Financing Real Estate in a Down Market

Written by: John Hardaway, HPI

Wading through the aftermath of the economic and financial meltdown, commercial real estate markets and owners continue to face an uphill climb when considering asset-level financing.  The sucking sound heard across all sources of liquidity is being replaced by banks and life companies providing conservatively underwritten loans in a vastly different and evolving financial landscape.  As the broader economy inches towards recovery, financing alternatives will improve as healthy banks and life companies increase their appetite for relatively attractive, risk-adjusted returns on commercial loans (read: high profits with low risk).

In general, lenders are focused on top-tier projects and best-in-breed owners/sponsors.  For top-tier projects, the focus is asset quality, occupancy, tenant credit and pending rollover.  There remains a “flight to quality” for top-tier projects and little or no appetite for everything else. Lender competition continues to emerge for the most stable/core projects. Conversely, projects with LTV issues, perceived leasing or tenant risk have few financing alternatives.  For sponsors, the focus is on “survivors” who bring value to the table, whether it’s a balance sheet, liquidity or a proven track record with local market expertise.

When looking to refinance, there are two primary scenarios to consider: is the project stabilized or is it underperforming/distressed? The answer will yield a widely different marketplace.  Either way, the key focus should be starting the conversations early, having a plan and understanding the reality of the current financing environment.

For stabilized projects, there are two primary sources of capital: healthy national/regional banks and life companies.  Life companies continue to re-enter the market, providing additional competition for quality projects; however, very conservative lending practices remain – applying current market vacancy rates whether stabilized or not, current market rents applied to future rollover, often overly conservative cap rates and zero value given to vacancy.

As a result, life company terms are relatively unchanged at 60-65% LTV (or 10-12% debt yield), which is more like a 50-55% borrower-perceived LTV, non-recourse, 6.5%-7.5% all-in rate which equates to a 400-500bps spread over the 5-year Treasury.  Banks have similarly conservative underwriting with the following general terms: 60%-70% LTV, some level of recourse, L+250-350 depending on the project with an all-in floor of 4.0%-5.5%.

For underperforming or distressed projects, there remain few alternatives but to negotiate with the current lender.  Alternatives include the emergence of mezzanine and preferred equity providers; however, there exists little “room” in the capital stack for these sources as values are often less than the outstanding debt.  When negotiating with current lenders, understanding lender wants and needs are pivotal.  Focusing on needs, lenders need a borrower who adds value with a logical plan and the ability to execute. In addition, lenders need a proactive borrower who engages in conversations early and often.  Bringing capital to the table is a key benefit to the borrower; however, absent of that, every other aspect of the refinance is negotiable involving “give and take” from the borrower, not just “take.”

While financing remains an uphill climb, life companies and healthy banks will continue to receive allocations and supply capital to real estate; nevertheless, it is unknown whether the conservative underwriting and sponsor/project “flight to quality” will continue.  Lender appetite in Austin and San Antonio remains strong. Economic and unemployment statistics for both locations are outperforming the general U.S., due to the perception that Austin and San Antonio will be the last in and first out for a recovery.

Given the current financing environment, borrowers should be focused on: initiating early lender conversations; understanding the reality of the financing markets; and, most importantly, adding value via a strategic plan and the ability to execute given the merits of the project, the strength of the sponsor and its leasing and management team.