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Roundtable: How are Banks Viewing SoCal Real Estate Financing for 2019?

Carrie Rossenfeld Roundtable

Jay Maddox
Principal – Capital Markets Group
Avison Young

Jay Maddox | Courtesy a representative of Avison Young

Commercial real estate values in Southern California have risen consistently for the past eight years. Despite the fact that valuations are in most cases at record levels, we continue to have abundant capital flowing into the market – debt and equity, foreign and domestic. The outlook for commercial real estate loans in 2019 is very good. Banks have been active, but because of regulations enacted after the Great Recession they have been much more conservative than the years prior to it. In general, existing, well-capitalized clients are having success obtaining new loans, whereas it has been a much bigger challenge for smaller developers. Banks have been particularly selective with new construction financing due to new regulatory capital constraints. Yesterday’s 70 percent to 75 percent loan to value is now 60 percent to 65 percent, and personal guarantees are almost always required. Consequently, we’ve seen a wide range of new competition from private equity funds, family offices and even insurance companies offering non-recourse construction and bridge loans with better proceeds, faster loan processing, and more flexibility than banks. Because of this, 2019 should be another good year for borrowers, although not as strong as the transaction volume seen in 2018.

Sales activity of commercial real estate in Southern California has been strong for the past five years, and we also expect that to continue in 2019. Despite record low cap rates for the best quality properties, Southern California’s major metro areas are still a bargain compared to other gateway cities such as New York, Vancouver and San Francisco. We expect cap rates to rise as there is a direct correlation with long term interest rates, which have risen. However, there is a lag, and so far, we haven’t seen much pressure on cap rates. When they do rise, that wouldn’t necessarily translate to lower values as long as we continue to see good market fundamentals, such as increasing rents and NOI.

Gary Bechtel
President
Money360

Gary Bechtel | Courtesy a representative of Money360

As the surge in population growth continues across Southern California, demand for commercial real estate development and re-development is growing and thriving, and I expect that to continue well into 2019, absent an unexpected economic downturn. Major metropolitan areas like Los Angeles remain attractive places for migration, but secondary cities like Long Beach and the Inland Empire are seeing even greater acceleration in population growth. The challenge for those areas is to meet the demand for new buildings – which include multifamily housing that enables density but also ancillary assets like hospitals, community centers, hotels and medical facilities – all on an expedited basis.

I expect borrowers to continue to seek alternative lenders over traditional financing because they are able to offer faster speed to close, transparency in loan process and flexible financing terms. With interest rates rising, traditional lenders may increase resources for commercial real estate financing as they are able to get higher rates of return on these loans versus consumer products. However, I expect borrower demand to be greater for short-term financing, such as bridge loans, and alternative lenders are better suited to facilitate such loans with built-in accommodations for changing market dynamics. Where a traditional lender may be required to stay hard and fast to initial terms, we pride ourselves on working with our borrowers to get them financing that continues to work for them through the life cycle of a property.

Steve Sefton
President
Endeavor Bank

Steve Sefton | Courtesy a representative of Endeavor Bank

The increased cost of borrowing requires more cash flow to service the same loan amount as in a lower-rate environment. If rents don’t follow the rise in rates, then income properties won’t support the same level of debt that they did in a lower-rate environment. This scenario could require borrowers to make larger cash-down payments. Higher rates, reduced cash flow, more down payment — this combination can lead to a cooling off in the investor real estate market.

I believe that we are seeing this scenario in the multifamily market. Many of our local multifamily experts are telling us that we are seeing a pause in the ever-increasing prices for apartment properties.
Prices topping out means sellers are asking for prices that, at the current lease-income levels, result in capitalization rates that are too low. This is not sustainable if rates continue to increase. Buyers and borrowers need to be prepared, unless prices relax, to come in with a higher down payment. Buyers and borrowers should have more frequent conversations with their banker and earlier in the process. Know the lender’s underwriting model. Ask the lender for a copy of its cash flow spread sheet, and know how the lender underwrites. This will help buyers/borrowers be prepared and avoid surprises when they enter escrow.

Regarding office properties, we have seen a trend in office users taking less space; more open bullpen environments with fewer individual offices. We are also seeing more of the WeWork-type shared spaces. These trends reduce demand. If (or when) economic growth slows, office demand will decline as well. I still believe there is plenty of life left in this cycle, but these are trends office investors know will affect their investments.

On the upside, I have seen more independent medical use come online. Changes in the medical environment are allowing doctors to recreate independent medical groups, which are driving medical usage. I saw more medical owner-user loan requests in the last year than in a long time. My own anecdotal experience may suggest a trend in this sector.

At Endeavor Bank, one of our preferred property types is industrial. Operating companies account for a significant portion of our clientele — primarily owner-user clients who are involved with manufacturing, business-to-business service and/or distribution that requires industrial or flex-industrial space. We continue to see a strong market in owner-user industrial as the economy continues to perform.

Patrick Ward
Founder and President
MetroGroup Realty Finance

Patrick Ward | Courtesy a representative of MetroGroup Realty Finance

We represent a broad range of lending institutions both large and small. The majority of lenders that we represent met or exceeded their allocations and targeted volumes for 2018. In our discussions with them for 2019, we see everyone with similar or stronger allocations and expected volumes. In the last several years, lending on commercial real estate has been a healthy and profitable investment for those lenders that compare their real estate loan portfolios to other investments. Obtaining yields of 1.80 percent to 2.40 percent over corresponding Treasury bills compares well to alternative investments.

The majority of real estate lenders set their pricing in the range of 1.80 percent to 2.40 percent over Treasury bills. This puts coupon rates for 10-year term mortgages in the 4.80 percent to 5.40 percent range. This is a range that is still attractive enough that it should not alter the velocity of transactions. In addition, the majority of loans maturing in 2019 typically fall within this range. We also must remember long-term rates don’t always respond to movement of short-term rates. U.S. Treasury bills, the index used to set real estate pricing, is an international instrument affected by worldwide geopolitical events as well as U.S. monetary policy.

The majority of the lenders we work with have not loosened their underwriting standards. We still see maximum loan-to-values stated at 70 percent to 75 percent; however, as a result in the approximate 100-basis-point increase in interest rates from approximately 4 percent to 5 percent, we see debt coverage ratios now restricting loan-to-values. Computing loan amounts on valuations using cap rates in the 5.25 percent to 5.75 percent range underwriting with a 5 percent rate as opposed to a 4 percent rate reduces the loan-to-value in the 7-10 percent range, oftentimes putting maximum leverage in the 65 percent range as opposed to 75 percent loan-to-values.

From what we see in providing capital for most product types on a national level, we see lenders careful with hotels and obviously retail. Multifamily, office, and industrial remain desirable and are preferred product types for lenders. The larger national lenders are being more careful in smaller markets. We see most lenders being selective with smaller hotels. Obviously with the e-commerce effect, retail lenders are being cautious and selective. Larger centers in smaller markets are very difficult to finance with the larger national lenders. Local banks who better understand their markets are filling the void. Reported sales history is almost always required on larger centers that have not been repositioned for an e-commerce world.