Michael Salzman
Vice president, loan production, Essex Financial Group, Denver
The commercial real estate lending market has remained strong for the duration of 2016, however, this past year also presented unexpected (but not insurmountable) challenges. As the new year quickly approaches and retail owners begin developing their game plan for 2017, it’s helpful to understand how dynamic the lending market was this past year and how some life companies’ criteria for assessing retail properties evolved accordingly.
At the beginning of 2016, most industry experts expected both supply and demand for real estate loans would be vigorous. However, a tumultuous bond market caught commercial mortgage-backed security lenders by surprise with implications reaching beyond the securitized market. In December 2015, a lack of buyers in the bond market forced CMBS lenders to widen their pricing significantly in order to bring salable fixed-income offerings to a bond market that was demanding yield. This caused an overall increase in CMBS interest rates of approximately 0.75 to 1 percent, an increase that lasted almost the entire first half of the year – CMBS credit spreads didn’t start settling down until May.
Since the CMBS market suddenly became a more expensive capital source, many borrowers responded by avoiding the CMBS market altogether and sought capital from balance-sheet lenders like life companies instead. In fact, CMBS issuance in the first half of this year dropped by over 40 percent. (According to Commercial Mortgage Alert, total U.S. CMBS issuance in the first half of 2016 was $30.7 billion compared with $54.49 billion in the first half of the prior year.)
Ultimately, the CMBS market’s loss was the life company market’s gain as the weak CMBS market fueled life company deal flow. Life companies already had been expecting a busy year due to the overall strength of the real estate industry, but while CMBS interest rates were high, chief investment officers at life companies seized the opportunity to invest loan dollars at relatively attractive yields. The life company market posted an incredibly successful first half and despite record-size allocations of dollars for commercial real estate lending, some life companies literally ran out of money to lend by midyear. This enabled the remaining life companies in the market to become more selective, because as the year progressed, there was less competition for each transaction. As a result, life companies seemed to grow increasingly selective across all property types, however, here are some specific topics that arose most often in discussions about retail properties.
Grocery anchors. It’s been no secret that many, but not all, life companies have preferred grocery anchored retail properties for a long time. However, in 2016, life companies placed even more emphasis on assessing the creditworthiness of each grocer and the likelihood that each location will remain open for business.
They primarily focused on three criteria. First, life companies look for store-specific gross sales figures to exceed at least $400 per square foot. Furthermore, a grocer’s occupancy cost – also known as a health ratio, expressed as a ratio of total rent and reimbursements over gross sales – should be less than 3 percent. Second, in an effort to reduce rollover risk, life companies strongly prefer to lend on grocery-anchored centers where the grocer’s remaining lease term extends beyond the maturity of the proposed loan. The third criteria also is the most stringent and doesn’t apply to all lenders, however, as loan dollars became scarcer over the course of this year, some life companies decided only to lend on grocery-anchored centers with publicly traded, investment grade credit grocers. This was not a widespread requirement in the life company market; however, it’s an example of how some life companies enjoyed strong deal flow in the first half of the year, affording them the luxury of being picky in the latter half of the year.
The impact of this criteria is significant, as many grocers commonly considered to be good operators are not necessarily rated investment grade and, in some cases, stellar sales and superior location were trumped by below-investment-grade credit.
In-line shop space. There were no hugely significant changes this year in the criteria life companies used to assess in-line shop space at retail centers. Much like last year, lenders are most interested in financing properties with experiential, service-based tenant lineups, meaning tenants whose sales are less vulnerable to competition from internet commerce. Examples of attractive tenants include restaurants, coffee shops, hair and nail salons, and health clubs. One point worth noting, however, is that as life companies grew more selective as the year progressed, they became increasingly sensitive to co-tenancy clauses, as they fear an anchor tenant’s departure can cause a domino effect within an otherwise healthy retail center.
Focus Shifts to 2017
Despite this year’s challenges in the capital markets, the commercial lending environment remained robust and there was more good news in the market than bad. There’s no doubt that as mortgage bankers, our roles became more challenging in the second half of the year as life companies became more selective. Even though I haven’t sugarcoated this reality, this year, we will still place more life company volume than ever before and most of our correspondent life companies will post record-setting loan origination figures. This has been a banner year and property owners shouldn’t be discouraged, but they should also be mindful that the first half of the year is generally the best time to present loan requests to lenders.
Since we’ve entered the fourth quarter, life companies have shifted their focus to 2017, and they’re eager to fill fresh allocations for commercial real estate loans. Their allocations next year will be the same, if not greater, and they will continue to offer the best interest rates. Since the CMBS market has come back strong, life companies have more competition for the time being, but there’s still uncertainty in the securitized market as DoddFrank regulations pertaining to risk retention and greater due diligence become effective this Christmas Eve.
While our outlook remains positive, based on our experience in 2016, we’re encouraging investors with 2017 financing needs to seek loans during the first half of the year while competition among life companies will be fierce. Additionally, we’re encouraging borrowers to explore forward commitments. In many cases, in an effort to win opportunities early, life companies already are considering 2017 loan requests, offering forward commitments up to 12 months early, which allow borrowers to lock rates now for future funding.
