Construction Projects, AZRE Magazine March/April 2011

Interest rates create uncertainty in CRE financing

Looking at the commercial real estate financing industry is like looking at statistics: There can be several different interpretations.

If you look at the numbers from 2015, commercial and multifamily mortgage bankers closed $503.8 billion in loans, according to a report from the Mortgage Bankers Association (MBA). Those numbers were 26 percent higher than 2014.

“Commercial real estate borrowing and lending in 2015 came within a whisker of the record  level of 2007,” says Jamie Woodwell, vice president of commercial real estate research for MBA. “Despite some credit market disruptions to start off this year and regulatory hurdles still ahead, many of those positive factors (that helped increase numbers) remain in place.”

Sounds pretty good, right? Not so fast.

A  three-year economic forecast from the Urban Land Institute (ULI) Center for Capital Markets and Real Estate says we can expect to see commercial property transaction volume decline over the next three years. ULI anticipates $475 billion in transaction volume by 2018.

One reason for the uncertainty is interest rates. The Federal Reserve made it clear in December that it sees growth as relatively stable and raised the rate a quarter point. While the Fed’s rate hike is small and the rate remains low, the hike is unlikely to have a massive effect on its own, but subsequent hikes are predicted for next year.

“In the short term, it does not appear that rates are going to be much of an issue,” says Stephen Loonam, executive vice president of commercial real estate for UMB Bank-Arizona. “We sensitize the floating rates so that we understand how high rates can go before a property’s income stream is no longer able to adequately service the debt.”

Loonam says that because rates are depressed at the moment, it is driving values higher in all asset classes, not just real estate.

“I think the larger concern is what happens in the long run,” he says. “Rising rates will eventually hold back values of assets, which could be a problem for assets with maturing loans. As rates rise in the long term, it may be difficult for borrowers with maturing loans to refinance.”

With rates at record lows for the past several years, lenders have been forced to widen their spreads and to sensitize their underwriting to make sure the property can service debt at a higher interest rate, according to Don Garner, executive vice president of Alliance Bank of Arizona.

“If rates increase in a gradual, measured fashion, it should have a moderating impact on development and lending as high leveraged deals will be less feasible,” Garner says.

Beyond interest rates, what can the commercial real estate industry expect when it comes to financing projects? AZRE talked with some of the most dynamic and active lenders in CRE to find out what they’re looking for, what projects they have financed and what to look for in the world of commercial real estate financing.

Don Garner, Executive vice president, Alliance Bank of Arizona

FACTORS TO CONSIDER: “In addition to the real estate specific factors like location, feasibility, condition, etc., we focus on the sponsor. Does management have successful experience with this property type and with a project of this size and scope? Are they familiar with the geographic market the project is in? And what is their history in terms of handling their loans with other lenders?”

TREND TO WATCH: “Overbuilding in certain property types is a concern. Developers and lenders often follow the herd instinct and financing becomes readily available at aggressive terms, which can lead to over-leverage and overbuilding. Apartment construction financing is a good example. Large banks were very aggressive two or three years ago, but now have pulled back significantly.”

PROJECTS ALLIANCE HAS FINANCED: Town & Country shopping center redevelopment, Enclave at the Borgata condo project in Scottsdale, expansion of the Trilogy project at Vistancia, Park Lucero light industrial project in Gilbert, SkySong 3 & 4 office buildings, new home subdivision at Mountain Shadows.

Brandon Harrington, Senior vice president, Capital Markets, Walker & Dunlop

FACTORS TO CONSIDER: “Each project is unique and requires an independent financing strategy. We often start with the client and their business plan, exit strategy, and ownership structure to determine the appropriate financing term and structure. For example, we have seen a lot of product for sale, only a year or two into a 10-year fixed term with punitive prepayment penalties that could have been avoided with more creative structuring.”

TREND TO WATCH: “We are long term bullish on Phoenix and continue to see net population and job growth as more and more people, including business owners, see Arizona and as an advantageous place to call home. Phoenix has established a critical mass as a top metro area by population and continues to attract out-of-state and foreign real estate investors.”

PROJECTS WALKER & DUNLAP HAS FINANCED: “We were recently reviewing an offering memorandum for an apartment community in Phoenix and every financed sale comparable noted Walker & Dunlop as the lender.”

Stephen Loonam, Executive vice president, Commercial Real Estate, UMB Bank- Arizona

FACTORS TO CONSIDER: “We look at a number of variables including the requested leverage amount, supply and demand in the market for the particular product being offered, borrower experience, guarantor strength, and both national and local economies.  As part of our standard underwriting process, we will sensitize current conditions of any income producing property such as increased vacancy and interest rates (for loans with floating rates). In addition to all of the above but maybe even more important, I want to work with responsible borrowers.  When there is a bump in the road, we need to have responsive borrowers that are willing to work through issues.”

TREND TO WATCH: “Multifamily developers have enjoyed a number of years of rising rents and maybe the cheapest financing in history. Rising rents have been a result of the housing collapse and borrowers inability to get financing for purchase.  The Millennial generation that we read so much about is delaying major decisions like marriage and children, which ultimately impacts the housing market. We believe that at some point that generation will want more living space as their families expand. Multifamily land prices and cap rates are being driven not only by a robust rental market but also by cheap financing. Many of the multifamily deals we see today are back by institutional capital partners driven by IRR. The IRR’s are enhanced by very aggressive bank construction financing and very aggressive permanent financing. This aggressive financing and development is concerning as you look back at the build-up to the housing crisis.

PROJECTS UMB HAS FINANCED: “All lending is about mitigating risk. A bank can have a string of successful, profitable years making good loans and getting repaid all principal and interest, but it only takes a couple of poorly structured loans or a few missteps to give all those gains back … Part of my job is recognizing the deals to avoid and being smart on the market to be able to avoid unfavorable deals – that can also be rewarding.”

Joseph Stewart, President, Arizona commercial banking, Bankers Trust

FACTORS TO CONSIDER: “Sponsorship, sponsorship, sponsorship. The sponsorship, or people we are doing business with, is always the first and most important thing we consider when evaluating a project.”

TREND TO WATCH: “Interest rates impacting commercial real estate financing in Arizona is definitely the biggest issue to watch. Beyond rate hikes, I believe commercial real estate financing has a large runway given where we are in the current Arizona real estate cycle.”

PROJECTS BANKERS TRUST HAS FINANCED: “Multiple downtown Phoenix projects that were financed during the recession have helped contribute to the growth in downtown Phoenix.

Doug Reynolds, Senior vice president of the Commercial Real Estate Division, Washington Federal Bank

FACTORS TO CONSIDER: “We consider factors such as the location and condition of the property to make sure we are comfortable with the project itself and the surrounding area.  This goes for both new and existing uses.  We’ll also look at the sponsors to ensure they have the capacity and experience to manage the project in question.”

TREND TO WATCH: “Employment and population growth, not necessarily in that order, will continue to be the driving force behind the commercial real estate market as they will impact supply and demand.  Both have recently shown positive signs, and the expectation is that the positive trend will continue.”

PROJECTS WASHINGTON FEDERAL HAS FINANCED: “The bank continues to have success with financing many real estate projects, such as apartment complexes, single family home developments, manufactured home parks and RV resorts, mini-storage facilities, and retail and industrial projects.”