Despite credit crunch, demand continues in 1999

Real Estate Weekly, Jan 27, 1999 by Orna L. Shulman

Since August, 1998, the commercial real estate market has felt the reverberations of the global credit crunch. Turmoil and lack of liquidity in the fixed-income markets, specifically commercial mortgage-backed securities (CMBS), in addition to tougher underwriting standards, have had a major impact on the financing of real estate.

Although short-term capital constraints have slowed down tenant demand slightly, they have not had a major impact on New York City office demand as a whole. In fact, the fundamental need for office product has not slowed. Even with flat to declining corporate profits, the supply of office products continues to be absorbed, and will do so in 1999. While the credit crunch will severely impact production of new commercial inventory, projects that are in place will continue to do well in 1999, given the supply demand in the market.

This is evident at Times Square Plaza at 1500 Broadway, which has, conservatively, quadrupled in value since we purchased it in 1995, and maintained an 97 percent occupancy rate. By Fall 1999, Disney/ABC will occupy 75,000 square feet of office and studio space on the building's first four floors. (Construction is currently underway on what will be a state-of-the-art studio.)

In addition, significant improvements, to the building by the owners have made Times Square Plaza at 1500 Broadway a sought-after address. Consequently, annual office rental rate growth has been over 30 percent these past two years.

The primary difference going forward in 1999 from 1998 in the office market will be the difficulty in underwriting new development projects. In the mid-1990's, financing for the vast majority of new projects came from sources other than traditional bank loans. The boom created the expansion of the REIT market, and Wall Street was a dominant factor in backing new development and acquisition all over the country.

However, the pullback in share price of the REIT market, combined with worldwide de-leveraging and the implosion in the debt market, have increased risk aversion from lenders and investors alike. In the future, it will be significantly more difficult to obtain financing for projects, if at all, by means other than securing definitive pre-lease requirements coupled with a significant equity investment.

In September, Intertech closed a $76 million loan for the construction of two speculative office buildings comprising 510,000 square feet in Reston, VA. Northwestern Mutual Life provided both construction and permanent financing to build these first two of four office towers for Plaza America, a mixed-use retail and office complex that will comprise over 1.1 million square feet of space on a 25-acre site in Washington, DC's Dulles high-tech corridor.

Tenant demand remains high in this market, particularly in Fairfax County, home to more than 80 percent of the inventory currently under construction in Northern, VA, where vacancy rates remain in the low single digits. Two examples of this type of tenant demand can be found at Plaza America, where two credit-worthy tenants have already secured most of the 510,000 square feet under construction. Cable and Wireless USA and its Internet business, recently acquired from MCI, will occupy Tower One. DynCorp, a leading, Reston-based international information technology and services firm, will house its new headquarters facility in most of Tower Two.

On the whole, lenders are demonstrating a clear flight to quality, a greater concern for sponsorship and less tolerance for risk in underwriting. In most cases, acquisition and construction loan-to-value ratios have decreased, requiring additional equity, while many permanent lenders have adopted interest-rate floors.

Borrowers who have been abandoned by CMBS lenders are flooding many life companies with loan submissions. The handful of permanent lenders that remain in the market are quoting a minimum of 8 percent interest rates, while the majority may never return to securitized lending again. The market for mezzanine and high-leverage bridge debt is virtually non-existent. Construction lenders, while still in the market, are re-evaluating opportunities and exit strategies because of the slowdown in the permanent loan market.

We will not see any real liquidity in the CMBS market until later this year, when the estimated $30 billion of loans in line for securitization clear the process. Only then will the CMBS market be a viable and reliable option for borrowers.

While spreads have narrowed for credit paper, CMBS debt has not yet reached the stature of corporate bonds. Lacking credibility in the eyes of investors, who still believe real estate operates in a boom/bust cycle, CMBS are considered riskier than corporate bonds, worthy of a higher return than corporate debt.

Life companies that have taken their cues from the CMBS market will be the preferred source of capital in the foreseeable future. These lenders will exercise extreme caution in allocating budgets for new loan production based on the strength of the real estate markets, the state of the U.S. economy and the stability of global financial markets.