Another Victim of Economic Dip: Commercial Real Estate Finance

Ken Griggs - Associate Vice President, Portland

In recent months, the economy has been at the forefront of Americans’ minds. Stock market volatility, the residential sub-prime mortgage crisis, job losses, and lowered consumer spending have all received considerable attention.

Commercial real estate finance has also been seriously affected. Numbers are down and the nature of commercial lending has changed significantly, with stricter standards and stronger underwriting. Yet Portland remains one of the more stable markets.

This year, commercial real estate mortgage bankers that are doing well have seen production volume fall 30 percent; other brokerages that relied heavily on Wall Street conduit loans have seen even steeper declines. The industry is shrinking, and it will continue to do so for the next 12-18 months.

Less money is available for lending now than at any point in the past decade. Many lenders were crippled or wiped out by the meltdown on Wall Street, leaving fewer lenders in the market. The types of lenders have also changed, and today the most active lenders are life insurance companies and banks. Both of these sources are down too, though, and this trend is expected to continue well into 2009, if not 2010.

Life insurance companies are making fewer mortgage investments for a variety of reasons, including weaker product sales, better investment alternatives and general market uncertainty. When they can get a spread close to 500 basis points over a corresponding treasury, it doesn’t make a whole lot of sense to make a mortgage for less.

Banks are facing severe liquidity issues, and have drastically slowed their lending activity. Those with heavy exposure to sub-prime lending have been hit especially hard. They face higher reserve requirements and subsequently have less money to lend. Construction loans that have been routinely taken out on time are now having difficulty getting refinanced, further burdening banks’ liquidity and their ability to lend.

That’s not to say that lending has come to a standstill. Capital is still out there; it’s just harder to get and it looks different.

Lenders today are much more particular about who they lend to and how they structure the loan. Underwriting is more conservative and isn’t based on predictions of future performance. In the past it would not have been uncommon to see a loan with a 30-year amortization and periods of interest-only. Today it would be rare to find these values. Loan-to-value ratios have decreased from 80 percent to 65 percent as a norm, and debt service coverage is the key today.

Lenders are also bringing back recourse loans, which haven’t been common in the past decade and require borrowers to personally guarantee that they will pay back the loan. This can be a risky proposition, but some borrowers take this chance because they have confidence in the performance of their real estate or have few other alternatives.

Acquisition of commercial properties has slowed significantly, but investment is still occurring in all property types. Multifamily remains a preferred property type for lenders. In the aftermath of the residential sub-prime mortgage crisis, many potential home buyers are renting rather than buying, so vacancy remains low and the multifamily market continues to be fairly stable. As a result of the economic climate, much of the borrowing activity today is in refinancing.

Structured financing, such as mezzanine and bridge loans, has also become more prevalent. For instance, an investor may be seeking a loan of $5 million for a project, but a bank may grant only $4 million. In the meantime, the investor can acquire a $1 million structured loan, typically called the mezzanine piece.

Unfortunately, 2009 looks to be a rough year. The Urban Land Institute’s recently released “Emerging Trends in Real Estate 2009” predicts that the market will bottom out in 2009, which is not good news for areas that have been suffering for quite some time. Since Portland is generally affected by national trends later, it’s hard to predict how the rest of the downturn will unfold. So all parties are cautious and taking their time in making major financial decisions.

But professionals in Portland and the Pacific Northwest are hopeful for the area’s prospects in coming months and years. Though Portland just missed the top 10 in the ULI’s ranking of investment markets in the United States, it scored fairly high. Seattle ranked No. 1.

Portland’s fundamentals remain stronger than those in many cities. People are attracted to the area’s quality of life. Diversified employment and a growing green energy sector are providing new jobs and opportunities, and the area has not seen the vast foreclosures that have plagued other parts of the nation. These qualities make Portland attractive to lenders, so they’re investing in this community even in difficult times.

Coming months will likely bring additional challenges in commercial real estate financing, but lending is happening and the long-term outlook for the Portland market is good.