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Commercial lending trends that will affect your business

By Chris Clepper, Nusenda Credit Union | Dec. 7, 2018

What are some commercial real estate trends that you've seen recently and how are they impacting lending?

Like all other industries today, commercial real estate is experiencing disruption and faced with uncertainty. There are too many trends to cover here, but a great example is retail.

When attending industry events, you often hear people lamenting about the ‘Amazon effect’, and like any other city, we have seen big box closures. Not everyone realizes that national retailer bankruptcies in 2017 and 2018 were comparable to the levels seen during the Great Recession, but this time it is due to changing consumer habits.

On the other hand, service retailers have expanded at a good pace. National quick service restaurants, gyms, dental franchises, and other medical users moving into retail locations have driven a good amount of our construction lending in recent years. Some local restaurants are benefitting from this and are aggregating in newer concepts that serve as neighborhood gathering places with a heavy focus on local businesses. Looking to the horizon, we have to wonder if new technologies like Uber Eats or telehealth will have sustained disruptive impacts on these service sector tenants.

Bottom line, you cannot simply accept a long-term lease to a national tenant at face value. Lenders are looking more closely at the financial performance of the tenant and the feasibility of their fundamentals, particularly in situations where basis in the property are relatively high due to land prices or significant tenant build-outs amortized through the lease. We are also taking a harder look at the downside risk and performing more exit analyses. The overall experience of developers and the diversity of their other cash flow sources are also key considerations in underwriting.

The good news is that access to finance is improving as more financial institutions are actively lending in Albuquerque again. Insurance companies and conduit lenders are also prominent funding sources for commercial real estate. There are aggressive government sponsored lending programs in the multi-family and assisted living sectors. However, the continued mergers and acquisitions in the financial industry are leaving fewer and fewer locally headquartered lenders in New Mexico, and the Great Recession showed that without healthy local lenders, access to business lending in mid-sized cities can be challenging during downturns.

Generally, we are seeing growth and a positive outlook for almost all industries and asset types in our portfolio stemming from the overall improvements in the local economy. Locally, retail and apartments are a little longer into their recoveries.  While these are still performing well fundamentally, asset prices have grown considerably, making the investments more difficult to underwrite. There is simply less cushion against future vacancy and sustaining relatively high rental rates, particularly for retail. These continue to attract out-of-state investors who often view them as safer investments with comparatively higher yields to their home markets. Our loan originations for retail properties are half of what they were in 2017, even though the demand is stable.

Our lending activity overall is comparable to last year as growth in other areas has compensated for this shift. Financing real estate purchases for business owners has driven a larger share of our lending activities in 2018. This segment of our portfolio represents a wide range of local businesses from medical groups to food manufacturers to local breweries, most of which have been expanding their businesses over the last several years. Many of these companies are seeing annual revenue growth in excess of 20 percent. This is a good sign for the local economy, and companies like these are having an impact on the recent job growth numbers.

What is the biggest challenge facing local businesses looking to attain commercial real estate financing?

In some sectors, pricing and inventory are the biggest challenges. It is a seller’s market for well-located, quality commercial properties. That creates a challenge for both local investors and business owners who are often bidding against the out-of-market investors. It is not necessarily bad; it creates more financial incentive to evaluate redevelopment opportunities, but these present their own unique risks.

Both redevelopment and construction are facing rising costs. The increasing activity in construction is causing higher demand for skilled trade labor, and material prices are seeing similar impacts. So far, these have not risen to a level to make construction unfeasible, but lenders are requiring adequate contingencies in project budgets.

How have interest rates affected business lending in New Mexico over the past year?

Directly, we have not experienced an impact on the overall demand for business loans. It is up this year, and that is largely attributable to general improvements in economic conditions in Albuquerque and Santa Fe. Jobs numbers reflect impressive growth in 2018 compared to prior years, unemployment rates are declining in both markets, and gross receipts continue to show similar improvements.

The indirect impact, however, is that the rising rate environment comes at a time that the local economy is just entering a stronger recovery. In a 5.25 percent interest rate environment (today’s Prime Rate), the cash cost of borrowing for a typical commercial mortgage exceeds the capitalization rate – the unlevered rate of return – in many instances. This means an investor is actually reducing their cash-on-cash return by borrowing. We are seeing many properties trade in the mid-6 percent range. While this oversimplifies the investment decision, the recent rate movement will result in downward pressure on the value of these commercial properties.

Historically, rates are still comparatively low. The current treasury rates are comparable to rates in the early 2000s, but we are coming off a seven-year stretch with no rate increases by the Feds. This has had an inflationary impact on commercial real estate. Nationally, Green Street Advisors reports commercial real estate is more than 30 percent higher than its pre-recession peak. Fortunately, in the local market, capitalization rates in sectors like office, industrial, and hospitality — and the yield over cost for build-to-suit construction — are largely above 8 percent, which compares favorably to today’s financing costs.

We advise business owners and investors alike to be cautiously optimistic today. The local economic conditions are improving. Business owners need to stick to fundamentals in their business and industry, but constantly evaluate these against current trends and disruptors in an effort to help plan for tomorrow. We strongly advocate maintaining healthy ratio of cash flow to debt, and maintaining cash reserves to manage uncertainty. Often times the best opportunities are found on the downside of an economic cycle.

Regarding rates, many borrowers gravitate to the longest fixed rate available in a period of rising rates. While there are no clear signs that the Fed will slow the rate increases in the near term, the flattening of the yield curve (the compressing variance between short-term and long-term rates) may suggest that the market currently does not expect the increases to continue over the longer term. I would advise a potential borrower to look at rate options that match their plans for an investment, and consider the total cost of borrowing – particularly prepayment penalties when opting for long-term rates. The cost of yield maintenance, defeasance, and interest rate swaps can be substantial, particularly in a declining rate environment. These costs will need to be dealt with if you sell your property or refinance early to access equity to deal with capital or tenanting costs.

Talk to your lender early when planning for an expansion or new investment. Your lender should take the time to evaluate your businesses performance and expansion goals, and give you preliminary feedback and ideas for structuring a loan. Our job is to identify and evaluate risk. We run sensitivity models internally to gauge things like refinance risk and leasing rollover, and these are things we can share with our potential clients. Managing these downside risks becomes increasingly important as the local economy gains momentum and attracts more competition.  In the end, promoting a business owner’s sustainable success is in your lender’s best interest as well.

Cole Flanagan, NAI Maestas & Ward Partner and Investment Specialist: "With the combination of the local economy showing strong improvement, continued development of fundamentals, and readily available financing, the commercial real estate investment market remains strong"

Jake Mechenbier, NAI Maestas & Ward Director Senior Advisor and Investment Specialist: "New Mexico continues to attract capital as many investors seek higher yields not found in primary and secondary markets."

 

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