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COVER STORY, AUGUST/SEPTEMBER 2010
LENDING MAKES THE WORLD GO 'ROUND
In real estate, access to capital is everything. So what is the state of commercial lending?
By Jaime Lackey
Two years after the $700 billion bailout, access to capital has improved, but who can get money and for what types of properties?
To find out, Northeast Real Estate Business talked with Alan Goodkin, managing director with New York City-based The Ackman-Ziff Real Estate Group LLC; David McLain, principal with Fort Lee, New Jersey-based Palisades Financial, LLC; and John Manginelli, senior vice president and Northeast regional manager with KeyBank Real Estate Capital.
According to Goodkin, “Generally, there is a reasonably vibrant financing market for office, retail, industrial and multifamily assets on either a permanent or bridge basis. Construction financing is available but limited to build-to-suits or projects with high levels of preleasing.”
Manginelli notes, “At KeyBank we have a primary focus on multifamily lending. There is an active pipeline, but much of it is agency-oriented. Fannie, Freddie and FHA are our biggest line of business now.”
McLain notes, “Multifamily is the only sector that has been performing well, but traditional lenders are having difficulty being competitive against the rates offered by Freddie/Fannie and HUD. Thus, there are few lending opportunities in this segment for traditional lenders.”
While Fannie and Freddie often have the best multifamily loan rates, owners of new or recently rehabbed multifamily properties may find significantly better loans with balance sheet lenders. Goodkin explains, “Fannie and Freddie look at cash flow for the trailing 12 months. Where the property has less than 12 months’ history or where a property has significantly increased occupancy due to lease up, balance sheet lenders can look at in-place cash flow and offer significantly higher loan amounts at competitive rates, say within a quarter to half point in pricing compared to an agency loan.” He cites a recent multifamily execution as an example. The trailing 12-month cash flow was $2.5 million, in place is $3.8 million and stabilized is projected to be $4.1 million. Balance sheet lenders were able to quote over $40 million in proceeds while the agencies were in the low $30 million range. The transaction closed at $42.5 million with an on book lender.
As for the hospitality sector, McLain says, “In some areas, such as New York City, hospitality occupancies are increasing again and showing some positive signs. Overall though, this sector was overbuilt by past excessive available leveraging and, as such, the ability to attract new lending to this industry will remain a major challenge.”
The Good News
“We have a subdued recovery. We still have high unemployment and weak consumer demand but employers are starting to report earnings,” Manginelli says. “Our pipeline reports are looking good, though the current financing is geared toward investors and owners of existing projects versus those coming out of the ground.”
Goodkin notes, “There is more capital in the market right now than financeable product to utilize it. There are not only a wide variety of lenders ready, willing and able to make non-recourse loans but there is also vibrant activity in the b-note, mezzanine debt, preferred equity and joint-venture equity areas of the capital stack. So from a commercial real estate lending perspective, conditions are significantly better than they were at this time last year.”
He continues, “Going into next year, it is anticipated that liquidity levels will continue to improve. Pricing and loan amounts for permanent and bridge financing should continue to improve compared to today’s market, where there is a significant spread between maximum and minimum loan dollars and cost of funds in the marketing of most debt transactions.”
Over-leveraged Properties
The fate of “underwater” loans will continue to play a significant role in the economic recovery.
On the one hand, McLain notes, many companies with equity to invest are attracted to opportunistic debt buys and foreclosed property purchases that offer much higher yields than recapitalizing an existing property.
On the other hand, there aren’t many of these properties coming to market.
Instead, lenders are working with borrowers. “Working through the borrower is often the lender’s best alternative for maximum net recovery of outstanding loan dollars, Goodkin says. “Lenders can generally negotiate 95 to 100 cents on the dollar at today’s fair market valuation. And there is equity, mezzanine and debt capital available to recapitalize these transactions.”
As examples, Ackman-Ziff has two separate shopping center clients, and each has in excess of $20 million of outstanding debt on their respective properties. Both shopping centers have a current market valuation of less than $10 million. If a lender seeks maximum recovery it has three alternatives:
• Foreclose, which takes time, money, energy and perhaps further deterioration of property value than where it is today, as well as further cost and delay due to bankruptcy risk;
• Sell the debt to a third party, which will be at some discount to market value when taking into account foreclosure and bankruptcy risk; or
• Working out a transaction whereby the lender recovers a current market value for the property, and the borrower has the opportunity to structure a tax efficient transaction as well as potentially staying in management and leasing.
“In the vast majority of cases,” Goodkin says, “the existing borrower will either need to invest all of the new equity to effectuate a transaction or at least take a sponsor position and align with a joint venture equity partner. In a limited number of situations, we have seen equity partners provide their sponsor partners with an implied capital account with no corresponding new cash investment.”
With regard to distressed new construction properties, Manginelli notes that there have been very few foreclosures. “In New York, Boston, and Philadelphia, we are seeing capital infused to finish those projects.”
Difficult Situations
There are still many scenarios that are difficult to finance. Land and construction loans in general are problematic.
According to Goodkin, “Land financings are the most difficult, on a non-recourse basis, whether it is urban infill in a primary market or a parcel anywhere else. Non-recourse debt and equity are available to experienced, well-capitalized owners and developers in their markets at yields commensurate with the risk involved.”
With regard to construction loans, the picture is improving. “Some construction loans are less challenging than others,” Goodkin says. “For example, if a developer has a build-to-suit for a dominant grocer in their market or a credit tenant for an office building or a retail box, there is construction financing available. But if a developer were seeking construction financing for a hotel or for a speculative commercial building, it would be far more challenging because hotels and speculative projects do not have underwritten contractual income from creditworthy tenants.”
When Will Things Get Better?
No one knows.
“What we are experiencing now is a slow process of dumping [toxic] assets into the system,” McLain says. “Every time there might be recovery in value, more bad assets enter the pipeline and push values down again. The real estate market cannot recover until bad assets and loans are shed, so elongating the process will only serve to hamper recovery.”
He references the crash of the late 1980s: “Then, the government formed the Resolution Trust Corp. and took measures for the lenders to quickly jettison bad real estate assets and loans. The system quickly cleansed these toxic assets, and that led to a recovery and normalcy in the real estate market.”
Goodkin believes the recovery in the commercial real estate sector is related to job creation. He is concerned that the lack of credit available to small businesses is impeding the commercial real estate recovery. “A strong, growing small business community would absorb more commercial and retail space,” he says. “When jobs return, the operating performance of buildings will improve.”
Small businesses account for roughly half of all jobs in the U.S, Goodkin notes. “It is the small business community that, in meaningful part, will help drive higher occupancies and rental rates for commercial owners and developers. The expansion of these small businesses would have a direct, meaningful impact on commercial real estate investment dynamics.”
McLain agrees that jobs and consumer confidence are vital to the recovery. He says, “Commercial real estate will not improve until confidence in the economy is restored. Even people with good jobs today are concerned about losing them, so many people are still in a ‘bunker’ mentality. Consumers must have confidence to begin spending, which will trigger the domino effect of consumption of goods, job creation, and demand for office and retail space.”
What’s Next in Lending?
According to Manginelli, “We will see stricter capital standards and higher compliance costs. There will be adjustments in loan pricing. Access to capital will not be a problem for larger, high quality companies but it could continue to be a challenge for smaller businesses.”
Goodkin says, “One trend that will continue into next year and beyond is the vertical syndication of many bridge and permanent loans. The one-stop shop of efficiently priced 80 percent of value permanent loans is gone — for now and the foreseeable future. The vast majority of our loan assignments that require 75 percent to 85 percent of value have at least two, and in many cases three, separate capital providers taking differing levels of risk within the capital stack and we see this dynamic going well into next year and beyond.”
McLain hopes to see “a change to the rating system that ensures separation between the issuers and the raters, so that once again confidence is restored in assigned rating of mortgage products.” He says, “This restoration of confidence is vital to attract the necessary capital back into the lending arena and rebuild the CMBS market to restore the real estate sector.”
In the meantime, McLain says, “Values are still difficult to pinpoint with so few transactions being done. Transactions will be conducted with an abundance of caution and risk aversion. Prime properties and transactions will attract lenders, while the B+ and lower properties will struggle for financing.”
LOAN MODIFICATION: A WORK OUT IN COMMERCIAL REAL ESTATE
In February of this year, the Congressional Oversight Panel issued a report announcing its concern that commercial real estate loan failures could threaten America’s already-weakened financial system. It stated, in part, as follows:
…Commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and … as the damage spreads beyond individual banks … it will contribute to prolonged weakness throughout the economy.
According to Foresight Analytics, a California-based real estate market research and analysis firm, about two-thirds of bank commercial real estate loans maturing by 2014 are “underwater” — that is, the borrower owes more than the underlying property is currently worth. In the first quarter of 2009, 9.1 percent of commercial property loans held by banks were delinquent, compared with 7 percent a year earlier and just 1.5 percent in the first quarter of 2007.
The ultimate impact of the commercial real estate loan problem will fall on smaller regional and community banks that have higher concentrations of, and exposure to, such loans than larger national or money center banks. This will be particularly problematic for the small business community because smaller regional community banks with substantial commercial real estate exposure account for almost half of small business loans.
If borrowers are unable to refinance their loans, financial institutions are faced with the dilemma of how best to recover their investments or minimize their losses. Are loans restructured and extended or are loans foreclosed and collateral liquidated?
Many banks have adopted the policy of extending loan maturities, hoping economic conditions improve and their borrowers’ ability to repay subsequently improves with the betterment of the economy. Stretching out maturities or allowing below-market interest rates has arrested the upward surge in defaults. These techniques have also helped preserve banks’ capital by keeping some problematic loans classified as “performing” and thus minimizing the amount of cash banks must set aside in reserves for future losses.
Some bankers see logic in extending loan maturities and delaying foreclosure as good business. They feel it is better for a bank to extend the loan and increase the chance that the bank will be repaid in full rather than call the loan and add the property to the existing glut of half-empty office complexes, hotels and shopping centers.
Others, however, characterize the strategy as “extend and pretend” or “delay and pray.” Skeptics argue that it is creating uncertainties about the wellbeing of both the commercial real estate market and some banks. The concern is that pervasive modification of this type obfuscates the actual breadth of the depressed commercial real estate market, as well as the damage banks will inevitably suffer to their balance sheets.
As a result of the commercial real estate crisis, a new cottage industry has been spawned – commercial loan modification consulting. Many people involved in the mortgage industry now perceive commercial loan modification as a new way to make money. Others such as commercial real estate agents, appraisers and residential loan modification consultants are adding commercial modifications to the array of services that they can now offer to their clientele. Groups in real estate departments of major law firms who previously worked on acquisitions, dispositions and leasing in the commercial real estate sector are now real estate “work out” specialists and spending the majority of their billable hours on these types of activities.
Appraisers have become particularly busy. A key component in determining the best course of action for both lender and borrower is an accurate measure of the current value of the property. This has become a very difficult task where many of the comparables typically used in a valuation or appraisal are a balance between foreclosure sales and legitimate investor income or capitalization rate based sales. Value becomes a moving target, changing monthly and having a wide range of variance.
A commercial loan modification consultant should understand how to value distressed real estate in a depressed market. What other qualifications should you seek in a commercial loan modification consultant? Certainly a consultant should have a strong financial background, preferably in commercial real estate. If the desired course of action is to salvage an owner’s investment, a consultant must be able to devise a going-forward plan that has credibility with the lender. A lender needs to be convinced that the borrower is in a better position than the lender to maximize the lender’s recovery. Put another way, a lender will want the outcome of a workout to be at least as favorable as would result from a foreclosure.
— Burton J. Jaffe is a partner in the Princeton, New Jersey office of Fox Rothschild LLP. |
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