Heartland Real Estate Business recently spoke with several lenders and mortgage brokers in the Midwest about what this year holds in store for the capital markets in the four major asset classes (multifamily, retail, office and industrial). The participants were Mike Miller, principal with Chicago-based Baird & Warner Real Estate Capital; John Luka, executive vice president of national loan production for Atlanta-based Column Financial; Stuart Greenberg, senior vice president and assistant branch manager in the Chicago office of Horsham, Pennsylvania-based GMAC Commercial Mortgage Corporation; James Turner, senior vice president with Chicago-based LaSalle Bank; Jim Hoopes, vice president/producer with Minneapolis-based NorthMarq Capital; Neil Gorosh, vice president of Southfield, Michigan-based Bernard Financial Group; Jim Doyle, president with Cleveland-based Capstone Realty Advisors; and Leonard Wineburgh, president of Chicago-based Dwinn-Shaffer & Company.

According to these lenders and mortgage brokers, commercial real estate will continue to be active this year following a busy year in 2003. One reason for this activity is that the capital markets view commercial real estate as the favorite asset class — not only because there is a lack of alternative investments, but also because it typically performs well. As a result, many lenders are maintaining or increasing their allocations for commercial real estate mortgages for this year.

“There is severe pressure on all financial institutions to fund even more loan dollars than in 2003,” Miller says. “Given the limited amount of new construction in the four sectors of commercial real estate on a nationwide basis, there will continue to be more money available than deals, creating downward pressure on spreads throughout the year.”

Luka has also noted this high availability of capital. “At this point, we see absolutely no diminished supply for real estate capital at all levels of the investment spectrum, including investment grade, B notes and mezzanine debt,” he says. “The last number I heard was $30 billion worth of mezzanine supply for only $3 billion worth of potential opportunities.”

GMAC’s Greenberg goes as far to say that, in his 30 years in commercial real estate, he has never seen a greater abundance of capital or rates at such favorable levels. “The past few years have seen long-term permanent mortgages widely available at rates of less than 6 percent,” he says. “Such low rates make it easier for properties to meet their debt service. Having mortgage rates as much as 250 basis points less than they had been for several years is a great benefit for the property owner.”

With all of this capital, the new development deals remain highly competitive. According to Turner, the few development deals that are moving forward tend to have significant pre-leasing or equity involved.

With these market fundamentals in place, lenders will continue to see greater leverage demanded by borrowers. “Low cap rates, coupled with lower interest rates have continued to drive up property values,” Hoopes explains. “The increase in property values, even with higher vacancy rates, has lenders struggling to meet the higher leverage demands of borrowers.”

In this borrower’s market, lenders will need to look beyond the four major asset classes to satisfy loan demands, Hoopes adds. “Lenders are considering medical office, self-storage and hotels to meet their 2004 goals,” he says.

Last year’s high lending volume has many lenders thinking about a possible decrease in volume this year. “Even in commercial real estate, where substantial prepayment penalties continue to be enforced, low interest rates have been driving refinancings,” Gorosh says. “Most of the properties that could be refinanced have been.”

However, the possibility of rising interest rates this year could be what fuels additional loan originations if borrowers forego low floating rate debt and lock into permanent loans. “Given the election year, we don’t expect significant change in the capital markets until late in the year,” Miller says. “If interest rates rise, or the value of the dollar weakens considerably, the dynamics of the market will change. We expect a rate rise to initially create a flurry of long-term lending as borrowers seek to lock up loans that they have been holding on a floating-rate basis due to the low, short-term rates.”

If this scenario is carried out, Miller would expect it to continue for 6 months to 1 year because there are a considerable number of floating rate loans that could be candidates for refinance. After this time period, Miller predicts that it will take an additional 6 months to 1 year for all players to adjust to the new interest rate environment.

In contrast, Greenberg does not expect interest rates to rise significantly, or at all, this year. “Because inflation has remained at less than 3 percent, there is not a viable reason to raise rates at this time,” he says. “Neither a new president nor an incumbent wants to confront a situation in which interest rates have been raised unnecessarily and the cost of money is rising rapidly.”

However, lenders continue to be competitive and innovative due to the opportunities that are available for refinancing commercial real estate mortgages. According to Wineburgh, lenders are optimistic about multifamily projects and industrial properties.

“Multifamily appears to be first on most lenders’ plates, with hotels and office buildings being more scrutinized,” Wineburgh says. “Retail and industrial continue to hold their own, with many lenders working hard to win the better deals.”

Multifamily has long been the darling of institutional investors in Ohio, according to Doyle. “It has only been in the recent past that vacancies have crept up as tenants have been lost to new housing, a poor economy and continued construction,” he says. “This asset class, however, will continue to be the favorite of most institutional investors as cap rates for multifamily are only outpaced by net-leased credit deals.”

According to Luka, retail will remain strong, and new home development will drive the need for new neighborhood centers. “Lenders looking for stability in the cash flows of their collateral will lend aggressively on long-term, credit-anchored retail,” he says.

The office sector, however, continues to lag behind the nation’s economic recovery. Yet, Luka believes that the office sector may be one of the most promising for lenders this year. “Properties with good locations and excellent management should outperform other property types for net operating income growth,” he says. “The biggest variable remains job creation, which will be needed to fill office space.”

The industrial sector, especially the warehouse distribution market, continues to see activity, but rental rates are competitive, Turner says. In Ohio, for example, absorption is starting to pick up, suggesting that the industrial market will have a bright future this year. “New construction starts are being seen and owner-occupiers are beginning to look for expansion and/or new buildings as they rev up the growth within their respective industries,” Doyle says.

With this abundance of capital available for financing commercial real estate properties, lenders have stuck to their aggressive underwriting standards. “Capital sources are focusing on the fundamentals of market vacancies, actual operating expenses and market capitalization rates to arrive at values for purposes of establishing loan amounts,” Doyle says.

These aggressive standards range from increases in allowable loan-to-value ratios to a recognition that capitalization rates below 8 percent are widely prevalent in the market for quality real estate assets, Miller explains. However, there is good news for lenders. According to Gorosh, the amount of available capital for real estate should ensure that all but the truly non-performing assets could be financed this year.

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