Today, the commercial real estate lending climate is one of contrast and concern. On one hand, many Midwest markets are overbuilt in almost all property types. For example, office space suffers from climbing vacancy rates and increased amounts of sublease space on the market. In addition, stagnate job growth and a weak economy have led to flat and/or falling lease rates, or increased concessions. Industrial space, traditionally a stable market for investment, has also seen increased vacancy rates due to a prolonged soft economy. Apartments — once a very stable real estate investment — have also suffered from increased vacancy and falling rental rates. Investing in retail is a concern due to decreased consumer spending and a general consolidation in the industry. Further, a tremendous amount of new and converted condominium product has come online in the Midwest.

Conversely, investors have become competitive with top quality real estate in major metropolitan statistical areas (MSAs). This phenomenon is the result of low interest rates, a lack of confidence in the stock market and an abundance of cheap capital. In addition, the cap rates at which these properties trade have continued to experience downward pressure at a time when the market continues to suffer from weak demand.

Apartments are feeling the effects of overbuilding in the marketplace and low interest rates on home mortgages. Further, many developers that typically build apartment product — then sell or place long-term financing on the property directly after completion — have been unable or unwilling to do so as the properties are taking longer to stabilize. Yet, investors still favor this product type because it is historically stable and because cap rates remain low.
Overall, construction for speculative properties has slowed to a trickle, and projects under development must have strong sponsors and good sources of equity. This trend — coupled with the general economic outlook — has caused many developers to wait for times to get tougher in hopes of some buying opportunities. At the same time, due to low interest rates, many current owners have elected to hang onto their properties rather than sell them. In sum, lower interest rates have masked many problems.

Accordingly, some investors have moved to second tier markets from major MSAs for better opportunities, as they cannot compete for properties that are selling at historically low cap rates in top tier markets. Also, some local and national investors continue to search for turn-around properties.

To this end, some Midwest and national banks are moving to back foreign and domestic real estate investors who are seeking high quality, Class A properties with a stable tenant base. Pricing on this type of product is usually thin.

Some banks are focusing on local and national developers via short-term bridge loans — providing capital to acquire turn-around or to carry newly developed projects. This financing solution tends to provide better fees, pricing, opportunities and relationships for the banks and financial institutions that lend to this market.

Still, other banks have taken a different view on lending. One example is providing lending for hotels, which have been very hard hit since September 11, 2001. Lenders to this product type are garnering higher spreads with lower loan-to-value rates than almost any other property type. Construction lending to this product type is generally made to strong developers with a proven track record. For existing hotel properties, bridge financing provides the developer just that — a bridge — until the market improves. The hope is that when the economy improves, occupancy and average daily rates also will improve. Accordingly, value increases should result in sale or long-term fixed rate loans when the property type comes back into favor.

Lending to retail properties — with the uncertainty of a pick-up in the economy, lower consumer spending and general consolidation in the industry — seems tough at best. However, competition is fierce for well-located, grocery-anchored centers, and for existing high-density retail areas. Banks continue to lend to this product, but returns for banks are thin at best.

However, investment opportunity does exist for well-located retail in secondary markets. During the past several years, the weak malls in secondary markets have failed. They have either been raised, or turned into secondary-use product such as flea markets, car lots or cheap offices. Much of this product currently sits vacant.

Many malls that have survived the retail downturn have started to benefit from renewed interest from retailers. In turn, real estate investors have been attracted to these properties based on high barriers to entry for new product. These trends make the existing product the only game in town. As such, out-parcel development is on the rise, and developers are focused on improving tenant mix leading to nice profits for developers and suitable spreads for banks with conservative loan-to-value ratios.

A number of lenders have funded condominium loans, a product type that has added about 3,500 units a year to Chicago alone in the last several years. Delivery by some estimates is about 11,000 units over the next 3 years. Of late, demand for product has slowed. Further, a reported high number of sales contracts have been sold to “speculators” (individual investors that enter into contracts with delivery dates as far out as possible with hopes of turning a profit). Bank advance rates against costs have decreased, and pre-sale requirements have increased. Spreads on well-capitalized development remains tight, but the trend has, in most cases, been for increased pricing.

Many banks are moving to finance smaller in fill projects or projects where development was stalled due to local governmental constraints. In cases where these constraints have been lifted — as in some surrounding Chicago suburban locations — cities are seeking development to garner tax dollars and urban development. In many cases this type of product offers low price points and acceptable spreads to banks.

In sum, the overhang of the economy has influenced the commercial real estate market for all property types. The ability to offer financial flexibility to the developer — and to lend into changing types of markets — helps fund investment in real estate, and helps provide profit and solid loans to the banking community.

Leonard Dzielski Jr. is vice president with Naperville, Illinois-based Pullman Bank.


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