Not as bad here as elsewhere but financing woes prevail

August 24, 2009
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The local commercial real estate investment market is mirroring the national trend, just not as severely.

Prices have fallen by nearly 35 percent nationwide since October 2007, when those values peaked. Commercial values across the region have dropped an average of 20 percent over the same time frame.

According to Grubb & Ellis|Paramount Properties, the difference in West Michigan property values and those elsewhere in the country is the cap rate that has been reached in other markets hasn’t arrived here yet. But despite the value-drop disparity between the nation and the region, both are facing the same problem: a lack of financing for loans that are maturing.

Bob Bach, senior vice president and chief economist in the Chicago office of the Grubb & Ellis Co., cited a Property & Portfolio Research report that said $497 billion in loans will come due across the nation this year, and banks hold 73 percent of those.

Of the banks’ $365 billion total, $237 billion are permanent loans and $128 billion are for construction. When commercial values become depressed as a loan matures, finding refinancing is difficult at best and impossible at worst.

“The lack of available financing to cover these maturing loans is pushing a steadily rising number of properties into delinquency, default and foreclosure. As of June 2009, according to Real Capital Analytics, troubled assets — those in default of their loans, foreclosure or bankruptcy — exceeded $108 billion, more than double the total at the start of the year,” said Bach.

Bach doesn’t expect the national market to correct itself any time soon either. And while this dark cloud has a silver lining, it’s just not silver enough for everyone.

“The wave of foreclosures is likely to build through the next two years to three years, creating deep discounts and opportunity for investors with equity and good relationships with financially sound lenders,” he said.

GE|PC Vice President Chad Barton, part of the firm’s investment advisory group, said his sector started feeling the negative vibes at the end of 2007 — but not in the normal owner-occupied or business line of banking. A year later, though, he said, everyone here began getting hit.

Commercial mortgage-backed securities and commercial debt held by insurance companies, non-recourse loans, were first to feel the pinch. A CMBS is an uncollateralized debt loaned to an investment-grade commercial property that does not feature an investor as an occupant.

“A lot of these investors across the nation not only have lost value in the property, now their mortgages are coming due and they don’t know where they’re going to find another mortgage. Banks are likely to tell them they don’t want to refinance,” said Barton.

“In the traditional days, you just rolled the refinancing and kept going on the mortgage. Suddenly, they’re saying you have to take this mortgage elsewhere and find another source for the funds,” he added.

Because property values have fallen and driven buildings “underwater” financially, Barton said an investor looking to refinance has to have more equity now to get a loan than in past years. A few years ago, an investor could get financing for up to 85 percent of a property’s value. Now, Barton said the upper limit is around 65 percent, and some lenders have set the high bar even lower at 55 percent.

“Even if you’ve gone through five to 10 years of a mortgage, it hasn’t been paid down enough based on the previous loan-to-value. So investors have to come to the table with more equity, which is very tough to do in this downturn because they’ve lost a lot of wealth in the stock market and other places,” he said.

“So, if they have non-recourse debt, they’re able to just hand the keys back to the bank.”

The telling statistic in the market decline is the cap rate. The income a property generates is divided by the purchase price and that resulting figure makes up the cap. The lower the rate, the better it is for investors to find financing because a lower cap means the property has good value.

Barton said properties were selling at around 8 to 9 caps in 2007. Now that prices have dropped, properties are selling for 9.5 to 11.5 caps and, in some cases, even more.

“There has been a significant increase in cap rate and a significant decrease in value across the board,” he said. “But we have actually seen less of an impact in West Michigan than the nation has.”

Although the impact isn’t as severe here as on both coasts, there will be delinquencies, defaults and bankruptcies in the West Michigan market. Barton said tenants are going under and not making their lease payments, which raises the building-vacancy rate. Other tenants are hanging on but asking their investor-owners for a rent decrease to stay, which doesn’t help make the mortgage payment as the investor’s net-operating figure shrinks.

Barton said the typical incident seen now in the region is term default. Investors who are getting to the end of the mortgage term are looking at their values and finding they are about 20 percent lower. So refinancing would put them at today’s loan-to-value mark, which is 60 percent, or 20 percent worse than their original loan.

“On the non-recourse side of things, which is the CMBS note and the insurance-held note, you’re going to see a lot of people just handing the keys back to the noteholders and they’re going to have to take the loss on those. But the investors will also lose any equity they had in the deal,” he said.

CMBS and insurance-held notes account for roughly 13 percent, or $67 billion, of the loans made in the U.S. commercial investment market.

What about the recourse-loan side? It’s easily the largest pot, held by banks.

“That’s where you’re seeing local investors and developers that are so deep in a hole or filing for bankruptcy. The banks are going to be taking the properties back, not realizing the value, and taking losses themselves. It’s a spiral,” said Barton.

Barton said there are limited sources of financing available, but only if an investor has a really solid deal. And it’s not just finding a lender that’s difficult. Buyers are scarcer because the amount of equity needed to purchase is higher. Having fewer buyers to choose from can lower prices even further. So most of the sellers who are selling are doing so to stop the bleeding and get out of the market.

“One of the things we’ve seen is a significant decrease in the amount of buyers because so much cash is needed for a deal. We’re seeing high-net-worth individuals, or groups of individuals who have pooled their money together, going after transactions now,” he said.

“Now it’s a buyer’s market, where it was a seller’s market only two years ago. We are seeing such a significant spread in sellers’ expectations and buyers’ expectations that it has paralyzed the market.”

If this scenario sounds familiar, it should. The commercial market is following in the same footsteps as the residential market, just a bit slower. “It’s trailing it by about two years,” said Barton.

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