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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2018

Rising Interest Rates Signal a New Investment Climate

Be flexible and identify the right lending partners for your deals

Historically low interest rates over the past decade have set the stage for many commercial real estate developers to easily obtain conventional financing in order to build, acquire, renovate or reposition a wide variety of properties.

This access to capital has enabled them to quickly act on new opportunities in the marketplace while realizing healthy investment returns. Gradually increasing interest rates, combined with a bullish stock market and fewer real estate prospects in some major metro markets, however, will likely put pricing pressure on commercial and industrial properties going forward. c_2018-09_Herrick_spot

Still, astute investors and commercial mortgage brokers working in these areas should be able to find attractive deals.

Pressure on profits

Against the backdrop of a relatively strong economy that has helped drive unemployment to record-low levels, the Federal Reserve has been gradually increasing interest rates, including another nudge this past June. Traditionally, well-placed commercial real estate has been a haven for investors seeking solid returns.

History also indicates, however, that in a rising interest rate environment, the increased availability of other types of investments with good returns may put pressure on real estate valuations. In today’s environment, this trend is being exacerbated by a relatively sharp rise in bond yields, which is being spurred by investor concerns over the durability of the stock market.

Additionally, there is tremendous new-construction build-out in certain metro areas. In the New York City/Northern New Jersey market, for example, the ongoing Hudson Yards project — a multiuse development encompassing more than 18 million square feet of commercial and residential space — has contributed to yield pressure by placing a staggering amount of additional product on the market, even as these kinds of projects limit the ability of other builders and investors to find “clean” or undeveloped land.

  A lender should be willing to gain a deep understanding of specific investment situations. 

Markets like New York City/Northern New Jersey should remain robust through 2018 and 2019. New Jersey’s distribution capacity, its dense population, and its proximity to seaports and airports will likely eclipse concerns about its aging infrastructure and the specter of rising state taxes.

The region’s retail component will continue to offer significant opportunities on a case-by-case basis, especially in the wake of the U.S. Supreme Court’s recent decision that allows states to require online retailers to collect sales tax. This should help level the playing field for brick-and-mortar retailers.

Across property sectors and geographic locations, deal participants should continue to look at investment fundamentals. Despite challenges, investors, mortgage brokers and lenders who balance imagination, caution and commitment can discover profitable opportunities.

Weighing the risks

Imagination refers to the ability to see beyond the obvious and to have the vision to consider new possibilities. This may include identifying investment opportunities using a limited inventory of undeveloped land, as well as rehabilitating or refreshing existing properties. The latter approach is being more widely embraced as the inventory of open land continues to shrink.

Caution, of course, refers to the ability to engage in due diligence by thoroughly examining potential opportunities and carefully weighing the risks and rewards. Commitment also is a key component of the mix.

A commercial mortgage broker, investor or builder may have the right mix of imagination and caution to make a project happen. Still, they also need to identify a committed lender that is able to understand their vision and tap into a base of capital that can enable that vision to be realized.

The ongoing consolidation of traditional lending institutions, however, has limited the number and availability of conventional capital sources. Simultaneously, larger institutions have increasingly focused their attention on larger loan opportunities, reducing the number of options for small-balance investors and mortgage brokers. These conditions have increased the need for specialized lenders with experience in nonconventional debt products — including high-yield bridge loans, mezzanine financing and preferred-equity structures.

Lender attributes

With this in mind, investors and mortgage brokers who are looking for the right funding sources may want to pay particular attention to a number of lender attributes. First, look for a lender that adheres to a disciplined risk-management process that is balanced by a willingness to continually adapt due-diligence processes and post-closing requirements in order to meet evolving market conditions.

Next, identify a lender that offers its clients speed and certainty of execution, particularly when working on complex value-add transactions. This innovative approach will enable borrowers to take advantage of opportunities before they are lost to competitors in a fast-moving commercial real estate market.

Finally, find a lender that has committed, long-term relationships with a variety deal sources as well as a track record of successful loan originations. A lender should be willing to gain a deep understanding of specific investment situations, and they should be able to think of and follow through with creative and unique solutions. In order to do this, they should demonstrate local-market expertise and have deep relationships with other lenders and industry partners.

A prime example

To illustrate this approach, consider a lender’s purchase of two delinquent mortgage notes secured by a portfolio of net-leased industrial and retail assets. These properties were primarily associated with master-lessee ownership structures, so the lender simultaneously executed a deed-in-lieu-of-foreclosure agreement with the owner of the underlying leaseholds. This occurred less than two months after the lender was advised of the properties’ availability.

The collateral for the notes consisted of a 127,000-square-foot warehouse and industrial facility, as well as eight high-credit, triple net-leased retail properties totaling about 85,000 square feet. The retail assets were strategically located, with five properties occupying prime sites on hard corners (the intersections of two roads) and the other three in highly visible spots on busy thoroughfares.

After acquiring the notes, the lender negotiated a long-term lease extension with the industrial-building tenant, which allowed its master-lessee position to later be sold for an attractive return on investment. Five of the retail assets were sold after being held for a year, making them eligible for favorable long-term capital gains tax treatments.

•  •  • 

Commercial mortgage brokers and lenders with deep industry knowledge and experience, along with creative and forward thinking, can help minimize risk with these market-sensitive transactions and obtain access to deals in better-quality locations.

Investors should adjust to the pressure on yields, compensating through ownership of a hard asset that delivers the possibility of appreciation and a greater stream of net operating income. Despite the yield pressure and other challenges, the next two years should include a robust period of commercial-property transactions with appropriate risk-adjusted potential. 


 


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