"...each individual strives to become wealthy intending only his own gain but to this end he must exchange what he owns or produces with others who sufficiently value what he has to offer; in this way, by division of labor and a free market, public interest is advanced."

- Adam Smith, Wealth of Nations

I like to think Adam Smith's words are as relevant today as they were when they were originally put to paper in 1776. Since our last newsletter, we've seen a continued deluge of cheap capital enter the market.

The abundance of seemingly ready cash would cause one to think that securing financing has never been easier. Ironically, the opposite seems to be the case. With every passing month, lender-underwriting practices are growing tighter and more restrictive. While one wouldn't know it looking at the cap rate trends, Smith's view of efficient markets looks to be kicking-in, as investor enthusiasm has increasingly run counter to more selective lender requirements.

Although especially frustrating for borrowers and those that represent them, a Smithian view of the markets would suggest that this developing push-and-pull is a positive step towards re-establishing equilibrium. In this addition of "From the Streets", we'll briefly look at where investment activity took place in 2003 as well as discuss some of the areas where lender scrutiny could be a leading indicator of a reversal in escalating values.

Difficult as it is to track commercial real estate financing and sales activity on a national level, Real Capital Analytics ("RCA"), led by Bob White, does an exceptional job of compiling national sales statistics for transactions above $5m. Bob was kind enough to share their recent December 2003 year-end report, and the following are snap-shots of those reports by sector: *(Jan - Nov for both years)

Although it shouldn't be news to anyone, almost across the board, despite softening rental rates and rising vacancy in most categories, cap rates continued to compress. One common explanation has been that many investors view real estate/bricks & mortar as a superior investment strategy relative to the Wall Street dotcom paper chase espoused only 3 years ago. However, as equity markets found their legs again in 2003, real estate buyers seemed oblivious to it leaving one to wonder what will turn the cap rate trends around. Besides the obvious influence of any upward pressure on interest rates, the far less apparent but still significant counter-force gaining momentum is that of lender scrutiny.

In our experience, lenders are becoming increasingly focused on market conditions regardless of individual property performance. Of course, this is not an entirely new phenomenon. Many conduits and life companies loaning on investment properties have usually taken the higher of "actual", "market" or 5% as a vacancy calculation. What we are seeing more times than not is that stronger performing assets are being penalized for weak market conditions. A commercial property that has an actual vacancy of 7% is being underwritten at the much higher vacancy rates found in the overall submarket. This can have a dramatic effect on the lender's underwritten net operating income if the local market vacancy is say 12%, 15% or higher.

Unlike underwriting for vacancy, assumptions for cap rates have enjoyed more flexibility among conduit and life company lenders. Buyers purchasing properties at low cap rates that are depending on up-ticks in rent to justify their acquisitions are no longer finding lenders who share their gusto. Where in the past the majority of lenders have played along, underwriting cap rates at increasingly lower levels and showing rents increasing at healthy rates year-over-year, it now appears many have recently reached the limits of their tolerance. As cap rates continue to feel downward pressure, lenders have begun to shy away from underwriting and qualifying deals at the cap rate level where the asset is actually trading hands. This directly affects the value attributed to the property and due to loan-to-value constraints, can negatively impact loan proceeds.

The upshot of all of this is that actual proceeds and borrower expectations are moving farther apart. At Steelhead, we've increasingly found ourselves directing strong operators with a requirement for maximum proceeds towards local banks. In our experience, local lenders tend to blend borrower strength with actual property performance to gain loan committee support. As a result, we're seeing local recourse lenders reclaiming some of the market share that was previously lost to non-recourse counterparts (conduits and life companies).

And so we return to Mr. Smith and the issue of greed for the greater good. The one certainty is that commercial real estate markets are bound to experience change. With loan proceeds trending down and the risk of personal guarantees and additional equity requirements trending up, it follows that property values might eventually begin to fall in line. Even if the Fed doesn't choose to pound investors with a sharp up-tick in rates, the capital markets could be a stabilizing force for change. That's not to suggest that any of us in the business of maximizing leverage will meet their newfound sobriety with enthusiasm. Although those experienced buyers confronting a market where there are a 100 basis points separating the cap rate that gets their offer accepted and the interest rate that they'll likely have to pay their lender, might welcome the reprieve.

Peter Slaugh

Editor of the "From the Street" newsletter, Chief Executive Officer Peter Slaugh founded Steelhead Capital in 1999. In the relatively short period since its inception, Slaugh has built Steelhead into a leading resource for debt and equity placement nationwide. Slaugh is primarily engaged in growing the company and its lender relationships, as well as working on financings. Email Peter

At Steelhead Capital our mission is to enable the long-term success of small and midsize CRE investors. Our actions are guided by the notion that all disciplined investors deserve equal access to reliable institutional financing products supported by effective transaction management and consistent client communication.

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