Thanks to trouble in the commercial mortgage-backed securities (CMBS) market, financing became more difficult in the final quarter of 1998. Spreads increased, loan-to-value ratios decreased and lenders played a much harder game than they had a year or even six months earlier.
Where it had not been unusual to see five or more lenders compete foras recently as last June, the competition had diminished by December. Nonetheless, few permanent borrowers came up empty, and the deals, if not as good as in April 1998, were better than in the two previous years.
Those seeking construction loans had a slightly tougher time than those seeking permanent financing, and many developers delayed construction in hope of a quick turnaround. Signs of such a turnaround appeared late in the year, but no one was certain how real they were.
According to most of those interviewed for this article, the changes in the lending market stemmed from the withdrawal of conduit lenders beginning in August. Several conduits went under because of the commercial mortgage-backed securities market.
Three factors received the brunt of the blame for the collapse of the CMBS: the general volatility of the stock market, the generally lackluster performance by real estate investment trust stocks and the Asian economic crisis.
Many analysts claim REITs' aggressive efforts to beef up their portfolios were driving prices to unrealistic levels and leading to risky ventures. Although retail REITs generally fared better than other categories, they failed to show the returns investors wanted to see.
REITs all but stopped buying once it became clear the CMBS market was in trouble. Because the pullback occurred well before disaster hit, analysts believe the market will correct itself and financing will loosen once again - though probably not to the degree of last spring. Spreads of one point over 10-year Treasury bonds are not likely to return anytime soon.
Then there is the uncertainty that surrounds the Asian economic crisis. Nobody seems sure how bad it will get and how much it will affect the U.S. economy. The impact has been more moderate than economists anticipated, though analysts consider the flight of money out of Asia and into U.S. securities the trigger for the CMBS debacle.
As far as retail goes, the so-called Asian flu has stalled or slowed plans by U.S. retailers to expand in that part of the world as well as impacted sales for retailers with existing stores in Asia. But it seems to be having a positive impact on retail sales here at home.
According to a report from PricewaterhouseCoopers, prices of the most common holiday gift items fell an average of 1% in 1998, primarily because the depressed value of most Asian currencies has lowered manufacturing costs.
Some retail categories are seeing significant price declines. According to the U.S. Department of Labor, prices for electronic goods dropped 10% to 20% in '98.
Despite these declines, the Consumer Price Index is rising, up 1.5% in 12 months. The Labor Department attributes the rise primarily to increased costs for U.S. manufactured goods and higher costs for services.
Sales have been very strong overall. Damian Zamias, president and CEO of Zamias Services Inc., a developer in Johnstown, Pa., calls '98 the best year for mall-shop leasing in at least the last four to five years.
"We're significantly ahead of our leaseup projection and sales have been strong. Most of the chains have met or exceeded the sales goals," he says.
A drop in unemployment to 4.4% in November boded well for the continued health of the U.S. economy. Retail led other sectors in the creation of new jobs.
Many people believe it is only a matter of time before the nation begins to feel the flu symptoms.
"If the Far East doesn't stabilize, I think it's going to affect the industry. Even neighborhood centers are probably going to be affected," ventures Lewis Sandler, president of United Investors Realty Trust in Dallas. "Everybody is expecting a hit the second half of the year. I've got to believe they're probably right."
Opinions differ Developers and investors seem divided on the current state of lending. When asked what it takes to get a loan today, Bruce Kaplan, president of the Kaplan Group, a real estate investment, consulting and development company in Chicago, replies, "A lot of prayers."
On the other hand, Kaplan's colleague, Michael Tobin, the firm's managing director of development, reports the company faced no serious obstacles in its quest for a construction loan to build a 150,000 sq. ft. mixed residential and retail complex.
He acknowledges however, that the project has a lot of pluses: The demographics are strong, with a median annual household income of $110,000 for the surrounding market; there are no nearby sites that could be used for competing developments; the city supports the project as part of its effort to revitalize the city center; and the complementary mix of uses provides a hedge against an economic downturn.
According to Sandler, lenders seem quite willing to make secured loans. It's the unsecured deals that face problems.
"We hear a lot of lenders are a little skittish on loans that rely on the credit of the company rather than properties," he says.
What makes the current financing situation different from the past, Tobin points out, is that while the underlying cost of money has gone down, the rates charged to borrowers has not dipped because lenders have increased spreads.
Robert Schneiderman, executive vice president of Parallel Capital Corp., a New York-based conduit lender, terms the competition among lenders in the first half of '98 "cut-throat." He admits his firm was forced to "cut margins to the bone." He feels confident the loans will prove sound but says the ability to get higher spreads due to a lessening of competition comes as a relief.
While this worried many observers, Robert Schonefeld, CEO of Bridger Commercial Funding, a Mill Valley, Calif.-based firm that acts as an intermediary between banks and the CMBS market, insists low spreads are positive not negative.
"In my mind, low spreads are the result of a more efficient capital market, not risky lending practices," he says.
Bond holders apparently disagreed. Their requirements pushed spreads up another point to a point and a half from earlier levels.
Tobin pegs current lending rates at 6.75% to 8% with most in the 7% to 7.5% range.
Barry Axelrod, senior vice president and Midwest regional manager for First Security Commercial Mortgage in Chicago, confirms this, reporting his company is quoting a range of 7.75% to 8.75%.
In Tobin's opinion, the conduits' higher rates effectively remove them from the market except for high-risk projects other lenders won't take on. He sees the conduits' withdrawal as having minimal impact because the higher spreads have made the market much more attractive to conservative banks, insurers and pension funds.
As spreads have risen, loan-to-value ratios have dropped, says Tobin. "You could find deals with 80% LTVs at the beginning of 1998, but 75% is the top now. [Lenders] want to see real hard equity," he says.
Bart Tabor, Northernmanager in the San Francisco office of Houston-based L.J. Melody & Co., reports 75% is the standard at his company, though he says Melody has gone higher. Some other firms will take greater risks, but there are fewer who will go out on a limb than in the recent past.
Press reports in early December suggested lenders were easing their stance somewhat, but no one interviewed for this article confirms that.
Longer amortizations remain available, with 25 years easy to get and 30 years not uncommon, according to Tobin. Longer terms also are available, he says, with many lenders asking for 10-year deals.
Sandler reports United Investors has been relying on a $30 million line of credit from Wells Fargo that it received when it went public in March after nine years a a private REIT. The trust, which began '98 with eight centers totaling 750,000 sq. ft. and had 20 centers with 2.5 million sq. ft. by Thanksgiving, plans to ask for another $30 million.
According to Sandler, his company has considered converting part of its credit line to a mini-perm loan with a fixed rate and five to seven-year term. If it does, it will not borrow more than 50% or 60% against current value, he says.
There is a lot of equity around There is a lot of equity around despite the general withdrawal of REITs from the market.
"Both equity investors and standard lenders are looking at a project's underlying fundamentals, not on forward projections that may not occur," says Tobin.
As Richard Kaplan, president of Syndicated Equities Corp., a net lease lender in Chicago, points out, overly optimistic projections about future income streams can be a problem for both borrowers and lenders. Using today's rosy economy as the basis for tomorrow's returns is a serious error, he says.
"We've had several years of increasing rents and returns. It becomes dangerous when you project out several years based on these same rates. The likelihood of having some kind of downturn is high, and you need to take this into account," he says.
Lawrence Bond, managing director in the Los Angeles office of The Summit Fund, a real estate investment firm in both Los Angeles and Chicago, reports the firm is actively looking for retail opportunities.
He says Summit, which typically works in the $1 million to $5 million range, prefers existing properties because the cash flow is there from the beginning, but the company recently joined with a Chicago developer to buy a site for a big-box project.
Unlike many equity investors, Summit seeks new relationships and likes to work with first-time developers, though typically these are experienced pros breaking away from a larger company rather than total neophytes.
"We like them because they can't afford not to have a home run. They don't go off on their own until they have a real fantastic deal," Bond explains.
He says many smaller investors are looking to place money right now, but because each has its own niche, it can be hard to match borrower and developer.
Another wrinkle in today's lending market is the increasing demand for reserves. According to Ernie Iriarte, a director in the Irvine, Calif., office of Phoenix-based Finova Realty Capital, his company impounds from 25 to 65 cents a sq. ft. per year to cover tenant improvements and leasing commissions needed for locating replacement tenants and for unforeseen problems.
Failure to take the need for reserves into account seems to be the single biggest shortcoming of underwriting today. From the borrowers' standpoint, not having to pay a reserve appears positive because it reduces costs, but if an anchor leaves and there are no reserves to pay for finding and installing a replacement tenant, the loan could slip into default.
With a high level of preleasing to top-credit tenants, a project is almost certain to get financed but the terms will be less attractive than in the past. As the amount of pre-leased space and the quality go down, getting a loan becomes more difficult and terms more onerous.
It is far easier to secure a construction loan today with better rates than it was five years ago. Any well-thought-out retail project can get funded, though there are fewer lenders. The question is: Is it better to take a higher rate and lower LTV now or hang on a few months to see if things change for the better?
Single-tenant net-lease transactions least affected The segment of retail least affected by vacillations in the lending market is single-tenant net-lease properties. According to Richard Kaplan, president of Syndicated Equities Corp., a net lease lender in Chicago, no matter what the surrounding conditions, the financing for these types of deals is largely set by formula based on maximum debt coverage ratios of 1.1:1 or 1.2:1.
He says loan-to-value ratios tend to be higher and can even reach 100%, though the current situation of uncertainty makes this level less likely. Interest rates are typically tied to 10-year Treasury bonds and lenders are more relaxed about spread. In the first half of '98, spreads of 115 to 130 basis points were not uncommon, but typically, says Kaplan, 140 basis points is the minimum spread.
The reason for lenders' liberal attitude to single-tenant projects is they are perceived as sure things. "There's very little risk," he says. "We're dealing with major credit tenants with A or high B ratings. Mostly they're Fortune 500 companies. These deals are pretty much like bonds."
In the first half of 1998, some lenders were willing to give 25-year amortizations based on 20-year leases, but in a today's more risk-averse market, such deals are uncommon.
"You could be left with 25 to 30% of the loan still owing when the lease expires. The gamble is that the real estate alone will have risen enough in value to cover that. Based on the past 50 years, that's always been true. It will probably be true in the future too, but who knows," says Kaplan.
Retailers often supply their own construction financing, points out Charlie Colson, senior vice president and director of retail investment at Staubach Retail Services in Dallas.
"The technique offers the retailer the greatest amount of flexibility," he explains. "They choose the locations, build the facilities to their specifications, keep total control of the process - all without carrying the real estate on their balance sheet."