COVER STORY, FEBRUARY 2009

LENDING A HAND
Challenges in the Midwest financial environment find lenders exploring various ways to jump-start business.
Kevin Jeselnik

The lending environment for the Midwest commercial real estate industry is tentatively toeing the water in the early goings of 2009. There is still very little capital flowing among lenders, and even less is making its way down to the businesses that rely on debt financing for their operations.

This stasis is the major cause for concern in real estate, explains Dwayne Sieck, managing director of Mutual of Omaha Bank. “The regional and local banks are like the heart of the body for commercial real estate,” he says. “If they are not pumping capital through the body, then the limbs — developers, owners, tenants — fall off. This analogy illustrates the intent of the bailout: to pump money into the market through the banks and revive some lines of credit for the end users.”

According to Andrew Aiello, a principal in the Chicago office of Prudential Mortgage Capital Company, more lenders will re-enter the marketplace as the year goes on, but there will not be a huge rush to return to business as usual until there is clear evidence that stability has returned to the market.

“There will have to be a 6- to 12-
month period where there is no significant negative news, where there is true stability, before lenders begin making loans like they were making 2 years ago,” he says.

At Mutual of Omaha Bank, the 18-month-old offshoot of the long-standing life insurance company, Sieck’s originators are taking a hard look at the data on every loan that comes across their desks.

“We are not necessarily in a wait-and-see mode, but we are doing a lot of in-depth sensitivity analysis when making loan decisions,” Sieck explains.

Currently, both Aiello and Sieck indicate that the sector that is garnering the most interest is the multifamily market. Because it offers the opportunity to align with the government agencies —FHA, Freddie Mac and Fannie Mae — multifamily lending has proven to be a safer bet in this turbulent market.

“The government plays a part in keeping it liquid,” Aiello says.

There is a great availability of capital for multifamily refinancing thanks to the Federal agencies involvement. And refinancing is the most prominent lending activity in the market today. The unemployment woes and lack of population growth in many Midwest markets has slowed development activity, while the acquisition and disposition market is hampered by the volatility in market values.

“There is little activity in the market, which makes it impossible to tell what market value is, so nobody wants to sell now,” Aiello says. “Values are probably artificially low, because the majority of sellers on the market are distressed sellers.”

“Commercial real estate really comes down to one word in my mind, and that is ‘jobs.’” Sieck says. “As jobs are lost, there is less demand for office space, and less consumer capital to spend on goods and services, which ultimately results in fewer goods being transported, which drives down demand in the warehouse sector.”

Rising unemployment, and its widespread impact on real estate, has hit certain Midwest markets harder than others. Detroit, with its auto industry troubles, and Ohio are suffering from high unemployment. Aiello points to the Chicago and Minneapolis markets as exceptions, but such conditions are not the ideal environment in which lenders look to provide capital to investors or developers.

The major issue facing lenders today is the risk of default by borrowers. And that risk is at the forefront of many professionals’ minds now, as a significant number of loans are set to mature in 2009 and 2010. The prospect of loan defaults looms, and lenders are responding by beefing up their special services operations.

“When a loan comes due and the sponsor does not have the cash to pay it down, the bank really doesn’t want to take a loss, and it comes down to a workout situation to right-size the loan against the property,” Sieck explains.

Loan workouts are expected to be a growing business this year, as banks work with their borrowers to facilitate a solution that allows both parties to get what they want, to an extent. In a loan workout, practically any condition of the loan is negotiable, and the objective is to reach new terms that keep the owner in the building and making monthly payments to the lender.

“Number 1, the sponsor hates to give a property back and blemish their credibility,” Sieck says. “My job as a lender is to make good loans and get paid back, but in some cases, [a workout] may be beneficial because the sponsor likely knows the property better than anyone.”

Some lenders, after weighing the cost of foreclosure against the potential outcomes of a workout, may opt to foreclose, or sell the loan at a discount and take the mark to market hit on its income statement. Another option is simply extending the loan, and delaying its maturity.

“Lenders and CMBS bondholders may be forced to extend these loans [that are coming due in 2009 and 2010], because lenders typically don’t want to own real estate” Aiello says. “There are going to be loan extensions, but it remains to be seen whether or not they will be extended long enough for borrowers to get their problems worked out.”

When will the financial sector rebound and begin providing debt to borrowers again? Aiello believes it will take some time for that to happen in the real estate sector, because lenders want to see how the industry fares as the impact of the economic troubles really begin to be felt.

“[Real estate] tends to lag the general economy, and we haven’t seen many real fundamental issues yet,” he adds. “No one wants to invest until they see some stability.”

While the market lacks the stability necessary to jump start significant lending activity, what do borrowers need to bring to the table to secure financing in the market as it  stands now?

“It comes down to analyzing two things,” Sieck notes. “First is interruption risk, which regards rent roll, and then, the potential severity of loss. Ultimately, it goes back to how strong the sponsor is behind the deal.”

Lenders have returned to stricter underwriting after the free-flowing activity of the last few years. Borrowers portfolios and past transactions are studied carefully to ensure that they have the equity and operations to run their business.

“If a company wants to borrow money, they are going to have to really open their books and answer all of our questions to our satisfaction,” Aiello says. “They have to truly be that partner that we are looking for, a long-term partner.”

In the face of these economic challenges, there remain some opportunities for well-capitalized banks and borrowers in the Midwest. Investors that can bring significant equity to a deal will find potential bargains across the region. According to Sieck, some struggling owners will put properties up for sale in order to obtain liquidity for other business operations, and if a buyer understands that position, they can use that leverage to take advantage of these high-yield opportunities.

The Midwest commercial real estate industry is braced for the tough year ahead; it will be interesting to see how the Emergency Stabilization Act and Troubled Asset Relief Program impact the capital markets when they are fully implemented, and if the Federal government’s measures create any positive momentum in the industry. In any case, there are many opportunities and challenges in the Midwest that will keep lending professionals busy throughout the year.

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