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The prospect of higher interest rates shows no sign of dampening borrower demand for commercial real estate debt, according to an exclusive survey of more than 400 developers and owners conducted by National Real Estate Investor. More than half of respondents (52%) expect total debt in their commercial real estate portfolios to increase during 2005, while only 14% expect their debt levels to decrease.
That’s sweet music to the ears of lenders and mortgage bankers. “The pipeline that we have is very strong going into 2005. We expect a very robust first quarter that is equal to or better than last year,” says John Fowler, executive managing director at Holliday Fenoglio Fowler, a Boston-based investment banking firm. HFF arranged more than $14.3 billion in real estate debt financing in 2004, up 24% from the $11.53 billion the firm placed in 2003.
To gain more insight into borrowers’ debt financing plans for 2005, NREI conducted an exclusive mail survey in November and early December 2004. The 400-plus respondents reported a median $9.4 million in commercial real estate assets. A majority of respondents (70%) own or develop multiple property types, though the largest group of respondents (43%) is active in apartments, followed by office (42%) and retail (41%) [Figures 1 and 2]. What follows are some of the study’s key findings:
Some 16% of respondents expect the total debt in their portfolios to increase significantly in 2005, while another 36% expect their total debt to increase somewhat. Nearly one-third of respondents (31%) expect their debt level to remain the same [Figure 3].
Over the past year, respondents have borrowed a median of $4.8 million, which represents a median of 15% of their total assets [Figures 4 and 5].
An overwhelming majority (83%) of respondents have borrowed from commercial banks and savings institutions over the past year. Private investors are the next most frequently cited source of debt financing (27%) [ Figure 6].
The largest group of respondents (31%) indicate that that mortgage rates on 10-year loans would have to rise to more than 7.5% – about 200 basis points from current levels – before their borrowing decisions would be affected [Figure 7].
In the next 12 months, 42% of respondents expect their use of long-term, fixed-rate debt to increase, while 33% expect their use of short-term rates to increase. Only 13% of respondents expect their use of short-term debt to decrease, and 8% anticipate a decrease in their use of long-term debt [Figure 8].
When selecting a loan officer, overall ease of the borrowing process ranks as the most important factor, earning a score of 5.5 out of a possible 6, followed by lowest interest rate (5.3), and speed with which loans are closed (5.2).
Although the speed with which loans are closed, low fees and flexibility of loan terms are three areas that rate relatively high in importance, they score relatively low in satisfaction, pinpointing possible areas of improvement for direct lenders and financial intermediaries to address.
The study found that borrowers are actively pursuing capital for a variety of reasons, including acquisitions, development and renovation of commercial properties, with the greatest number of respondents (39%) citing development.
The Miller-Valentine Group of Dayton, Ohio, is a fitting example. The company borrowed more than $200 million in 2004, and the developer expects to meet or exceed that level in 2005 thanks to a major project in the pipeline.
Miller-Valentine is moving forward with the $150 million third phase of Rookwood, a mixed-use development in Cincinnati that Miller-Valentine is developing in partnership with Cincinnati-based Anderson Real Estate Group.
“The market is very liquid right now. All lenders are looking for quality product with quality borrowers,” says Sharon Pennell, partner and director of finance at Miller-Valentine. “They are not doing crazy deals. But they are trying to be a little bit more aggressive on price and flexibility.”
Commercial banks riding high
Among the myriad debt sources available today, borrowers’ most frequently cite use of commercial banks and savings institutions. Some 83% of respondents indicate they’ve borrowed funds from these two capital sources in the past 12 months.
One reason that banks are a top pick in the current market is incredibly low short-term rates. Banks are traditionally a more active player in providing short-term debt such as construction loans, interim financing and lines of credit, while other lenders, such as conduits and life companies, tend to specialize in originating permanent financing. Cleveland-based KeyBank Real Estate Capital, for example, closed approximately $8 billion in construction and interim loans in 2004, a 60% spike from $5 billion in 2003.
A good chunk of KeyBank’s increase in interim lending was due to existing borrowers taking out 2- to 5-year floating-rate loans. “Part of that has to do with the fact that LIBOR (London Interbank Offered Rate) for 2004 has been at an incredibly low rate,” says E.J. Burke, an executive vice president at KeyBank Real Estate Capital. The 3-month LIBOR ended the year at 2.56%, which is still incredibly low compared to historical levels. In 2000, for example, the 3-month LIBOR averaged 6.5%.
Another reason banks score high among borrowers is that they offer a variety of loan products. In addition to its interim loan products, KeyBank offers its clients a full menu of financing products such as mezzanine debt, private equity investment and permanent loans – including arranging financing via conduits, life companies, Freddie Mac and Fannie Mae. Banks also cater to smaller borrowers, while conduits and life companies tend to pursue larger transactions. The average loan transaction by banks during the third quarter of 2004 was $6.5 million compared with $11.9 million for conduits and $11.7 million for life companies, according to MBA.
Opus Northwest, based in Minnetonka, Minn., borrowed $500 million from banks in 2004, and the group expects to borrow as much or more in 2005. “Bank flexibility has not changed a lot, but there is a lot of capital on the debt and equity side for developers of strong projects,” says Becky Finnigan, vice president of finance for Opus Northwest, a division of Opus Corp.
Banks are attracted to well-located projects with solid anchors, such as the Shoppes at Arbor Lakes in Maple Grove, Minn. Opus Northwest built the 411,000 sq. ft. lifestyle center in conjunction with Kansas City-based Red Development. The project, which opened in 2004, features tenants such as Williams Sonoma, Pottery Barn, Talbot’s and P.F. Chang’s.
The 1,260 loans originated by commercial banks during the third quarter of 2004 easily surpassed the 758 loans originated by conduits, according to the MBA. Commercial mortgage-backed securities, or CMBS, accounted for the highest dollar volume in originations during the third quarter. CMBS transactions totaled $9.4 billion compared with $8.2 billion for commercial banks, and $5.9 billion for life companies.
“The whole CMBS market right now is very profitable,” says Ed Padilla, CEO of NorthMarq Capital based in Bloomington, Minn. That’s partly due to overwhelming demand. “There doesn’t seem to be any shortage of customer for what they are creating. Pools are selling out, and there doesn’t seem to be any end in sight,” he says.
Borrowers brace for higher rates
Respondents are highly confident that interest rates will continue to rise. Specifically, 84% expect higher long-term rates, while 77% anticipate higher short-term rates [Figure 9]. But how high, and how quickly those rates rise could impact not only the amount of dollars borrowed, but also decisions to refinance and whether to pursue floating-rate or fixed-rate financing.
The largest percentage of respondents (55%) expects long-term mortgage rates to rise between 1% and 2% in 2005 [Figure 10]. Under that scenario, the 10-year Treasury yield – which as of mid-January hovered around 4.25% – would rise to 5.25%. Industry experts emphasize that by historical standards, 5.25% is still relatively low. In 1981, for example, the 10-year Treasury yield averaged nearly 14%.