Since the capital markets froze in 2008, commercial real estate (CRE) lending has experienced significant constraints that continue to persist. Amidst reports suggesting that CRE lending has begun to return, it’s important to realize that any market loosening is far from universal. So far, debt providers have focused on core cities and select asset types during this prolonged recovery.
Since small and midsize businesses have generally relied on commercial banks for their lending needs – commercial banks comprise nearly 50 percent of the commercial real estate lending in the U.S. – the lasting impact of the severe recession is proving quite substantial. For many, the limited access to traditional real estate financing has created newfound interest in asset-based loans (ABLs).
Historically, ABLs have been seen as a solution for industries with higher levels of accounts receivable and inventory, such as durable goods manufacturers, wholesalers, consumer product companies, rental companies/equipment leasing, energy companies and retailers. Collateral has commonly included such non-real estate assets as inventory, accounts receivable, machinery and other more liquid assets. But today, lender portfolios are expanding to more frequently include real estate.
As commercial property values gradually rise, creating more equity, asset-based financing is quickly shedding its reputation as a financing choice of “last-resort.” To better understand the emerging opportunities in the real estate financing market, it’s important to highlight four key trends that will guide ABL growth in the year ahead:
1. Real estate debt providers, specifically business lenders, are moving at a measured pace.
Many small and midsized businesses rely on smaller regional and community banks to finance their real estate and their operations. But after the recent downturn, there are simply fewer of these healthy banks left standing. Smaller lenders that survived typically had an over allocation of commercial real estate and now are making efforts to diversify and limit new loans. Smaller banks are concerned about the changing regulatory environment and are trying to find the economies of scale needed to comply with new regulations.
Banks also face internal strife, including dealing with a host of factors limiting origination of new loans. Legacy issues of non-performing commercial real estate loans are still a focus and consume a lot of attention. Housing-related loans continue to drain capital and resources as foreclosures and lawsuits carry on. All of these factors are constraining available capital and distracting bankers from their core business of making new loans.
2. Moderate U.S. economic expansion is giving rise to increased demand for industrial space.
The first signs of increased residential housing construction are emerging. This will lead to more light industrial use, such as building supply warehouse and distribution facilities, construction rental equipment, and retail locations for construction equipment and supplies. These are all industries that consume more physical space and have traditionally relied heavily on asset-based loans in their capital structure. Additionally, rising shipping activity and robust energy-related activity will also drive demand for industrial space. In preparation for the expansion of the Panama Canal and the resulting changes in trade lanes, values have already increased for industrial properties in select markets such as Houston, New Orleans, Mobile, Miami, Jacksonville, Savannah, Charleston, Norfolk, Baltimore, and the New York–New Jersey region.
3. As the economy improves, businesses may require more project financing.
If the economy gradually improves in 2013, as expected, businesses will likely require more immediate capital for project financing needs such as inventory purchases, mergers, acquisitions and debt purchasing. Small and midsize companies frequently use a combination of financing facilities so that if one type of financing is impaired or enhanced, they can employ more or less of other sources of capital. Given traditional debt lending constraints, businesses may increasingly turn to asset-based lending to fill-out their debt structures.
4. Equity values in secondary geographic markets are beginning to rebound.
Persistent global economic uncertainty and volatility, has pushed investors to a “flight to quality” by purchasing U.S. Treasuries. We have seen a similar trend in commercial real estate, as investors have concentrated investments in the safer “core markets” of New York, Boston, Washington, D.C., the Bay Area, Southern California, and Seattle. Capitalization rate compression and increased valuation happened much faster than anticipated in these core markets, which has caused a growing number of investors to search for opportunities in secondary markets.
This investment activity has been gradually increasing property valuations in those secondary markets. And since the severe recession delayed or shelved plans for any new construction, the constrained supply, and improved economic fundamentals in some markets, slow improvements in both vacancies and rents are expected to continue in 2013.
It is somewhat ironic that just as real estate values greatly contributed to the Great Recession and the resulting credit crisis, commercial real estate valuations are now poised to provide a growing number of small and mid-sized businesses with an asset-based financing solution to assist in their recovery.
Jonathan Bushnell is a Director at Carl Marks Advisory Group, a leading consulting and investment banking advisor to middle market companies.