Modification In The Lending Market
Retail lenders are tightening borrowing requirements in response to the struggling real estate market.
Lara Fuller

The state of the residential real estate market is influencing many aspects of the economy, including the commercial real estate market. With many borrowers defaulting on their loans and mortgage companies declaring bankruptcy, the struggling housing market affects more than just single-family housing. Lenders in the commercial real estate arena have had to alter the way they handle loans and the underwriting process. Shopping Center Business recently spoke with a few of the leading commercial lenders to get their take on the current lending climate.

Though the commercial lending market is not seeing the same number of defaults and delinquencies as the subprime market is at the moment, there has still been a notable change in the way loans are handled.

“Subprime defaults have disrupted the flow of capital from investors who also invested in subprime paper or subprime lenders,” says Dan Smith, managing director with RBC Capital Markets. “These capital sources generally bought at the lower end of the credit spectrum, which has resulted in increased spreads and more conservative underwriting. I have concerns about the overall effect of the subprime situation on the United States and global economy of the credit crunch caused by these defaults. In addition, the liquidity of the U.S. consumer has been adversely affected by these disturbing trends in single-family housing.”

Scott Lynn, director/principal with Dallas-based Metropolitan Capital Advisors, has also seen the problems of the subprime market trickle over to the commercial real estate market. “In a nutshell, the problems in the subprime market resulted in the agencies who rate the quality and risk of commercial mortgages to change ‘the rules of underwriting’ almost overnight,” he says. “Investors and buyers of long term mortgage paper debt lost confidence. A substantial amount of unsold paper that was underwritten using aggressive old-style rules had to be heavily discounted, further exasperating the situation. Interest rate spreads widened and the cost of real estate capital became more expensive. Said differently, the price of risk has increased. Over-aggressive underwriting has gone away, for now. However, some short term correction in the capital markets was inevitable, but I would argue it will create long term health for property markets.”

Because of the issues facing the industry, there have been changes in the way loans are handled. Borrowers are now required to meet standards that are more stringent than those in the past.

“Borrowers should bring to the table the realization that lenders on a go-forward basis will require tighter underwriting standards, lower loan-to-values and slightly increased pricing,” says Lynn.

“Borrowers must bring cash equity to the table today,” says Smith. “They also need to manage their expectations about the current lending climate. Capital is readily available from both capital markets and institutional capital sources, although at more conservative levels than months ago. Still, borrowers should realize that the deal must be supported by cash flow and that rent trends are important.”

For most lenders, having a well-planned project in a strong market is high on the list of requirements.

“Borrowers in today’s market need to bring strong fundamentals, and carefully selected projects and locations,” says Charles Krawitz, managing director, Key Commercial Mortgage Direct, of Cleveland-based KeyBank Real Estate Capital. “As we always have, lenders prefer retail projects with high-quality anchor tenants or strong shadow anchor tenants, preferably located in markets that continue to offer strong job growth.”

Though the commercial real estate market has been affected by the struggles of the overall real estate market, the retail sector is one area that has not been as hard hit as some other areas. Retail is still going strong in most cities, and lenders are continuing to handle loans for retail, though with slightly different requirements than before.

“The lending environment for retail projects remains very strong and competitive despite the current turmoil in the capital markets,” says Krawitz. “In today’s environment, lenders are expecting solid pre-leasing and less reliance on letters of interest. According to retail developers, big box retailers are continuing to move into or expand throughout the country, but particularly in the demographically strong markets in Texas and Florida. While it may be more challenging to secure a conduit loan due to the markets right now, there are many other types of finance that can get a project out of the ground.  Full-service lenders will continue to provide multiple viable financing options.”

“RBC Capital Markets continues to lend on retail properties,” says Smith. “We think the sector is strong, but we’re underwriting based upon existing cash flow, requiring reserves for rollover and TI/LC, as well as focusing hard on tenant’s sales histories of tenants and their overall credit quality.”

Adds Lynn, “Retail continues to be one of the ‘darlings’ of the lending and financing intermediary industries. Underwriting long term retail leases, as well as understanding tenants’ sales, offer the best opportunity to maximize leverage and minimize cost of capital. We find there is an abundance of construction debt, permanent lenders and equity capital available for retail development and long term financing. The biggest challenge is that credit tenants, national users and junior anchors all know they hold the cards when it comes to developers competing for leases and as a result, competitive rents have pushed down yields on shopping centers to a point where it is very difficult to gain high leverage and positive leverage when it comes to financing a shopping center.”

Retail will continue to remain a strong sector, even if the housing market continues to struggle. “Households are still being created even though there may be less reliance on single-family home developments due to the slow down,” says Krawitz. “But, rental housing is still strong and these households also require retail nearby, particularly the grocery-anchored shopping centers and big box retail developments.”

While all of the changes in the retail lending market, and the overall lending market, are challenging for both lenders and borrowers at the moment, the adjustments should only serve to strengthen the industry. The tighter lending requirements being implemented by lenders should help safeguard the industry from some of the problems facing the subprime market and will also help the market recover.

“The short term pain that is now being infused into the capital markets through more disciplined underwriting should help to create long-term health for property markets,” says Lynn.