Retail lenders are facing a borrower's market and fierce competition; some ask if it's a disaster waiting to happen.

The question facing retail developers and investors today is not whether financing is available but whether it is too readily available. Projects that two or three years ago would have had difficulty finding a single lender willing to take them on today have four, five and six lenders battling for the deal. In the view of some analysts, this is just as it should be. To others, it's a disaster waiting to happen.

"It clearly is a borrowers' market," says Robert Schneiderman, executive vice president of Parallel Capital Corp. in New York. "Borrowers are responding almost instinctively, asking for more and more and more. And some lenders are, how should I say it, cooperating. That seems to be indicative of some problems on the horizon, but I wouldn't characterize [too relaxed lending] as epidemic."

Those who believe the current level of lending is appropriate point to low vacancy rates and rising rents and sales as signs of a market with room to grow. The most recent figures from the International Council of Shopping Centers in Chicago show vacancy rates at 3.7% for strip centers, 6.9% for factory outlet centers and 6.5% for malls. A recent Finard & Co. study of 38 New England shopping centers shows that malls over 500,000 sq. ft. had an average vacancy rate of 3.6%.

According to the National Real Estate Index published by CB Commercial Real Estate Group and Alliance Capital, overall retail rents rose 5.4% last year, while ICSC reports retail sales climbed 5.3%.

On the other hand, the Finard survey finds centers under 500,000 sq. ft. posting vacancies of 11.5%, while CSC notes that mall vacancy rates jump to 16.1% when anchor tenants and food courts are removed from the picture.

Furthermore, returns on retail properties have not been particularly impressive. According to the CB/Alliance index, returns for retail real estate last year averaged 6.7%, compared to 8.6% for apartments, 12.4% for downtown offices and 14.3% for suburban offices.

Looking just at REITs, Prudential Real Estate Investors pegged retail returns at 4.5%, compared to 11% for multifamily, 13% for warehouse, 15% for office and 23% for research and development.

The Urban Land Institute in Washington, D.C., reports neighborhood shopping centers are outperforming all other retail categories, with average sales of $216 per sq. ft. in '97. Neighborhood centers showed a 16% increase in net operating balances since 1994, compared to 10% for community centers and 5% for superregionals. Regionals actually lost ground, with net operating balances declining 7.2% in the same period.

Dividend yields for REITs paint a slightly different picture, with factory outlet centers leading all other property categories at 8%, according to the ABKB/LaSalle Securities Group. Health care facilities was the only other category that broke 7%. Shopping centers came in at 6.6% yields and regional malls posted 5.9%, according to the Chicago-based real estate investment advisers.

Competition thins spreads Lenders, however, apparently give more weight to the positive statistics than the negative. The financing market has become so competitive that lenders have pared spreads very thin. Spreads of 150 basis points on permanent loans are not uncommon, and many deals have been made below that. Schneiderman says most Parallel loans have spreads in the mid-one hundreds. Investors in freestanding retail buildings with long-term leases to high credit tenants can get rates as low as 75 basis points over Treasuries.

Elliot Eichner, managing director in the Los Angeles office of New York-based Sonnenblick-Goldman, reports deals his company has arranged typically run from 120 to 160 basis points over 10-year Treasury bills, which at the moment translates to the low 7% range.

As an example, Eichner points to a $116 million refinancing of Pier 39 in San Francisco, a 250,000 sq. ft. tourist-oriented retail center that draws 13 million visitors annually. Sonnenblick-Goldman placed the loan with Goldman Sachs, which offered a 10-year loan at 7.25%, 145 basis points over 10-year T-bills. David Sonnenblick calls the $500 per sq. ft. value "probably the highest loan per sq. ft. on a retail property anywhere."

Lance Graber, a director of Credit Suisse First Boston, and Joseph B. Rubin, national director of E&Y Kenneth Leventhal's financial services and institutions practice, both express concern that increased competitiveness among lenders could undermine stability by flooding the market with capital. According to a report from E&YKL, the commercial mortgage-backed securities market grew to $44 billion last year, compared to $30 million in 1996.

Speaking at a real estate trends conference in Los Angeles, Christopher E. Turner, executive vice president of Los Angeles-based Keystone Mortgage Co., warned that an oversupply of money may ultimately lead to refinancing difficulties and failed exit strategies for property owners and developers in all property categories.

"It's quite easy to get 25- and 30-year amortizations today, even for older buildings, and loan-to-value ratios have been liberalized to where it is commonplace to see a 75% loan for B class and below properties," he told his audience.

The problems, he commented, will not show up until later when owners attempt to refinance or sell these properties. Even after 10 years, minimal amortization will have occurred, he pointed out.

Analysts show concern The amount of money available for construction has analysts particularly troubled. Graber cautions that Wall Street's entry into the construction financing market could lead to overbuilding and another meltdown like the one that began in the late '80s. According to a report from Palo Alto, Calif.-based Marcus & Millichap Real Estate Investment Brokerage Co., a total of 223 million sq. ft. of retail space was added to the market last year.

Ironically, Graber's own company has dropped a massive amount of money into the market of late, including a $177 million loan to Forest City-New York City Retail of Cleveland for development of a power center in Manhattan and one of $284 million to the Mills Corp. of Arlington, Va., for two superregional malls. A partial list of CreditSuisse retail deals, entailing 11 retail properties, reveals some $650 million in loans from $4 million up.

Wall Street drives liberal lending Although multiple factors contribute to the liberal lending climate, the single biggest factor driving the market is the growing presence of Wall Street in investment. Real estate investment trusts are going after property with a vengeance, and their competitiveness is forcing other investors to either follow suit or lose out. Meanwhile, conduits are pouring money into both construction and permanent lending.

Of the 10 most active REITs last year, according to the CB/Alliance index, two - TrizecHahn Corp. and Commercial Net Lease Realty - were primarily retail-oriented. Retail was second to office in terms of the amount of money REITs spent on property purchases.

Mary Ludgin, chief operating officer of Heitman Capital Management in Chicago, which has $9 billion of funds under management, says most of the malls and large portfolios sold last year went to REITs.

"REITs are driving the industry. They're buying everything in sight," agrees Peter Korpacz, president of the Korpacz Co. Inc., a pension fund adviser in Frederick, Md.

Although the largest REITs tend to focus their portfolios on regional and superregional malls, others can be found buying in virtually every category. REITs' emphasis to this point has been on acquisition rather than development, says Hessam Nadji, senior vice president of marketing and research in Marcus & Millichap's San Francisco office.

Despite the media attention showered on REITs in the past couple of years, they account for only a small percentage of commercial property ownership in the United States. As Mark Schlacter, senior vice president of Aegis Realty Inc., a recently formed REIT based in New York, points out, "REITs get a lot of publicity about how much they own, but it's still only 10% to 15% of the market."

Institutional investors evince less reluctance now than they did 18 months ago to get involved in the retail arena. Data from the National Council on Real Estate Investment Finance shows a modest rise in pension fund interest in shopping centers last year, with more than $20 billion invested in the retail sector. Investment advisers expect the majority of pension funds to show a bigger increase in the amount of money they spend on retail properties this year.

Ludgin and Korpacz report funds managed by their firms likely will boost their level of retail investment. Tom Prendergast, president and CEO of NET Properties Management Inc., the company set up by the New England Teamsters and Truckers Pension Fund to handle its investments, reports NET anticipates investing $150 million on retail properties this year, the highest level since 1991-92. In February alone, he notes, the fund closed on $75 million in transactions, most of which were initiated in late '97.

On the other hand, Robert Welanetz, chief executive, Retail Group of Atlanta-based ERE Yarmouth, says funds under his management plan to maintain the same level of investment as last year. In addition, Ludgin says a few pension funds have exited the retail sector entirely.

A significant difference between this year and last is that pension funds, to some extent, have shifted their focus away from regional malls. The primary reason, according to Ludgin and Korpacz, is that REITs' appetite for malls has driven prices too high.

In a comment worth noting, Kenneth Cooley, senior vice president of asset management for Dallas-based L&B Group, says pension funds are looking at retail not because it is inherently attractive, but because yields are falling in other sectors.

Based on a survey Cushman & Wakefield completed last summer, C&W vice president Richard Latella pegs average cap rates at 9.3% for neighborhood and community centers, 9.7% for power centers and freestanding big-box stores, 8.3% for regional malls and 9% for specialty retail. All have climbed two-tenths to four-tenths of a point since a similar survey in 1996, except for neighborhood and community centers, which dropped from 9.6%. He expects the cap rate for regional malls to begin declining as well.

A year-end survey by the Chicago-based Commercial Investment Real Estate Institute and Landauer Associates puts shopping center cap rates somewhat higher, averaging 10.3%.

Nadji notes that REITs have focused on acquisition rather than development. But because the number of attractive acquisition opportunities is diminishing, they are looking to new development to provide the portfolio growth they need to keep their stocks up. Conduits, he says, are also looking for opportunities.

Construction lending on the rise Consequently, construction lending is growing substantially. According to figures from Marcus & Millichap, 223 million sq. ft. of new retail space was built last year.

Lenders like new projects, says Nadji, because they know they will be built to meet current retailer requirements. "Retail is moving so fast, in terms of concepts and prototypes and different formulas, that the new product seems to have temporary advantage because it features the latest and greatest way of capturing the attention of the consumer," he says.

Among the easiest projects to finance are freestanding retail stores pre-leased to credit tenants for long periods. Gary Ralston, president of Commercial Net Lease Realty in Orlando, Fla., calls this the fastest growing category of retail development.

Several lenders, including Ralston's company, have arisen specifically to serve the sale-leaseback market. All provide takeout options, but most also provide construction financing. Because the tenant for the space is guaranteed, loans are available with very high loan-to-value rates, sometimes 100%.

New York-based Capital Lease Funding L.P., for example, offers construction financing from $1.5 million to $50 million at 1.5 to 2 points over LIBOR with LTVs from 80% to 100%.

Ralston notes that retailers will often finance their own freestanding construction. Usually they hire a developer on a fee basis, but he says some large chains with deep pockets will actually serve as construction lender when a take-out loan is guaranteed in advance by companies like the above.

Eichner says the majority of construction loans continue to come from commercial banks, but he adds that conduits are making increasing numbers of these deals. "They're doing construction loans, then turning around and doing takeouts on the projects built in order to build their portfolios," he says. Equity of 20% to 25% is typically required, continues Eichner, and a reasonable amount of preleasing, generally a minimum of 30% to 40%, is required. Projects with higher levels of preleasing can get by with less equity, he says.

Although consolidation has reduced the number of banks, new ones have opened, primarily to serve a limited geographic market. A substantial number of small banks are actively looking for lending opportunities. For example, a quick perusal of construction financings for the Sacramento, Calif., region reveals numerous low-profile institutions such as River City Bank, Bank of Lodi, Stockmans Bank, Ocwen Federal Bank, SacramentoCommercial Bank, American River Bank, Mechanics Bank and Capitol Thrift & Loan a long with the better known ones such as Home Savings, Bank of America and Wells Fargo.

Borrowers receive lending options In regard to permanent financing, the range of options is vast. Virtually every category of lender has been actively making retail real estate deals. The exception is pension funds.

According to Douglas Callantine, a senior managing director with Legg Mason Real Estate Services Inc. in Philadelphia, current interest rates of 7% to 7.5% on conventional A-quality properties are too low to give pension funds the returns and comfort they require. "Pension funds want returns of 8% or higher," he explains.

While most of the big pension funds, including the California Public Employees' Retirement System and the Ohio and New York state teachers' retirement funds, have mortgage lending programs, most are limiting the amount of money loaned, according to Prendergast, whose fund has a portfolio of about $250 million in commercial mortgages.

Callantine says some pension funds are looking at involvement with unrated commercial mortgage-backed securities, but most, including those advised by Legg Mason, hesitate to enter this arena.

"We don't feel comfortable with the CMBS market because we haven't had enough time to evaluate it and understand how it works. We feel its newness makes it too high a risk right now. If it proves itself out over time, then we will reconsider," he says.

Insurance companies have also reduced their level of lending, according to several commentators, but not to the extent of pension funds. However, not a single insurer appears on a list of the top 25 retail lenders prepared by Shopping Center World magazine.

Banks appear on the list, but not in great numbers. CS First Boston comes in at No. 3, with $2 billion committed to retail and $3 billion set as a goal for '98. The next closest is Cleveland-based KeyBank N.A. at No. 9, which has a $950 million goal this year. Boston-based Fleet Bank, New York-based Hypo Bank, Chicago-based LaSalle National Bank, Princeton, N.J.-based Summit Bank and Richmond, Va.-based Crestar Bank are the only others to appear.

Many other banks are active, nonetheless. First Union National Bank of Charlotte, N.C., Chase Manhattan Bank of New York, Bank of America of San Francisco and numerous others have been quite aggressive in seeking deals. Eichner, for example, reports that Sonnenblick-Goldman arranged a $33.4 million first mortgage through First Union for Potrero Center, a 226,646 sq. ft. Safeway-anchored promotional center in San Francisco.

Conduits lead in permanent lending By far, the most active permanent lenders are Wall Street conduits. "The money is coming primarily from Wall Street, which is securitizing the loans and selling the packages to the public," says Eichner.

Lehman Brothers is way out in front of the pack on this, according to Shopping Center World, with $5 billion of committed retail funding and a goal of $7.5 billion for '98. Other Wall Street companies on the list include CIBC Oppenheimer, Goldman Sachs, Morgan Stanley Dean Witter and Bear Stearns & Co. All are based in New York.

But San Francisco-based Nomura Capital, with $2.789 billion committed, hopes to take the lead by doing $12 billion in retail loans this year.

According to a report from Deloitte & Touche in Chicago, conduits issued $44 billion in commercial mortgage-backed securities (for all property categories) last year. The figure represents 50% of the CMBS issuance, compared to 24% in '96. It is this money, says Alex Erwin, senior manager in the consulting firm's Portfolio Services Group, that has turned the market into a bonanza for borrowers.

Traditional private mortgage companies and other nonbank suppliers of investment capital are also active, but even they have got into securitizing, say commentators. The number of lenders in this category is staggering, especially considering that many, if not most, did not exist a few years ago or existed in a very different form.

Thinning spreads change structuring As mentioned earlier, spreads are already thin. They are so thin that few lenders can afford to shave them down further in order to land a deal, according to Schneiderman, who reports that Parallel Capital expects to do about $100 million in retail loans this year, with deals from $150,000 all the way to $30 million.

"We've cut rates to the bone," he remarks.

Lenders are instead depending on the intricacies of structuring, the value of established relationships and even winning personalities to get business. Even quick closings do not help much. They have become so commonplace, says Schlacter, that borrowers expect them as a matter of course rather than regarding them as a bonus.

Speaking at the Mortgage Bankers of America Association conference in San Francisco in February, Mendel Nudelman, director of the National Real Estate Group of Altschuler Melvoin and Glasser L.P., reported current commercial real estate transactions are being completed in three months or less.

"The efficiency of real estate transactions is improving, despite a notable rise in activity," he said.

Still, some lenders manage to move with unusual speed. Ginn Downing, assistant vice president of Fremont Investment & Loan in San Francisco, reports her company managed a three-week turnaround for a $4.7 million loan on an 80,000 sq. ft. mixed-use building in downtown Oakland, Calif. The specifics were not that noteworthy - 3.5 points over six-month LIBOR with a five-year term and five-year option - but she explains that Fremont specializes in atypical and higher-risk deals other lenders avoid.

How long the current lending climate will last is anybody's guess. Few respondents were willing to make an estimate.

"It's tough to tell how long this market will last," says Schneiderman. "People are speculating that some players will be dropping out this year because margins are becoming too thin, but I don't know."

Underwriting concerns continue He says concern about underwriting is growing, though he believes standards remain generally high. As he puts it, "We're trying very hard to hold the line, but it's becoming increasingly difficult if you want to make deals."

According to Schlacter, a lot of existing property with great sales potential has yet to come on the market. Many of them, he says, have considerable upside potential, which will make them very attractive to lenders.

"Most of the stuff we've seen to buy is coming from long-term owners. If you look at the history of the shopping center industry, a lot of the original builders are getting up in years. A lot of them own just a few properties, and they're going to be of interest mostly to smaller REITs like ourselves and other small investors," he says.

As long as interest rates remain below 8%, he continues, "[A] lot of property is going to change hands."

Defaults are happening, but most involve shopping centers financed in the late '80s. Two Northern California malls - the 1.1 million sq. ft. Vallco Fashion Park in Cupertino and 450,000 sq. ft. County Fair Mall in Woodland - went back to their lenders early this year, but both had 10-year-old loans. Loans from the current wave of transactions are too recent to be in trouble, says Schneiderman.

With the stock market continuing to soar and money pouring into all areas of trading, including the CMBS sector, it certainly looks like pocketbooks will not be closing any time soon. For the time being, says Schneiderman, "the competition is cutthroat."