In just one bruising season, the habits of commercial real estate borrowers have changed greatly. They're reducing reliance on credit as volatility persists in the capital markets, and paying a higher price to obtain financing.

The results of an exclusive survey by National Real Estate Investor also show that despite a 14% decrease in borrowing among respondents compared with last year's study, more than 60% have received debt financing, and nearly 40% are using it to forge ahead with new development.

Still, a majority (62%) think that it will take more than a year for liquidity to return to the capital markets in a normalized fashion, and one in three believes that it could take longer than 18 months.

What began as a bump in the road for borrowers after the collapse of two Bear Stearns hedge funds in the summer of 2007 amid the subprime mortgage meltdown has evolved into the worst credit crisis in more than 30 years.

Wall Street banks have taken subprime write-downs totaling hundreds of billions of dollars, Lehman Brothers has gone bankrupt, the U.S. government has seized control of giant insurer American International Group (AIG) as part of an $85 billion bailout, and troubled mortgage giants Fannie Mae and Freddie Mac have landed in conservatorship.

The surprises continue in 2009. In January, the federal government provided $20 billion in aid to help Bank of America absorb its acquisition of Merrill Lynch & Co., a mega deal which closed Jan. 1. Merrill reportedly had a lot of toxic assets on its balance sheet.

New economic headwinds compound the problem for commercial real estate borrowers and lenders. U.S. non-farm payrolls fell by 524,000 in December and 1.9 million in the last four months of 2008. “We are more in the third or fourth inning of this [downturn] as opposed to the seventh or eighth,” says Ryan Krauch, a principal with Los Angeles-based Mesa West Capital, a direct lender. “It's going to be a slow process, and ultimately that's a good thing. We needed this bubble to burst, and we needed some correction in the industry and the economy.”

The responses to NREI's fifth annual Borrower Trends Survey reflect a more conservative lending landscape than in years past. The survey yielded 289 responses from commercial real estate owners and developers who are active across multiple product types [Figure 1].

Among the survey highlights:

  • The majority of respondents (62%) have borrowed funds in the past 12 months compared with 72% in last year's survey. The median of loan proceeds borrowed was $7.5 million, or 16% of assets, compared with $10.5 million, or 19% of assets, in last year's survey.

  • Nearly four out of 10 respondents (38%) have borrowed funds for new development over the past year compared with 57% in the prior survey [Figure 2]. Similarly, 18% of respondents have borrowed funds in the past year for renovation projects compared with 26% in the previous survey.

  • Respondents indicate that loan-to-value ratios have fallen from a mean of 79% in the 2008 survey to 70% in this year's survey as lenders tighten their underwriting standards [Figure 3].

  • While 60% of respondents believe liquidity will return to the capital markets in a normalized fashion within the next 18 months, 32% indicate it will take at least 19 to 24 months and possibly longer. Another 7% do not know [Figure 4].

  • Certainty of execution is the most important quality borrowers seek in a lender today, say respondents, based on a scale of 1 to 6 with 6 being very important and 1 not at all important. Flexibility of loan terms and lowest available rate were the next most important with each receiving a 5.1 score [Figure 5].

Construction loan challenge

Among respondents who have borrowed funds within the past year, 60% have used construction financing, down from 80% a year ago [Figure 6]. That plunge in construction lending doesn't surprise Ben Carter, founder and chairman of Atlanta-based Ben Carter Properties, whose company has developed nearly 5 million sq. ft. in retail and office projects valued at more than $1.1 billion since its start in 1993.

“Fortunately, most of our projects are capitalized and financed, but there is an extraordinary crunch in the availability of construction loans and senior debt, which is having a big impact on development as well as acquisitions,” explains Carter. “The lenders are very picky, and the demands on the borrowers are probably as great as I've seen in my career.”

What are those demands exactly? “Lenders are looking for substantial guarantees, they're looking for substantial leasing, they're looking for virtually no construction risk, and the spreads on their pricing are greater than historically.”

Construction financing is linked to the benchmark three-month London Interbank Offered Rate (LIBOR), which was pegged at 1.14% as of Jan. 16. In a normal, or less volatile market, the spread over the three-month LIBOR is typically 100 to 200 basis points for construction financing, says Carter. Today, that spread ranges from 300 to 700 basis points.

Carter is developing the Streets of Buckhead, a luxury mixed-use community in the heart of Atlanta's Buckhead neighborhood, once famous for its nightlife. The first phase, which is 50% leased, will open in March 2010 at a cost of $600 million and include 400,000 sq. ft. of retail, about 80 retailers and 14 restaurants. CB Richard Ellis Strategic Partners is providing the construction financing.

The Buckhead project's second phase may include more retail, restaurants and a residential component. “We're going to watch the economy as to when we start Phase II.” Carter hopes to start it in 2010.

The cost of financing can make or break a project, and never has that been more true than today. Associated Estates Realty Corp., an apartment REIT whose portfolio includes more than 13,000 units principally in the Midwest, just scrapped plans for a joint-venture project due to problems tied to construction financing.

Associated Estates planned to take out the apartment developer at a pre-determined price after completing the project. But the developer could not obtain construction financing at favorable terms.

“The developer expected to get 65% to 70% loan-to-cost. The loan was probably going to be in the vicinity of 50% loan-to-cost,” says Jeffrey Friedman, president and CEO of Associated Estates, based in Richmond Heights, Ohio. “This was a development team with more than a 10-year track record of developing, designing, owning, managing and leasing up apartments in a number of markets.”

The onerous terms meant that as a joint venture partner Associated Estates couldn't achieve an internal rate of return of 12% to 15%, its target for new development, so the proposed deal was shelved.

Dramatically altered landscape

For borrowers who have never endured a major retrenchment in the capital markets, this downturn shows how suddenly dramatic market swings can occur.

“Borrowers have been humbled. That's the reality,” says James Merkel, president of Columbus, Ohio-based RockBridge Capital LLC, which has provided $1.4 billion in debt financing to the hotel industry since 2005. “Borrowers do not have the negotiating power they had. Today, it's more about access to capital and liquidity than about the ability to negotiate the best deal.”

Respondents say recourse loans make up 51% of their current debt vs. 49% for non-recourse loans [Figure 7]. While the majority expect that ratio of nearly 50-50 to remain the same over the next 12 months, nearly one in four (23%) expects the percentage of recourse loans to increase. Only 12% expect it to decrease.

One-third of the commercial real estate loans originated in the past 10 years were structured as commercial mortgage-backed securities (CMBS), loans packaged and sold as bonds to investors, estimates David Rifkind, principal and managing director of Los Angeles-based George Smith Partners. The company has arranged in excess of $10 billion in commercial real estate financing since 2005.

“There are no CMBS lenders at this point in time, so that takes a huge amount of lenders out of the game,” says Rifkind. Indeed, domestic CMBS issuance totaled $12.1 billion in 2008, a dramatic drop from $230 billion in 2007 and $203 billion in 2006. During the second half of 2008, there was no issuance.

The moribund CMBS market is only part of the story when it comes to a shrinking supply of lending sources, explains Rifkind. “Among smaller regional banks, there is just a handful of lenders in any particular region who are lending. Your first-tier national banks are lending, but we're finding they're only lending to their best borrowers.”

Owners of blue-chip commercial real estate assets that are conservatively underwritten stand the best chance of getting financing. There are many lenders who will tell you that they're in the market,” says Rifkind, “but when you really drill down on a specific transaction, you find out that they really aren't, and they're really unsure of when they will be again.”

Loan-to-values are averaging 65% in today's marketplace, Rifkind says, lower than the 70% to 79% range cited by owners and developers in the survey. The discrepancy might be explained by the legendary optimism of the owner/developer community. Also, a significant number of respondents are active in the multifamily market, where 70% loan-to-value is more common through agency lenders like Fannie Mae.

Carter, a developer with three decades of experience, concurs. He is encountering loan-to-values in the 60% to 65% range, down from 75% to 80% over the past year. Loan-to-cost, meanwhile, now ranges from 50% to 60%, down from 70% to 80% a year ago, adds Carter.

Interest rate toss-up

Trying to determine the future direction of long-term mortgage rates is like predicting the outcome of playoff football — anything can happen. But with so much monetary and fiscal stimulus being injected into the U.S. economy, the conventional wisdom is that rates will increase in the year ahead, right?

Respondents are divided on that issue. While nearly half of respondents (46%) expect that long-term mortgage rates will be higher 12 months from now, another 21% expect them to remain the same, and 20% expect them to fall. Some 12% of respondents say they don't know [Figure 8]. Among those expecting an increase in long-term mortgage rates in the year ahead, most believe it will be 2% or less.

Friedman of Associated Estates says that as the debt markets begin to stabilize in 2009 and financial alternatives re-emerge, most notably CMBS, borrowers will have greater access to long-term debt. But those loan proceeds are likely to come attached with a higher interest rate than many borrowers anticipate, he says.

“I think rates will rise above where people thought they would be, and the underlying Treasuries should increase because of expected inflation down the road from all the feeding of the economy that the federal government has done,” says Friedman. On Jan. 20, the 10-year Treasury yield stood at 2.38%, down from approximately 3.7% a year ago.

Respondents also are split on the direction of short-term mortgage rates. More than four out of 10 respondents (42%) expect rates to rise over the next year, while 25% say they will remain the same and 20% expect them to go lower. Another 12% do not know.

Ultimately, the future health of the economy will play a big factor in the direction of interest rates. Borrowers indicate that the weaker economic conditions, not the higher cost of capital, have proven to be the biggest factor in their ability to obtain financing. On a scale of 1 to 5, the impact of weaker economic conditions rated 3.9 compared with 3.5 for the higher cost of capital [Figure 9]. At the low end of the impact scale was the takeover of Fannie and Freddie (2.3).

Friedman expresses confidence that both Fannie and Freddie, which have a social responsibility in the housing and apartment market, will endure in some capacity. “I am certain the new [Obama] administration recognizes the importance of doing what it can to keep housing affordability at the best possible level.”

Matt Valley is editor-in-chief.

Survey Methodology

Data for the 2009 Borrower Trends Survey was collected Oct. 29 through Dec. 5, 2008. Penton Research mailed questionnaires to 1,500 subscribers of National Real Estate Investor in late October. Subscribers were selected on an nth name basis from the magazine's database of commercial real estate owners and developers. The purpose of the survey was to quantify borrowing activity. The questionnaire yielded 289 completed surveys for an effective response rate of 19.4%. This report also is available on nreionline.com. For more information, please contact Editor matt Valley at matt.valley@penton.com

“Fortunately, most of our projects are capitalized and financed, but there is an extraordinary crunch in the availability of construction loans and senior debt, which is having a big impact on development as well as acquisitions,” explains Carter. “The lenders are very picky, and the demands on the borrowers are probably as great as I've seen in my career.”

What are those demands exactly? “Lenders are looking for substantial guarantees, they're looking for substantial leasing, they're looking for virtually no construction risk, and the spreads on their pricing are greater than historically.”

Construction financing is linked to the benchmark three-month London Interbank Offered Rate (LIBOR), which was pegged at 1.14% as of Jan. 16. In a normal, or less volatile market, the spread over the three-month LIBOR is typically 100 to 200 basis points for construction financing, says Carter. Today, that spread ranges from 300 to 700 basis points.

Carter is developing the Streets of Buckhead, a luxury mixed-use community in the heart of Atlanta's Buckhead neighborhood, once famous for its nightlife. The first phase, which is 50% leased, will open in March 2010 at a cost of $600 million and include 400,000 sq. ft. of retail, about 80 retailers and 14 restaurants. CB Richard Ellis Strategic Partners is providing the construction financing.

The Buckhead project's second phase may include more retail, restaurants and a residential component. “We're going to watch the economy as to when we start Phase II.” Carter hopes to start it in 2010.

The cost of financing can make or break a project, and never has that been more true than today. Associated Estates Realty Corp., an apartment REIT whose portfolio includes more than 13,000 units principally in the Midwest, just scrapped plans for a joint-venture project due to problems tied to construction financing.

Associated Estates planned to take out the apartment developer at a pre-determined price after completing the project. But the developer could not obtain construction financing at favorable terms.

“The developer expected to get 65% to 70% loan-to-cost. The loan was probably going to be in the vicinity of 50% loan-to-cost,” says Jeffrey Friedman, president and CEO of Associated Estates, based in Richmond Heights, Ohio. “This was a development team with more than a 10-year track record of developing, designing, owning, managing and leasing up apartments in a number of markets.”

The onerous terms meant that as a joint venture partner Associated Estates couldn't achieve an internal rate of return of 12% to 15%, its target for new development, so the proposed deal was shelved.

Dramatically altered landscape

For borrowers who have never endured a major retrenchment in the capital markets, this downturn shows how suddenly dramatic market swings can occur.

“Borrowers have been humbled. That's the reality,” says James Merkel, president of Columbus, Ohio-based RockBridge Capital LLC, which has provided $1.4 billion in debt financing to the hotel industry since 2005. “Borrowers do not have the negotiating power they had. Today, it's more about access to capital and liquidity than about the ability to negotiate the best deal.”

Respondents say recourse loans make up 51% of their current debt vs. 49% for non-recourse loans [Figure 7]. While the majority expect that ratio of nearly 50-50 to remain the same over the next 12 months, nearly one in four (23%) expects the percentage of recourse loans to increase. Only 12% expect it to decrease.

One-third of the commercial real estate loans originated in the past 10 years were structured as commercial mortgage-backed securities (CMBS), loans packaged and sold as bonds to investors, estimates David Rifkind, principal and managing director of Los Angeles-based George Smith Partners. The company has arranged in excess of $10 billion in commercial real estate financing since 2005.

“There are no CMBS lenders at this point in time, so that takes a huge amount of lenders out of the game,” says Rifkind. Indeed, domestic CMBS issuance totaled $12.1 billion in 2008, a dramatic drop from $230 billion in 2007 and $203 billion in 2006. During the second half of 2008, there was no issuance.

The moribund CMBS market is only part of the story when it comes to a shrinking supply of lending sources, explains Rifkind. “Among smaller regional banks, there is just a handful of lenders in any particular region who are lending. Your first-tier national banks are lending, but we're finding they're only lending to their best borrowers.”

Owners of blue-chip commercial real estate assets that are conservatively underwritten stand the best chance of getting financing. There are many lenders who will tell you that they're in the market,” says Rifkind, “but when you really drill down on a specific transaction, you find out that they really aren't, and they're really unsure of when they will be again.”

Loan-to-values are averaging 65% in today's marketplace, Rifkind says, lower than the 70% to 79% range cited by owners and developers in the survey. The discrepancy might be explained by the legendary optimism of the owner/developer community. Also, a significant number of respondents are active in the multifamily market, where 70% loan-to-value is more common through agency lenders like Fannie Mae.

Carter, a developer with three decades of experience, concurs. He is encountering loan-to-values in the 60% to 65% range, down from 75% to 80% over the past year. Loan-to-cost, meanwhile, now ranges from 50% to 60%, down from 70% to 80% a year ago, adds Carter.

Interest rate toss-up

Trying to determine the future direction of long-term mortgage rates is like predicting the outcome of playoff football — anything can happen. But with so much monetary and fiscal stimulus being injected into the U.S. economy, the conventional wisdom is that rates will increase in the year ahead, right?

Respondents are divided on that issue. While nearly half of respondents (46%) expect that long-term mortgage rates will be higher 12 months from now, another 21% expect them to remain the same, and 20% expect them to fall. Some 12% of respondents say they don't know [Figure 8]. Among those expecting an increase in long-term mortgage rates in the year ahead, most believe it will be 2% or less.

Friedman of Associated Estates says that as the debt markets begin to stabilize in 2009 and financial alternatives re-emerge, most notably CMBS, borrowers will have greater access to long-term debt. But those loan proceeds are likely to come attached with a higher interest rate than many borrowers anticipate, he says.

“I think rates will rise above where people thought they would be, and the underlying Treasuries should increase because of expected inflation down the road from all the feeding of the economy that the federal government has done,” says Friedman. On Jan. 20, the 10-year Treasury yield stood at 2.38%, down from approximately 3.7% a year ago.

Respondents also are split on the direction of short-term mortgage rates. More than four out of 10 respondents (42%) expect rates to rise over the next year, while 25% say they will remain the same and 20% expect them to go lower. Another 12% do not know.

Ultimately, the future health of the economy will play a big factor in the direction of interest rates. Borrowers indicate that the weaker economic conditions, not the higher cost of capital, have proven to be the biggest factor in their ability to obtain financing. On a scale of 1 to 5, the impact of weaker economic conditions rated 3.9 compared with 3.5 for the higher cost of capital [Figure 9]. At the low end of the impact scale was the takeover of Fannie and Freddie (2.3).

Friedman expresses confidence that both Fannie and Freddie, which have a social responsibility in the housing and apartment market, will endure in some capacity. “I am certain the new [Obama] administration recognizes the importance of doing what it can to keep housing affordability at the best possible level.”

Matt Valley is editor-in-chief.

Survey Methodology

Data for the 2009 Borrower Trends Survey was collected Oct. 29 through Dec. 5, 2008. Penton Research mailed questionnaires to 1,500 subscribers of National Real Estate Investor in late October. Subscribers were selected on an nth name basis from the magazine's database of commercial real estate owners and developers. The purpose of the survey was to quantify borrowing activity. The questionnaire yielded 289 completed surveys for an effective response rate of 19.4%. This report also is available on nreionline.com. For more information, please contact Editor matt Valley at matt.valley@penton.com