May 2003

Commercial Mortgages & Real Estate Loan News:
Through The Looking Glass

With the Iraq conflict in the clean-up phases, it is still challenging to forecast what lies ahead for the world economy and commercial real estate loan financing. In this issue of "From The Street," I'd like to provide an overview of some of the trends we saw in 2002 coupled with how they will ultimately effect commercial real estate investments into the foreseeable future. Although some reports indicate generally sound fundamentals in the commercial investment arena, we've noted some alarming trends that are driven by increased demand for commercial investments in a low rate environment.

For the last few years, interest rates have reached historical lows and there has been an abundance of capital available for commercial real estate mortgage financing. This seemingly bodes well for all commercial investors, but there's a double edged sword that lies in waiting for those investors compromising acquisition fundamentals in order to put their money to work - especially given available investment alternatives in other traditional sectors. With a glut of investment dollars chasing a limited number of transactions in the marketplace, the competition is fierce.

For those investors who have owned commercial assets for several years and are merely reducing their cost of capital through refinancing, the current rate environment equates to a windfall of additional cash flow. This is obviously beneficial as it improves an operator's staying power as we collectively weather uncertain times. For those looking to acquire new investments however, the competition for well located assets is driving "cap rates" down to levels where the returns are extremely thin. This may work in today's commercial rate environment, but as mortgage interest rates begin to rise and the loans become due these assets are in jeopardy of falling into a "negative yield" scenario.

Take the apartment financing sector for example, in terms of commercial real estate financing apartments are the most favored asset type for conventional mortgage lenders. It's not uncommon to see well-located and well-maintained apartment projects trade on aggressive/low cap rates.

Here in the Bay Area, we've seen a number of projects trade on 7%, 6% or lower cap rates in an interest rate environment of 5.5%. What happens when that loan is due in 3, 5, 7, or 10 years, and the interest rates are back to a level of 7%, 8%, or 9%? The Net Operating Income would need to substantially increase beyond a modest inflationary level just to break-even or show a modest cash-on-cash return. In a softening commercial mortgage market, is it reasonable to expect consistently strong returns?

As reported by CCIM's 2002 ITQ National Overview, "Investment real estate has emerged as something of a safe harbor in this uncertain environment. This has been true even though buyers are well aware of the industry's own cyclical risks. Vacancies have been rising across commercial property markets nationwide. Rents have either stalled or, in more numerous instances, actually fallen.

Nevertheless, investors looking across the array of choices in domestic and international stock and bond markets have found a lot to like in U.S. real estate. There is unquestionably a "disconnect" in the investment and occupancy trends. But it would be a mistake to characterize the investors as naïve optimists or speculators chasing yet another bubble. Rather, what we see is an example of the need to put money to work, and to do so even when the range of choices is sub-optimal." In all likelihood, quite a few of these investments will fall short as the existing debt unwinds and higher rates prevail.

Ken Rosen, a real estate industry expert, recently addressed some of these factors and made the following commercial market forecasts:

• Interest rates will rise 200 - 300 basis points over the next 18 - 24 months.
  
  
• Rental growth rate assumptions should be viewed very conservatively.
  
  
• Any recent economic growth has been driven by consumer spending fed by cash from home refinancing - growth is now very fragile.
  
  
• Confidence for consumer and corporate spending will not return until geopolitical clarity returns.
  
  
• There is a 70% chance we will dip into a full blown recession in 2003 with 1% growth.
  
  
• The U.S. dollar will weaken and lead to inflation and thus drive up loan rates.
  
  
• Opportunistic investors may finally begin to see non-performing commercial assets coming on line as existing owners find themselves under water.

All things considered - this last forecast is exactly what we're suggesting investors avoid to the best of their ability. Maintain investment discipline with prudent loan underwriting assumptions, especially in the area of future interest rates and rent growth. Steelhead Capital has a sound reputation based on advising its clients not only on what is occurring in the current commercial capital markets, but also looking at a project's ability to meet and enter subsequent capital markets.

Read the next commercial mortgages & loan newsletter "From the Street"

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With an extensive lender and commercial mortgages network, Steelhead Capital has built its reputation on structuring commercial mortgages and commercial real estate loans requiring both debt and equity placement. Fluctuations in the capital commercial mortgages present significant challenges for investors and we are pleased to provide financing, as well as, guide and advise its clients through the process of obtaining commercial mortgages. Whether you are looking for apartment financing, commercial financing, commercial mortgages, or creative "out of the box" real estate loan alternatives, we can help.

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