Borrowers seek alternative financing as conventional lending market tightens - Banking & Finance

Real Estate Weekly, Jan 14, 2004 by Richard Ortiz, Spencer Garfield

Historically low interest rates in recent years have enabled borrowers to obtain aggressive conventional financing and to both acquire and carry properties with relative ease.

However, in 2004, it is likely that interest rates will rise and a number of other factors will occur that will impact the availability of conventional financing for the real estate industry.

Due to the strengthening economy, we expect to see an increase in interest rates during the next 12 to 18 months.

This rising interest rate environment will be combined with relatively stagnant commercial property values and the ongoing consolidation of traditional lending institutions. These factors will result in more stringent underwriting criteria and fewer options for capital from conventional lenders thus enhancing the need for non-conventional debt products.

For example, in recent years there has been a plethora of conventional lenders issuing short term, interest only floating rate debt. In many cases this debt is coming due and the more stringent underwriting criteria of conventional lenders is restricting the proceeds of the permanent financing thus forcing borrowers to bridge the gap with mezzanine financing.

In other cases, this short term interest-only debt was issued in anticipation of borrowers repositioning their assets.

Given the increased vacancy rates and lower rents experienced by most asset types nationally, many borrowers are unable to effectuate their repositioning in the timeframe originally anticipated by their lender.

As a result, there will be an increased need for nontraditional financing in the form of high-yield bridge loans providing the borrower with more time and flexibility to complete the repositioning of his asset.

Finally, there will be increased demand for both mezzanine financing and bridge loans for borrowers seeking to acquire out-of-favor assets such as hotels, vacant or partially vacant office space or unanchored retail properties.

While the overall economy is beginning to strengthen, and we are seeing some improvement on Wall Street, the real estate market traditionally lags anywhere from 18 months to two years behind the stock market.

This means we will continue to see an increase in the number of real estate workouts in 2004, particularly in certain regions, that have experienced overbuilding during the last real estate cycle.

While New York City, Los Angeles, Washington, DC and other core markets have experienced modest corrections and are now showing signs of improvement, cities such as Atlanta, Dallas and Phoenix are predicted to continue with soft market conditions.

In these regions in particular, conventional lenders will be less active, resulting in the switch among savvy real estate borrowers to seek out non-traditional capital sources for acquisitions, repositionings, purchases of distressed debt, etc.

Mergers and acquisitions among banks and other lending institutions is a trend that is well underway, and one that will further limit traditional financing opportunities. As a consequence of such mergers, borrowers will find fewer conventional lenders from which to choose.

In addition, the increasingly larger institutions are likely to focus their attention on larger loan opportunities. This will reduce the number of options for smaller borrowers seeking financing of less than $15 million.

All of these factors will create increased demand in the coming year for non- conventional real estate financing products. These products include high-yield bridge loans, mezzanine financing and preferred equity structures.

Further, borrowers will seek out lenders that have the ability to offer highly structured finance products, and offer speed and surety of execution that is unavailable from conventional lenders.

RICHARD ORTIZ & SPENCER GARFIELD MANAGING DIRECTORS, HUDSON REALTY CAPITAL (HRC)