FEATURE ARTICLE, FEBRUARY 2005

MIDWEST LENDING CLIMATE
A look at what lending activity to expect in the four major property types this year.
Tom Anderson, Susan Branscome and Terry Dunaway

Commercial real estate in the Midwest has long been a favorite investment of life insurance companies and conduit lenders. The increasingly stable economy and low cost of living appeal to these institutional lenders, who 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 selective appetite for hotels). Last year may not have been an ideal year for industrial, office, multifamily and retail lending, but 2005 is looking promising across these four property types in the Midwest markets.

Industrial

The industrial real estate sector (specifically multi-tenant, office/

warehouse and high cube distribution buildings) was once again an important asset class for institutional lenders in 2004 and is expected to continue to grow in 2005. The reason for this is two-fold: 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 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. This has resulted in a very competitive environment for portfolio transactions — those with several properties being financed simultaneously for loan amounts in excess of $10 million to $15 million.

Market fundamentals also are working in favor of industrial lending, as most industrial markets have weathered the recent recession far better than office, and in some markets, apartments. Vacancy rates are currently less than 10 percent in Kansas City, St. Louis and Cincinnati. With the improving economy, industrial properties will be one of the first product types to recover as manufacturing inventories grow. The lack of new speculative industrial construction in most markets also will contribute to the segment’s continued improvement.

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.

Office

The forces affecting office properties are both positive and negative going into 2005. A growing economy is creating new jobs and new development is minimal, both of which should increase demand and reduce vacancy rates for Class A and B buildings. However, existing shadow space and the trend to do more with less people will temper office space demand.

Lenders will continue to selectively finance office properties. Some lenders are looking to reduce exposure to this property type, having increased the percentage of their mortgage portfolio to more than 30 percent in the past cycle. Well-located, multi-tenant properties with strong and experienced ownership will always find competitive funding sources. Compared to conduits, life insurance companies will take a more conservative approach to loan-to-value (LTV) and amortization, but will be more flexible regarding reserves for tenant improvements, leasing commissions and tax and insurance impounds. Life insurance companies can also be more creative than conduits when structuring hold-backs or future funding. Aggressive lending goals for this year will force lenders to continue with this product type, but they will do so with care and selectivity.

On the investment side of office buildings, the average investor will continue to be cautious. Special niches and partial users will attract buyers that are mindful of rising interest rates. The institutional buyers and sellers will continue to be active, as their portfolio needs dictate. This class of buyer will have a longer investment horizon and the staying power to see this soft market through to occupancy in the 90 percent range. Rising rates may squeeze some owners, which will cause foreclosures and activate another investor segment looking for bargains offered by lenders.

Retail

Retail lending has been a bright spot in an otherwise cautious lending climate. Despite the jobless economic recovery, consumer spending is 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 able to be financed at some loan-to-value and interest rate by many life insurance companies and conduits. Credit tenant lease deals give the owner an advantage with 100 percent financing possible if the retail credit is investment grade and all real estate risk in the lease is mitigated through insurance or amortization.

The lifestyle center is still the newest kid on the retail block. This retail center concept enhances the customer shopping experience through a unique combination of anchors, tenants and restaurants. Conduit lenders and life insurance companies differ greatly 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. Conduits will offer up to 80 percent LTV, while life insurance companies will generally not lend more than 70 percent LTV.

In terms of large format retailers, discounters like Wal-Mart, Target and Meijer are doing fairly well. However, traditional department stores struggle to find a winning strategy to capture the consumer dollar, and the jury is still out on what the Sears/K-Mart combination will mean for the market. 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 115 to 135 basis points during the 10-year treasury yield are common on the best deals, which are currently yielding interest rates in the mid-5 percent range.

Many life insurance companies have realized that to originate multifamily loans, they must offer borrowers 80 percent LTV to effectively compete with conduits and the Freddie Mac and Fannie Mae. Interest rates and LTV levels by life insurance companies now are much more competitive with Fannie Mae and Freddie Mac. Conduits tend to gravitate toward the tougher multifamily deals based on age, location or condition. Although, many conduits are also offering loan terms that are quite competitive on Class A properties. Life insurance companies have an advantage over their competition by locking the interest rate in early during the origination process and not requiring funded replacement reserves.

There is one dim spot in the multifamily sector — climbing vacancy rates due to continued 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, although it appears that the vacancies are being absorbed with little new construction.

Tom Anderson, Susan Branscome and Terry Dunaway are commercial mortgage bankers with Triad Capital Advisors, a full-service mortgage banking firm with offices in Kansas City, Missouri; St. Louis and Cincinnati.



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