Back to Basics

The Panel:
- Shane Albers, Chairman and CEO of IMH Real Estate Financiers
- Don Trossman, Managing Dir. and Partner of the Capital Markets Unit for Cohen Financial
- William “Bill” Spart, Sr. VP/Manager of Commercial Real Estate at Wells Fargo Bank
- Curtis J. Hansen, Executive VP and Department Manager, Phoenix Commercial Real Estate Division at National Bank of Arizona
- Stanley W. Farmer, VP and Commercial Real Estate Loan Officer at CBN Financial

Capital Flow
Trossman: I believe that the commercial real estate fundamentals are pretty well in balance, not just in Arizona but across the country — although in the case of office properties they’re beginning to erode a little bit, and in the case of multi-family they’re beginning to improve because of the lack of ability to buy condominiums on the part of the public, with the financial markets in disarray.
Commercial financial markets are normalizing, probably to the ’04 and ’05 levels in terms of underwriting; and the excesses that have occurred in the commercial business are being wrung out, such as 10-year interest only loans, one to one debt service coverage, lending on projections and loans with no equity or 90 percent loan to values. All of that is no longer readily available. I believe for Arizona, as well as other markets similar, the necessary developments will get done, quality developments will get done, but they will all require more equity.
I also believe that the credit crunch is a major overreaction to subprime issues, because our fundamentals are really pretty good.

Hansen: There’s enough capital, and banks are in the business — especially locally — to get necessary developments done. I think the key word is “necessary,” and I do believe amateur hour is over in this state. There are a number of projects that were probably done in the last five years that wouldn’t get done today. That’s a good thing for the long-term health of the economy and real estate community here.
A lot of these fundamentals have been coming for some time now — this wasn’t just something that all of a sudden happened in August. The fundamentals of real estate development have been changing, in my mind, for the last couple of years.

Albers: I think that the regulatory environment and the attitude of the regulators are different this time around than from the RTC. There are projects that should be financed, that adhere to the core lending fundamentals, and because of that I think you’re going to see continued capital flow. Markets recover because the financial world is driven by income-earning assets — ultimately, pension funds, life insurance companies, banks, endowments and investors purchase income-earning assets, such as loan portfolio or real estate with income. If investor’s money is merely earning money-market rates, investors are not achieving their investment objectives.

Farmer: The thing I see different in this market today versus the RTC days, is that we do not have the gigantic surpluses that existed then. The inventories in the current environment can be methodically absorbed, even though there will be short term financial losses.

Foreign Capital
Albers: It’s opportunity capital. You’re seeing foreign capital primarily that’s driven by the Canadian dollar, or the Euro in these markets. The capital coming in is to essentially land bank certain positions.

Spart: The equity is still coming into the marketplace. Many of the sources are private placement to public sources (i.e. REITs). The flow of capital will affect all of us and the type of projects that get done. Investors believe the area is still a good market over the long term given the dynamics of Arizona versus other parts of the country.

Hansen: I think those types of inflows of capital have a much longer term horizon than bankers do — than even traditional real estate investors for that matter. I think what they’re seeing right now is an opportunity to get in on the ground floor, and maybe a ground floor that they missed 10, 15 or 20 years ago. They’re seeing this as an opportunity to make a very long term play in our market. The long term prospects that Arizona holds, with outstanding population growth and all kinds of opportunity — I think that will be challenged in the next 18 to 24 months.
I think we like to hang our hat on population growth in this state as the savior to all ills. I don’t know that that’s going to occur at the same pace in the next 24 months. I think it’s going to be difficult. However, looking at the long term, there is probably no better place to be than Arizona.

Albers: The worst thing is that a significant amount of money could come in with the anticipation to flip it right away. And I agree with you that they (foreign investors) are realistic that the long dollar is not in the next couple of years.

Farmer: I think the international market is disciplined in the assets they are acquiring. The assets being acquired are at a low basis with cheaper foreign funds. The only negative I see is that if the international entities take asset ownership the local lending opportunities may be missed, because most of the financial institutions are not comfortable financing foreign-owned companies. There may be projects with proper leveraged positions that may not be financed locally because of the foreign ownership.

Trossman: Where the lack of discipline occurred was in the distribution channel side which was primarily the CMBS side. There is significant influence in terms of the number of foreign entities that are playing in the CMBS lending business. But I don’t think that there’s going to be any major shift in how they do business other than the new disciplines that are being self-imposed on the CMBS system.

Albers: Now is the time for each one of us in the room to lend and here’s why — we have values that make much more sense than they did in ’05 and ’06, we have loan terms that adhere to our fundamentals, and frankly we have economics that make more sense.
In my particular space, prior to 2004 I had 10 competitors, 2006 I had 60, now including ourselves I have three that are actively funding. The reason you have such a deterioration in the number of players is obviously those that were the last to arrive are the first to leave. Obviously they didn’t know the market or the real-estate values, and they are now suffering a loss. They simply loaned too much money.

Borrowers & Underwriting Terms
Spart: In regards to short term construction loans — we are seeing, as well as other lenders and banks, more equity, stronger guarantees and tighter structures versus the limited recourse and looser structures we have seen in the past.

Hansen: You had a bunch of banks running around over the past couple of years doing things they shouldn’t have done in order to gain market share in a new market. We just need to get back to the basics. I think borrowers are receptive to that.
(Borrowers are) now understanding that there is value to a relationship, but that value had been missing in the last couple of years. Some borrowers will have trouble this year and next year.
We’re not over some great hurdle. I think there’s opportunity for the right kind of deal, but it’s going to be a little bit of a bumpy time here and we’ll see some people have stress that we never expected to have a crisis or stress.

Trossman: I certainly think borrowers who are not well capitalized are going to feel stress. On the other side of that coin there is opportunity in that because there’s talent with people who aren’t well capitalized that you can back with capital, whether it’s syndications or institutional partnerships. The underwriting is going to be stricter in all cases and require more equity. I think there’s going to be stress across the system, but this is the sixth time I’ve been through major financial disruption. What happens when you go through this is we all go through an adjustment period of a new set of parameters, which we’re going to lend by. It then takes the borrowing community somewhere between 3 and 6 months to settle into the new lending parameters, get their act together, wring the stress out and raise the capital they need to move forward. And that’s going to happen.

Albers: If you look at the exposures of the lending institutions in Buckeye, Surprise, Maricopa, Casa Grande and other markets in Maricopa and Pinal counties — there’s enormous stress.

Hansen: I think some of it is a matter of how well capitalized you are going in, but a lot of it — and here’s where the stress comes and where we haven’t seen it all yet — is how you acquired your property. If you bought your land wrong, or if you acquired your property at a very low cap rate planning to sell it at x dollars a door, you made those decisions two or three years ago. Today, you’re at that phase where you’ve got to develop it to get out. You have stress because the fundamentals are no longer there and you can’t go back in time and correct (the acquisition mistake).

Albers: And then you have the Mezzanine market — there’s no equity, there’s a promise of some future profit so it’s called Mezzanine, which is an elevated name for second lien positions. This paper is now absolutely worthless.

Hansen: It will recover when those things trade hands.

Albers: I agree, but those two things have to happen. It has to trade hands and it’s not going to trade until there’s a discount.

Spart: The other thing that we saw over the last five to ten years was the number of start-up banks that were created. As a result of the number of new entrants in the market, there was a lack of qualified lending talent available in the marketplace. In some cases, lending structures became looser and institutions probably did some loans without the seasoned experience of veterans in the industry. As the financing sources retrench, we’ll see some people leave the industry.

Albers: It’s very easy to lend in a growing market and the magic is not in the lending, the magic is getting your money back. If you looked at ’05 and ’06, money was commoditized. Relationship lending went away since money was a commodity. Now if you look at today, you have the market understanding and recognizing that borrowing money is a privilege. But what we had previously was that it was a right, that it was a commodity and everybody should get this. And it is absolutely changing from that direction.

Trossman: There was a lot of money chasing deals, especially through the CMBS markets.
The last ten years, the CMBS marketplace has allowed the borrowing public to borrow money as a commodity without the disciplines that a portfolio lender actually had. It had gotten more and more creative as to how you get to the high loan dollars for people who wanted them.

Spart: All of those lenders who made those loans are gone. We’ll probably see over time some mergers will come in and clean up some of the issues in the marketplace.

Trossman: It also questions the efficacy of the rating agencies, which has now become a major issue because the buyers didn’t know what they were buying with the rating agencies calling them AAA bonds or whatever....

Albers: The rating agencies structured them, you’re dead on right. They went to the agency and they said, would you structure this, would you give us the rating.

Trossman: One of the questions that was posed was the outlook in two to three years, and my response note to myself was — it’s almost enough time to screw it up again.

Albers: You both are right. RTC said this would never happen again and it has.

Trossman: But it’s a little different this time.

Albers: So now it’s residential, but my point is that you need a generation. So you wait long enough and have the next generation, you wait 15 or 18 years and we will see this again. Please remember that many on Wall Street are in their late 20’s or early 30’s, and were in grade school during the RTC years and have never known a bad market.

Cap Rate Shifts
Hansen: At what point do we all recognize that cap rates have shifted? (Permanent lending) rates have shifted, and cap rates have to follow suit at some point. I think the development community and everyone is thinking — the capital markets will come back. But I’m having a hard time buying in to this. I think what we’re seeing now is a fundamental shift in pricing risk that is not going to go away any time soon, and if that risk premium has changed, then I don’t see how cap rates can remain unchanged.

Trossman: We have definitely seen this shift in the cap rates. We’ve seen them rise and the prices of properties drop. Risk is being repriced. If you look at buying properties and where the cap rates went — we were asking the question all along as the cap rates were dropping if this was a fundamental shift or was an economics driven shift? It turns out it’s partially economically driven, because as cap rates rise you can’t create the same leverage on a piece of property that is being bought at a higher cap rate. The only asset that I’ve heard recently that’s maintained its low cap rate, which I find to be a paradox, is trophy office assets.

Farmer: I think the international market is looking at trophy properties because they are easier to evaluate. The trophy properties have typically performed through the tough times and investors will diversify their portfolios with these solid properties, even though they are not deeply discounted. There will not be the deterioration in cap rates for the trophy properties, but cap rates will increase for the majority of other property types.

Hansen: I haven’t heard anyone openly say this in a while, but there were a lot of people anticipating that what we’re seeing in residential spills over into commercial.

Spart: I think on the commercial side you may see some deterioration. Properties located on the fringe or ill-conceived will probably be more affected than well-located ‘A’ type properties.

Hansen: But we’re not talking about that, we’re talking about Scottsdale office.

Albers: In the Scottsdale office airpark, there is no question that vacancies are increasing and you’re seeing it throughout the Valley. You’re seeing retail softening here, seeing industrial softening here and throughout the United States. There is no question that there is deterioration of fundamentals and property values.

Trossman: Hopefully it won’t get that deep that it will be that drastic, but it’s something to watch out for. However, there are going to be institutions that are going to be selling assets that they foreclosed on soon again.

Hansen: I’m wondering what that time horizon is when you see banks have stress with commercial properties. We’re not seeing any of that.

Spart: As a portfolio lender we have to know our borrower. Borrowers with experience in development, along with financial capacity, can take an average property or one that’s not performing well and still, in most cases, make the situation work. However, borrowers with minimal or no experience can take a great property and run into a lot of trouble, even if they have financial capacity. Execution is the key to success for both the borrower and lender.
The worst thing that you see out there are borrowers who don’t take action and they hope the problem goes away. That’s where they get in trouble.

Trossman: This too will shake out, because it’s a short term strategy. The only way that it doesn’t shake out is if the market turns itself around in an instance.
Albers: A rolling loan incurs no loss, but again it is a short term strategy.

Loan to Value
Spart: On the commercial side we’re seeing a normal 75 percent. Sometimes an 80 but 75 percent is the average. Equity ranges from 15 percent to 25 percent, depending on the project and its economics.

Trossman: Bank level you’re looking at recourse and if you have a strong borrower you can do things that are far different than if you have a borrower that’s relatively weak. So typically you may be 80 percent or 75 percent loan to value, but if some guy comes to you and he’s got a $100 million statement and $50 million dollars in cash and wants to borrow 85 percent, you’re going to do that. It’s different buckets as to what the approach is.

2008 and Beyond
Spart: It’s going to be a turbulent market, at least for the foreseeable future. If people stick to the fundamentals of equity, experience and proper structure, then they should be able to get their deal done. Some loan structures acquired in the marketplace from borrowers in the past will probably not be well received in the future — such as interest only, no equity, or a borrower’s first time attempting a particular type of project.

Albers: If you want to buy real estate now’s the time. If you’re going to borrow money, come in with 25 to 30 percent down, real equity, a guarantee and real sponsorship, experience, and you’ll get your money. And if you’re a lender, now’s the time to loan money. You’re going to loan at better loan to values, better economics and loans that adhere to traditional lending disciplines.

Trossman: This is a very treacherous marketplace and most real estate transactions have timing issues associated with them. My recommendations would be to seek out a company or professional who has good market knowledge, good relationships and who can help you access reliable capital in an efficient accurate manner.

Hansen: We are now in a period when there should be a premium on location of a project, its viability, feasibility and banks need to see real feasibility analysis. It’s incumbent upon the borrower to convince the bank why the project makes good economic sense. I can’t finance a project for anyone when I don’t understand the return. When you come in and you can’t show where the returns are for you as a developer, then it’s not financeable. To that end, that analysis needs to include a downside analysis, your most probable, and an upside analysis. You’ve got an expected return for the downside, one for the probable and one for the upside. The weighted average is what you get in terms of an expected return. We’ve gotten away from doing that — developers and bankers alike — we go to the best possible scenario, that becomes the risk and the expected return, just looking at that great best case scenario.
As a borrower you need to know who you’re dealing with in terms of your bank, because I can tell you right now there are banks out there that are struggling. They have liquidity issues. I think most people focus on capital issues and credit concerns when it comes to banks, but liquidity issues are as much a risk in terms of who you’re dealing with in terms of your financial institution. You can pretty much pull up the financial standing of any bank by going to the FDIC Web site. I would say if you’re a borrower and you’re looking at three different kinds of banks and one of the deals is too good to be true — their deal is too good to be true. You may have a commitment on paper, but you need to be able to borrow money from that bank — and you can’t if it’s out of business.

Farmer: Identify your portfolio. When you’re looking at that A/B type credit facility — listen to what they have to offer. A correct decision can either make that deal survive or you can bury it. The correct decision can make you money in this cycle. There is always a group of borrowers that are borderline. The ultimate decision is whether to restructure and advance additional funds, or to liquidate the collateral asset. The people at the top of the food chain really need to have qualified people evaluating each transaction, rather than painting all troubled transactions with one brush. Having good input will make or break a lot of transactions.

Web Sites:
www.communitybanknv.com
www.cohenfinancial.com
www.imhre.com
www.nbarizona.com
www.wellsfargo.com