates and increasing asking rents over the last 12 to 18 months. This in turn has lead to more aggressive pricing for all types of products available to borrowers. Similarly, there is a strong appetite for both flex and industrial buildings from the same lending community.

The future bodes well for office building owners. There appears to be an ample supply of available funds and enough competition amongst lenders to put borrowers in a strong negotiating position. Look for this trend to continue for at least the foreseeable future, as sales prices remain high and cap rates remain low.  Lender demands will remain keen!

James P. Houlihan, partner, Houlihan Parnes-iCap Realty Advisors, LLC;  founding member and president, iCap Realty Advisors, LLC

Retail

Joseph LaVita, Silver Hill Financial, LLC

Industry experts predict that although sales are still above last year’s record levels, retail demand will continue to decline, making it perhaps the flattest performer of the property types in the remainder of the year. Partially to blame for retail’s plateau are high and rising energy costs that have discouraged consumer spending, along with the slowing housing boom. Not unlike the rest of the country, small towns across the Northeast are seeing a slight up-tick in cap rates. Observers note that this signals a peak in slower-growing markets, but on average, cap rates and prices have remained relatively stable.

Retail activity in the southern portion of the region — Connecticut, eastern Massachusetts and southern New Hampshire — is quite strong. This is in contrast to the fairly flat performance in other areas of the Northeast. However, retail properties in small-town New England are often mixed-use retail, the predominant stock in older communities. For example, the bakery with an upper apartment, or office space with a retail component, are commonly found in many communities across the region. Therefore, these “small-town” markets are more difficult to gauge in terms of the overall retail activity one could expect in the remainder of the year.

In upstate New York and major metropolitan areas of the Northeast, there seems to be a shift in interest from malls or small retail properties to more big-box stores. Strip malls are still very prevalent and one of the most common retail properties financed in the small commercial category. With high gasoline prices showing no signs of relief for consumers in the coming months, strip malls are likely to fare better than shopping centers. The former, usually offering a better mix of stores selling non-discretionary items, is less likely to be affected by tightened consumer spending. Still, retail rents are rising modestly. And with construction restrained at below-average levels, retail centers, particularly the very large and smaller deals, are being funded at record-high prices.

Retail’s flat activity has fostered a healthy competitive environment among lenders in the Northeast. In some areas, traditional lending institutions appear to be hungry to finance small commercial deals to keep business flowing. Perhaps viewing the commercial market as the knight in shining armor, many small and mid-size traditional community lenders are adding commercial to their portfolios. In addition, lenders are locking in rates in an effort to keep depositor business. Investors seem slow to consider non-traditional specialty lending programs to fund smaller deals, but may begin to see the benefits of these more efficient and flexible programs as lender competition heats up. Especially, as traditional lenders discover that it takes depth of staff and experience in commercial lending to be an enduring player in the market. 

Joseph LaVita, sales director, Silver Hill Financial, LLC

Thomas F. Welch, Meredith & Grew

Recently we have had the privilege of assisting retail developer and investor clients in obtaining high-leverage permanent acquisition financing, non-recourse land and construction financing, forward takeouts for construction loans and prepayment penalty avoidance, blend and extend loan rewrites, structured bridge loans for repositioning, preferred equity investments, and long-term self-amortizing loans. In fact, in conjunction with our Strategic Mortgage Alliance affiliated companies, we financed 376 retail properties in 2005, representing the largest total dollar value of any single property type among $12 billion in total financing.

The most frequent request has been for acquisition debt providing high positive leverage for deals bought at the lower cap rates dictated by a competitive sales process. While cap rates have remained low, the 10-year Treasury and the 10-year swap spread, a major component of quoted rate spread, have both increased over the past year. Consider, for instance, that on June 27, 2005, the Treasury closed at 3.9 percent and the swap spread was at 40.25 basis points. On July 31, 2006, the closing rates were 4.98 percent and 56.2 basis points, respectively. All else being equal, that equates to a rate increase of approximately 125 basis points over the past year. Cap rates have not increased nearly as much, if at all, so what has changed to make acquisition financing work?

In some instances, deals have fallen out of contract. However, lenders’ insatiable appetites, particularly for retail, have led to some meaningful changes in underwriting. First, in late 2005, spreads compressed to below 100 basis points for full 80 percent leverage deals, and while profit margin concerns put upward pressure on spreads, competition and product diversity requirements have kept spreads razor thin, especially for the conduits. Second, deals that were formerly underwritten at 1.25 to 1.30x debt service coverage are now routinely underwritten with 1.15x debt service coverage tests, or, alternatively, with a 35-year amortization schedule. Loan-to-value no longer constrains loan amount, and the proceeds are a function of an underwriter’s aggressiveness and creativity. To compensate the equity position’s need to achieve an adequate return on equity, many deals include a significant interest only period, which is followed by a 30-year amortization schedule. Often this bridges a period of time until scheduled rent increases occur, or until below market spaces can be re-tenanted. Also, while tenant improvement/leasing commission escrows and structural reserves are underwritten, lenders now commonly waive the actual collection, especially for retail properties. 

Normalization of scheduled rent increases and exclusion from stabilized vacancy and escrow/reserve underwriting for credit tenants (generally defined as BBB- or better) provide another technique for improving going-in debt service coverage. Mezzanine and preferred equity, the costs of which have compressed, may also be used to increase leverage well above 80 percent. Finally, potentially cumbersome and inflexible earn-outs and funded holdbacks, which are most often employed for space that is not yet completed, leased or occupied, offer the ability to increase leverage beyond what the property can support at time of initial funding.

Improved early rate lock options and the willingness to provide forward loan commitments, often with reasonable extension options, have better positioned CMBS lenders to compete with life insurance companies. These options allow borrowers to lock in rates in an uncertain rate environment and to remove a portion of the debt service coverage variable from underwriting. Not surprisingly, as the 10-year Treasury yield has fallen from its recent high of 5.25 percent on June 28, 2006, to its current 4.98 percent, borrower interest in locking rate upfront has increased.

Maximizing proceeds for CMBS financing of a retail asset requires collaboration between borrower, mortgage banker and lender to ensure that no opportunities are overlooked. This requires an experienced mortgage banker to review and identify any underwriting opportunities within individual tenant leases, to fine tune the analysis of operating expenses, and, ultimately, to determine which lender has the greatest need for retail product.

Thomas F. Welch, vice president, Meredith & Grew’s Capital Markets group.

Multifamily

Thomas Economou, The Park Avenue Bank

The major trend in multifamily real estate financing is the development of residential condominium projects; however, the type and size of developments are changing. Items now being considered in condo projects include the layout of the apartments (e.g. duplex, triplex, multiplex), attention to outdoor space, amenities equal to upscale luxury developments and greater privacy.

The hot multifamily market of the Northeast is Manhattan with increasing activity in Brooklyn, Queens and the Bronx. Outside of Manhattan, real estate owners are developing properties to address the demand for rental apartments. 

A recent report states some 7,500 residential rental apartments have been lost to condominium conversions. As a result, rental properties are experiencing a substantial rise in rates. Higher land and construction costs made it such that developers could not achieve a desired return on rental property investments. Now rising rents will provide a better return then originally contemplated for developers.

Borrowers are also developing rental properties for future conversion to condominiums. They are installing separate heating systems, on site parking and other amenities that would attract a condominium buyer. In these areas, a strong market for two- and three-family homes exists. These types of developments afford a buyer the ability to own their home and be a property owner. Rent from the apartments covers a portion of the carrying costs, plus a majority of these developments come with long-term real estate tax abatement.

Looking at multifamily financing in the next year, unless land prices and construction costs stabilize, an expected slow down in large condominium projects is projected. The market has already seen larger projects abandoned by their developers and/or a reconfiguration of the project, but smaller units are now appealing to a larger segment of buyers. Some developers are planning the sale of a portion of a project and retain the remaining units as rentals for sale later to maximize their return. Every condominium construction/conversion loan request is analyzed with a rental fallback scenario and alternative exit strategy in case the market softens further.

Lenders will continue to be attracted to investors that partake in adjustable rate and/or floating rate loans because there is little interest rate risk.

The multifamily lending environment has seen a reduction in the number of rental properties in New York City, causing greater competition for the remaining properties.  Few lenders that specialize in this type of lending hold their loans for their own portfolio.  They originate these loans for securitization and then sell them in the secondary market to bondholders; therefore, a lender can afford to provide low rate financing.

Changing interest rates are always a concern in multifamily lending. The Federal Reserve continues to raise rates; however, recent comments by the chairman has left the market believing there will not be many more rate hikes, (barring any major world or natural crisis). Despite the recent rate increases, Treasury rates remain flat.  However, if there are future rate hikes, Treasury yields may decline further.

The biggest factors affecting the real estate financing industry are higher land costs and construction costs, primarily steel, concrete and copper. These factors along with higher interest rates affect a developers’ overall return on investment. Given the limited supply of vacant land, a developer must acquire two or three contiguous parcels, assemble the parcels, and then submit their development plan. This process can take a year or more depending on the proposed development, but if an uncertain market strikes, developers may scale down their project or abandon it completely.

Thomas Economou, senior vice president, The Park Avenue Bank

Industrial

Paul Braungart, Regional Capital Group

With the rise in interest rates over the last couple of years, Industrial properties, or light industrial property-types are becoming increasingly popular. Industrial properties were originally located in urban areas for distribution purposes, but advancements in technology and infrastructure have allowed for companies to relocate or establish themselves farther away from their distribution sources. The technological advances available today have increased the demand for extremely large properties; giving individuals and companies the ability to reuse or lease/sell the unused space to virtually anyone. The ability to completely change the build-out in a facility or structure to accommodate multiple tenants allows and almost encourages the development of enormous industrial properties; whereby, should there be a need to sell or re-lease a space, there is very little cost and effort to do so.

Lenders have been seeing many condo-warehouse facilities being built and it’s a fairly simple concept. Similar to that of a residential condominium; whereby, a certain number of pre-sales are required, depending on the lender, but the costs are relatively low because the buyer is responsible for the build-out of the individual units and because they are zoned commercial. These trends towards multi-faceted industrial properties have driven the construction and redevelopment of industrial properties today, regardless of the interest rates. Every property will have the ability to accommodate any individual or company who elects to share space in an effort to reduce their overhead. Many developers or builders will borrow to construct these properties because they have pre-sold the property; thus, the rate is of little concern.

With existing industrial properties, the major concerns are environmental in nature because a large portion of the older buildings were constructed when contaminants, such as coal ash and chlorine, were not a concern of tenants, builders or buyers. As a lender, an environmental engineering report or a Phase 1 report is required and typically, the report may not be older than 6 months. This report looks at the property, its history and what the building or facility was previously used for. Based on this information and an in-depth analysis, the engineers determine whether the property is clean or if further investigation is deemed necessary. Typically, lenders will not provide financing for a property that is contaminated, but there have been situations in which a contaminated property has received an environmental insurance policy that will cover the costs to clean the property or the loan may include those costs as well.

Paul Braungart, founder and president, Regional Capital Group

Hospitality

Gregg Wolfer, Kennedy Funding, Inc.

However, it’s obvious that the overall market is tightening. And, as interests rates continue to rise, finding cash also becomes more difficult. Traditional lending institutions’ requirements become stiffer, the obstacles put in the way multiply, and the time it takes for borrowers to actually receive their money becomes even longer. 

However, direct, situational lenders, among them my company and others, represent an alternative to the barriers imposed by traditional lending institutions and conventional requirements. This type of lender not only offers an alternative money source, but extraordinary speed in closing the loan. Loans between $1 million and over $100 million that could otherwise take weeks or even months are concluded in as few as five days, with some closing in just 48 hours. It also helps immensely if the lender understands the hospitality genre thoroughly, and can structure virtually any kind of hotel project. 

By way of example, we recently closed a deal with an investor in Canada for the purchase of a hotel in the Niagara Falls area. The 1.59-acre property included a 113-room, 11-story tower hotel, a 32-room, two-story motel and a 403-seat restaurant. As it turned out, however, finding a lender ready, willing, and able to fund the borrower’s acquisition was no easy task. There were time deadlines, contractual issues with the seller, and certain building structural concerns which needed to be addressed. 

When the borrower eventually contacted us, we, like certain other private lending institutions, were able to help. The seller’s complications were handled, the structural concerns addressed and the borrower received his money in just days. 

Both lenders and borrowers can benefit from direct, situational lending in today’s hospitality marketplace because this type of lender specializes, which is the magic that makes deals work, especially in the competitive hospitality sector. 

For the foreseeable future, the probable pattern is that the hospitality market will continue to improve, while the overall market declines. And situational lenders will continue to offer innovative strategies and insight in making some of the fastest loans in the industry. Consequently, the opportunities for both lenders and borrowers in the hospitality arena will increase, and shrewd players on both sides of the fence will continue to flourish. 

Gregg Wolfer, co-CEO, Kennedy Funding, Inc.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.