Bruce Norris is joined this week by Paul Earnhart (Founding Principle) and
Erik Hernandez (Senior Vice President) of Lee and Associates in Ontario, CA.
Lee and Associates specializes in industrial commercial real estate. Bruce asks
when the commercial real estate market peaked. Paul said the peak was about the
same as residential but that it became more obvious in July of 2007. This is
when several partners backed out of deals and much more scrutiny started taking
place.
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Bruce asks Erik about financing and if commercial had its own
version of stated income. Erik says Lehman was doing commercial lending as well
but it wasn’t as aggressive. Paul says lenders were willing to finance on sales
comparables instead of income streams. No income stream analysis was taking
place but now that has changed.
The typical buyer from 2004-2006 in the commercial Inland Empire market were
Asian entrepreneurs and domestic buyers for consumer services. The market has
receded but some areas on the outer edges of the Inland Empire are being hit
harder. No new development is taking place. Foreign investors haven’t
disappeared but are slow and cautious when making decisions.
Bruce asks if commercial deals were leveraged or if they were bought cash. Erik
says if it was an owner occupant (owner user) the deal would typically have 10%
down and 90% would be financed. Lenders would do a first trust deed at 50% and
then a second at 40% would be guaranteed by the Small Business Administration
(SBA). Erik says this program is currently still around. Wells Fargo, Bank of
America, and some regional banks are still active in the commercial arena since
they are only 50% into a transactions. Bruce asks if the SBA is in line for the
bailout.
Paul says prices are down around 15% from the peak. There are a few spots where
it’s worse. For those that can’t refinance, they are letting the building go
into foreclosure.
Paul says they are expecting a rough road for the coming year. Rents and values
have dropped and financing is impossible for some. The SBA financing is only
good up to $3 million dollars. Anything over must use conventional financing.
SBA is also more conservatively underwriting their loans. SBA is paying more
attention to debt-coverage ratios (DCR) as opposed to pure sale comps. DCR
measures your ability to pay the property's monthly mortgage payments from the
cash generated from renting the property. SBA has not dried up so financing is
still there.
Conventional financing is now limited to 65% of value. Lenders are much more
cautious here. Bruce asks about mezzanine financing. Paul says it’s changed.
Mezzanine financing used to be anything above 75% loan to value. Now it’s 60%
loan to value. If the underlying lender will allow it, it’s much more expensive.
14-15% rates will apply and the financing will be for 3-5 years typically. The
first can be around 10 years. They will want to get as much risk out of the way
as possible.
If the property is very good construction and has good tenants, Cap rates are
held low. Investors feel better protected here. The all cash buyers are looking
for these nicer buildings. Leveraged buyers see higher cap rates. Caps rates are
up 25% and Paul expects it to go up another 10%.
Bruce asks about what happens when a cap rate goes up from six to eight and what
happens to the value. Paul says about a 25% in value takes place. Any new
development is nearly impossible because land and construction can’t keep up
with price adjustments. Bruce says similar things are happening for the
residential market as properties are being bought for land value.
Bruce brings up that there is $100 billion of commercial financing that comes
due in 2009. Bruce asks if Paul and Erik think it’s a problem for those hoping
to refinance. Paul thinks that number is low because that number is premised on
individual loans and some business have leveraged their building for lines of
credit and those are coming due as well. Paul says that lenders can also make
margin calls on these lines of credit. It could be a huge problem.
Bruce asks if pension funds buy real estate free and clear. Paul says that is
true and pension funds don’t act as quickly and have a longer range outlook for
investments. REITs are structured differently and some are fairing better than
others. Bruce and Paul talk about REIT values going through the floor and if
that will change how they are able to fund future projects.
There were many non recourse loans being made in commercial. Non recourse loans
are now much more difficult to get.
Bruce asks about how insurance companies are involved and if they are big
players in the financing of commercial real estate. Paul says they are much more
risk averse and have pulled back in availability of funds.
Paul says vacancies are not out of control yet but they are starting to
increase. Erik talks about vacancy (buildings with no tenants) versus
availability rates. Many companies are subleasing space since down sizing is
taking place. Vacancy numbers may be around 6% for the West End but availability
rates are around 12%.
More coming next week and you can find Paul and Erik at
www.lee-assoc.com .
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