Financing trends: A Q&A on making sense of today's climate

Real Estate Weekly, June 25, 2003

Today's financing market affords abundant opportunities for investors and owners of commercial real estate. But with the vast number of available options, which tools can borrowers best use to leverage their buying power and/or lower debt payments? In the following interview, mortgage broker Sam Kirschenbaum, who heads the Debt Division of Cushman & Wakefield's Metropolitan Area Financial Services Group in East Rutherford, New Jersey, answers questions about current financing trends and considerations at mid-year 2003.

Q: What major variables are contributing to today's attractive financing market?

A: Low interest rates, narrow spreads and excess liquidity in the marketplace have created a "trifecta" for borrowers.

LIBOR (London Interbank Offered Rate)--the primary floating rate vehicle--is currently below 1.50. The 10-year Treasury is below 3.30%. Theseare the lowest rates I have seen in my 20-plus years of experience. At the risk of overstating the obvious,, the current climate enables owners to-significantly lower debt payments through refinancing. For investor the low-rates enable buyers to pay more for new properties.

At the same time, spreads, or the difference between the rate at which money is deposited in financial institutions and the higher rate at which it is lent out, remain narrow. This can. be attributed-to a-lack-of available product and indicates that lenders. are anxious to put more money into the hands of borrowers.

Q. How has this impacted the popularity of: alternative financing structures?

A. In this climate, lenders- are more willing to look at non-traditional financing. For 'example, we have seen a significant increase in the number of mezzanine loans being granted, and we are currently working with several -borrowers - to provide them with this structure. For investors, mezzanine financing provides an excellent tool to leverage buying power. For sellers, this debt structure enables them to ask for and achieve higher pricing.

Essentially, mezzanine- loans finance-the gap between a traditional first mortgage loan (generally 70 to 80%-of a property's value) and up to 90% of the value. A buyer today can-achieve a rate as low as 5% on a first mortgage loan. They can use mezzanine funds--at a rate of about 10%--to borrow an additional 10 to 20% of the capital structure. Assuming the aforementioned rates at 90% loan-to-value, the blended cost of financing is 6% .-

Q. Does it make more- sense to borrow fixed rate or floating rate financing?

A. Choosing between fixed and floating rate financing today presents less of a dilemma than in the past. Securing a fixed rate has always been preferable for long-term investments, while borrowing with a floating rate has generally provided cheaper money on a short-term basis. The advantage of the latter has been marginalized due to the incredibly low fixed rate loans currently available. Today, fixed rate financing is the best way to go, arguably, across the board.

Q. What challenge does the current climate present when it comes to underwriting real estate?

A. Determining "real" property values against low interest rates becomes more challenging as rates continue to drop. When interest rates go down, the real estate capitalization rate also decreases, which results in increased property values. Eventually, rates will rise, but does that mean that property values will fall?

The bottom line is that, right now, the fundamentals of the real estate industry are poor. Yet low interest and cap rates are driving property values up, in some cases falsely. On one hand, if rates begin to creep back up before the economy improves, investors may see property values drop below purchase price.

On the other hand, rising interest rates historically have paralleled economic growth. Thus, when rates increased 'in the past, so did leasing activity. This bolstered property value, creating a natural hedge against the marketplace.

However, since no one can predict with certainty where the economy and rates will be over the next several years, the most prudent way for investors to tackle this dilemma is to avoid getting caught up in the attraction of low interest rates. Rather, the best approach is to examine the fundamentals of a product--its quality, location and leasing history--when determining current and future value.