Lessons in Commercial Real Estate (OPINION)

Following the residential real estate market turmoil, securitization market collapse and deterioration in economic conditions since 2007, the business of financing and developing commercial real estate has changed dramatically.

While the media have regularly chronicled the lack of lending withdrawals by many large financial institutions and small community banks, well-capitalized banks with moderate real estate exposure levels are still active.  

Yes, banks have tightened their underwriting guidelines to compensate for previous overly aggressive practices and to recognize higher levels of risk in our economy, but savvy investors recognize that exercising more caution is a prudent strategy in today’s economic environment. While the commercial real estate industry and U.S. economy are slowly recovering, bankers have learned some lessons in this recession that influence lending and underwriting decisions.

Potential borrowers may benefit from understanding these perspectives:

• Cash is king.

In today’s environment, retail, office or industrial project developers will need to show they have their debt service covered by firm commitments from tenants. With significant weaknesses in the retail and manufacturing industries, lenders are extremely reluctant to finance speculative cash-flow projections. Given the losses many lenders experienced on projects that were more than moderately leveraged, the critical importance of cash equity has been reinforced in the policies of all lenders.

• Land values are extremely volatile.

In the words of Mark Twain, “No real estate is permanently valuable but the grave.” Real estate land development is inherently risky, and few lenders have an appetite for this level of risk today. The extreme volatility of land values was reinforced to bankers during this latest recession, particularly for those who made loans in California, Nevada, Arizona and Florida. For borrowers wanting to finance land, non-real estate cash flow adequate to support the debt will be an essential requirement for those lenders willing to entertain such requests.

• Moderate leverage is a key ingredient.

Bankers expect interest rates to rise and expect cash-flow growth to be difficult to predict. Optimistic cash-flow projections and expectations for durability of today’s low capitalization rates will prove difficult for lenders to accept. Make sure your lender is realistic, too. This is no time to over-leverage your property with short-term debt. Most bankers believe your equity and guarantee will likely be at substantial risk at refinance time.

• The housing market is hard to predict.

While the stage seems to be set for the multifamily housing market to rebound as a result of record low new-housing starts, an improving economy, improving occupancy and rents, there are still notable risks in this property class. Increasing interest rates, shadow market rentals, improved affordability of single-family product and the uncertainty of the primary permanent market funding sources – Fannie Mae and Freddie Mac – combine to curb lenders’ willingness to make aggressive loans in this property category.

• Relationship portfolio lenders have value.

Working with a portfolio lender can prove beneficial for borrowers who need flexibility from their lender in order to deal with changing tenancy, finance rehabilitation or re-tenanting or simply need the ability to take decisive action on a timely basis.

Jeff Dunn is president and CEO of Bank of Arkansas, a division of BOK Financial, located in Fayetteville and Bentonville.