After an increasingly difficult development market in 2008, commercial real estate developers across the U.S. have few illusions about their chances for a lively 2009. The strongest firms, however, hope to maintain a stable portfolio of existing properties and continue to push their existing long-term projects toward the finish line – albeit with possible shifts in timelines or tenancy, given the realities of the national economy and the credit markets.
‘We had a number of projects in the pipeline when the credit markets went sideways,’ reports Bob Habeeb, president and chief operating officer of First Hospitality. ‘Our position for 2009 is that we have hit the pause button.’
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Instead, the firm will focus on seeing two existing hotel projects to completion. A 250-key Hilton Garden Inn in downtown Minneapolis was on track for a February opening, and a 300-room Chicago hotel known as theWit, a Doubletree Hotel, is still slated for a May opening. According to Habeeb, both endeavors have been ‘relatively uneventful’ – a victory in today's market.
Other projects, especially those with exposure to the severely suffering retail sector, have encountered delays or complications.
Jeff Thompson, president of Robert B. Aikens & Associates, says that the company's Pinnacle Nord du Lac lifestyle center, located in Covington, La., is now tentatively scheduled to open in March 2010, rather than October 2009, as originally planned. Project partner Colonial Properties Trust opted to shift the timetable in response to the state of the nation's general economy.
Simple survival – and minimizing expenditures on any future development – will be the company's and the industry's goals for 2009, Thompson notes. Despite Aikens' concentration of operating properties in acutely downturn-plagued southeast Michigan, its portfolio has fared notably well – so far.
‘We've managed to keep the properties relatively full,’ he remarks. For instance, ‘We just signed a deal at the Village of Rochester Hills with Joseph A. Bank to come in and fill up a vacant space from when Bombay went out of business last year.’ Meanwhile, Aikens' Village of Orchard Hills, currently in predevelopment in Grand Rapids Township, Mich., remains on track for a grand opening during the third quarter of 2011.Â
On the property-acquisition side, declining asset values have pushed many previously active firms to the sidelines. As of early December 2008, Los Angeles-based Voit Development Co. had yet to purchase a single property during the entire year, reports David Allison, executive vice president and chief operating officer of the company. He characterizes the extended pause as highly unusual for the company, as Voit focuses on the traditionally well-performing Southern California industrial market.
Now, however, ‘You're not doing yourself any favors buying something that you know is going to go down,’ he says, adding that sinking values in 2009 will likely be driven by continued cap-rate expansion.
In an earlier, appreciating market, the generally accepted cap rates for particular property types were based on the assumption that the favorable conditions would continue. Allison estimates that a good industrial asset in Southern California might have reached a 6% cap rate in that era, but now, that figure might revert as far as the 9% cap rate seen years ago.
For future acquisitions, Voit will probably use an exit cap rate of around 8% to 9% when valuing an industrial property. Yield pricing and other conditions in the volatile capital markets, however, may substantially shift assumptions, Allison adds, and the global lack of liquidity continues to impede anyone's calculations of the new ‘normal’ values.
In any case, ‘All else being equal, if you're going from a six to eight, or six to nine, that's a 33 percent to 50 percent devaluation, essentially,’ he points out. With net operating income (NOI) trends largely negative due to increasing expenses and flat or declining rents, that plunge in value will likely be difficult or impossible to overcome in many cases.
Refi blues
Some of the best-positioned developers may be able to simply hit the pause button in 2009, tend to their existing properties and hope to re-enter the market when it restabilizes. Other firms – particularly those that participated heartily in the recent financing boom – are faced with an immediate and potentially crushing concern: refinancing.
‘There are a lot of companies that bought during this last frenzy that are very heavily leveraged and have term debt that will be coming due in the next 12 months,’ Habeeb says. ‘I couldn't even hazard a guess on where they could start.’
Sinking property values and the shut doors of the capital markets may be a foreboding combination for any overleveraged borrower, but certain sector-specific lending patterns – as well as developers' individual refinance histories over the past few years – will probably dictate if and exactly when refinance troubles will occur.
Hospitality lending, for instance, tends to feature perilous seven-year debt and balloon payments, notes Habeeb. He still expects that First Hospitality and other firms that structured their loans conservatively may emerge unscathed, especially if the markets correct themselves in time for refinancing to occur relatively normally within about three years.
In the meantime, developers with existing projects that face potential loan trouble will likely need to offer rent concessions or turn to other occupancy-boosting measures in order to maintain cashflow and meet debt-service coverage needs, says Brett Hutchens, a partner at Casto. ‘A vacancy does you no good right now. There's nobody waiting in line to lease the space,’ he points out.
‘We have some maturities coming up that we are going to have to deal with,’ acknowledges Jonathan Brinsden, executive vice president and chief operating officer of Midway Cos. ‘But we're not dealing with issues that values have declined so much that you're completely out of whack with your loan-to-values.’
Midway has been actively formulating its attack plan for loan maturities and has planned several meetings with its lenders, adds Bo Sanford II, president of Midway Holdings. The company anticipates no significant challenges in refinancing, due to its conservatively structured, low-leveraged deals.
Finding capital
With the credit markets still frozen – not to mention a national economy that continues to deteriorate – developers stress that ensuring quality project characteristics and verifying in-place market drivers before even considering a project now almost goes without saying.
Not surprisingly, ‘The projects that are not happening are the ones in the suburban areas, where the retailers just can't count anymore on consistent historical growth rates in residential,’ Hutchens says. Casto has thus been focusing on dense infill locations.
For Aikens' Thompson, solid cashflow, NOI in excess of 10% and an occupancy rate of at least 85% to 95% are musts for a potential project to make sense. ‘Well-located real estate, as always, will continue to do well, even through this anomaly that we're suffering through right now,’ he adds. Operators' experience and developers' attributes will also factor into lending decisions.
Many development executives insist that these cautious practices and policies should govern dealmaking not only during these lean times, but also in more forgiving economic environments. As an industry, ‘We should only be doing the deals that make sense, in locations that make sense, with leverage ratios that are good and vehicles that are reliable,’ says Habeeb. ‘It's when we stray from that that we get ourselves in trouble.’
For now, developers that have recently ventured into the market report that a project's price tag will undoubtedly affect its chances for funding, perhaps to an even greater degree than any other property attribute.
‘If you can get in the $15 million to $20 million range, there are several regional banks that are in the market,’ notes Hutchens. However, requests for small loans – particularly $5 million and below – may fail to attract most lenders' attention and wind up requiring a disproportionate amount of marketing effort.
‘We had one little project we owned that took an inordinate time to finance, given the size of the loan,’ Allison recalls. During the course of 2008, he found that lenders were more interested in loans around $10 million, but became ‘very skittish’ about anything over about $40 million.
Additionally, local banks may still fund the smallest projects – albeit with the type of caution and extremely conservative structures that will surprise no one by this point. Habeeb reports that requests to these firms for any deals above about $10 million – no matter the quality of the project – will probably be met with rejection attributed to the bank's ‘revising the credit policies’ or ‘restructuring the lending department.’
Other capital providers, of course, have moved away from financing anything altogether – to developers' continued frustration.
‘Lenders are using their human capital right now to assess what loans they have, where their problems are and how they might approach those, as opposed to using that human capital to focus on developing new business or looking for new lending opportunities,’ Sanford observes. ‘A lot of it is a pure manpower issue.’
The broker-advisor
Because assumptions of rates and terms can no longer be relied upon even day to day, developers may quickly find themselves in the dark when searching for that elusive funding source. ‘When you're a developer, you don't have your hand on the pulse of the market as much as the mortgage broker and banker community,’ Allison notes.
He thus encourages commercial mortgage bankers and brokers to adopt an assertive consultant/advisory role, keeping in close contact with their developer clients to evaluate available options and discuss breaking trends in this ever-evolving market.
‘The mortgage brokers and bankers need to stay abreast of which entities are actually active in the market – and are seeking new opportunities – so that they can be a resource for their clients,’ agrees Sanford, adding that developers appreciate being equipped with realistic expectations for taking their projects to the lending markets.
One vital trend metric for brokers and bankers to monitor throughout 2009 will be regional variations. Developers agree that no region of the U.S. is immune to the national recession, but Texas – and particularly the Houston market – may be more resilient than many other areas.
‘We've always benefited from a lower cost of living and business operation, and I think people are starting to take advantage of it,’ says Brinsden. He points out that Texas also evaded the dramatic upswings in property values – in both the residential and commercial markets – that now haunt other regions currently in free falls.
According to Habeeb, college towns around the U.S. might be a relatively safe bet for hospitality development, as a university often adds local economic stability and provides a reliable demand base. Markets dependent on local airport traffic, in contrast, have notably suffered from drops in passenger volumes and should probably be avoided at least through the end of the year. Â
‘Hospitality is a lagging industry,’ he warns. ‘We were late to get the rug pulled out from underneath us – financing-wise – and we'll probably not be the first to see the benefits of the credit markets' opening up.’ Accordingly, First Hospitality may depart from its historical business model and target selective acquisition rather than ground-up development.
Meanwhile, in the office and industrial sectors, Allison says that when Voit re-enters acquisition mode, the company will focus on distressed-property opportunities for the next year or two. Many of these now-distressed developments are sold out or stabilized, he adds, and with the wide selection of troubled properties now available even in traditionally healthy markets, Voit will zero in on the properties located in the most desirable locations.
