FEATURE ARTICLE, APRIL 2004

INSTITUTIONAL LENDING GAINS FAVOR
This year shows promise of a growing appetite for commercial real estate loans.
Tom Anderson, Susan Branscome and Joseph Monteleone

Midwest commercial real estate has been a favorite investment of life insurance companies and conduit lenders for a long time. The relatively stable economy and low cost of living appeal to these institutional lenders, which finance real estate on a long-term, fixed-interest-rate, non-recourse basis.

Institutional lenders typically concentrate their lending on four main asset types: industrial, retail, multifamily and office (with a much smaller and selective appetite for hotels). While 2003 may not have been an ideal year, 2004 is looking promising across these four property types in the Midwest markets.

Industrial

The industrial real estate market sector — specifically, multi-tenant, office/warehouse and high cube distribution buildings — continues to be an important asset class for institutional lenders. For most lenders, this class represents a targeted property type because of asset diversification and market fundamentals.

In contrast to other property types, industrial projects take fewer dollars to produce, so the loans on these projects tend to be smaller than loans on typical shopping centers, office buildings and apartment complexes. This factor results in lenders’ portfolios being somewhat under-weighted in industrial loans. With the increasing appetite for commercial real estate loans on the part of investors, there is a push to produce proportionately more loans on industrial projects. As a result, the environment for portfolio transactions with several properties being financed simultaneously for loan amounts in excess of $10 million has become competitive.

Market fundamentals also are working in favor of industrial lending because most industrial markets have weathered the recent recession far better than the office market and the apartment market. In Kansas City, St. Louis and Cincinnati, industrial vacancy rates are currently less than 10 percent, which is well below current office vacancy rates in these markets. Industrial properties also are typically one of the first product types to recover from recessions as manufacturing inventories grow. The lack of new speculative industrial construction in most markets also will contribute to the segment’s recovery.

There has never been a better time to finance industrial real estate on a long-term basis. Historically low interest rates, strong lender appetites and improving market fundamentals combine to produce an attractive combination for borrowers.

Retail

Retail lending has been a bright spot in an otherwise cautious lending climate. Despite our jobless recovery, consumers are still spending, leading to fairly strong retail markets.

Grocery-anchored retail centers remain the favorite retail property among institutional lenders. These centers are increasingly harder to come by, as strong grocery players like Kroger are more likely to build their own stores.

Unanchored strip centers, power centers and free-standing big box retailers all are financeable at some loan-to-value (LTV) level and interest rate by many life insurance companies and conduits. Credit tenant lease deals (CTLs) provide an advantage to the owner with 100 percent financing if the retail credit is investment grade and all real estate risk in the lease is mitigated through insurance or amortization.

The newest kid on the retail block is the lifestyle center. This retail center enhances the customer shopping experience through a unique combination of anchors, tenants and restaurants. Conduit lenders and life insurance companies differ in their approach to lifestyle centers. Conduit lenders are aggressive in their underwriting of lifestyle centers with much more acceptance of co-tenancy clauses and lease cancellations based upon sales levels. Conduit lenders will offer up to 80 percent LTVs, while life insurance companies will generally not lend more than 70 percent LTV.

In terms of the retailers, discounters, such as Wal-Mart, Target and Meijer, are all doing fairly well, while department stores continue to struggle to find an accepted niche and capture the consumer dollar. Many specialty retailers and drug stores are performing well and expanding.

Multifamily

Comparing all commercial property types, the best interest rates can be found in the multifamily sector. Spreads as low as 125 basis points to 140 basis points over the 10-year treasury yield are common on the best deals, yielding interest rates of about 5.5 percent to 6 percent.

Many life insurance companies have realized that if they want to originate multifamily loans, they must offer borrowers 80 percent LTV to effectively compete with Freddie Mac and Fannie Mae. Conduit lenders tend to gravitate toward the “tougher” multifamily deals based on age, location or condition, although conduits’ loan terms are quite competitive on Class A properties. Life insurance companies have an advantage over their competition by locking the interest rate early in the origination process and not requiring funded replacement reserves.

Nonetheless, Freddie Mac and Fannie Mae still dominate the origination of permanent multifamily lending. Despite Freddie Mac’s accounting woes and management upheaval last year, the company continues to lend aggressively.

One dim spot in the multifamily sector is climbing vacancy rates due to low-interest-rate-driven home ownership. Low interest rates are a double-edged sword for apartment owners: the advantage of obtaining low interest rates on their permanent loans is offset by losing tenants who take advantage of low residential interest rates. All lenders focus on vacancy rates in their underwriting, which can lead to lower-than-acceptable loan amounts for borrowers. Overbuilding in the high-end multifamily sector also has led to higher vacancy rates.

Office

The weak fundamentals of office leasing have made lending on office buildings more difficult than in the past. Vacancy and concessions are up, and lease rates are down. Together, these trends mean the value of many office buildings has decreased significantly. Most institutional lenders will now lend only 65 percent to 70 percent LTV on office buildings, and they require escrows to cover leasing rollover risk.

Some buildings are inherently easier to finance. Lenders will stretch for an office building with excellent access, visibility and plenty of parking in a viable central business district. The ideal building will be multi-tenanted, with not more than 10 percent to 15 percent of the building’s leases rolling in any one year. Other considerations include the building’s operating and occupancy histories, as well as the management capabilities of ownership.

Office properties that do not match this ideal can require a creative loan structure to offset the possible downsides. One example is retaining ongoing reserves so the cash is there if needed to pay for new tenant costs, such as leasing commissions and interior improvements.

Several lenders have developed mezzanine debt financing, which essentially is a form of secondary financing that enables a borrower to get additional loan proceeds. The interest rate coupon for the mezzanine debt usually is in the double digits but, when combined with the first mortgage debt (depending on amortization), the all-in blended rate is in the acceptable range of the market.

It takes a little imagination to make loans on office buildings right now. The market appears to have hit the bottom of the cycle, and vacancy levels may soon start to decrease. Even with the current weak fundamentals, office buildings are a class to keep, especially if borrowers can lock in today’s long-term rates.

Executives of Triad Capital Advisors: Tom Anderson, senior vice president, Kansas City; Susan Branscome, principal and executive vice president, Cincinnati; and Joseph Monteleone, principal and executive vice president, St. Louis; wrote this article.


©2004 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.