As interest rates rise, commercial financing enters a new phase

Susan Blumberg

Susan Blumberg

by Dan Rafter

No one knows yet just what kind of president Donald Trump will be. But one immediate result of his election was a quick rise in interest rates. And that has already brought a change to way developers and investors are borrowing money to fund their commercial real estate developments and acquisitions.

Illinois Real Estate Journal recently spoke with a pair of Chicago-area commercial finance pros

– Sue Blumberg, senior vice president and managing director in the Chicago office of NorthMarq Capital, and John Petrovski, managing director and head of U.S. commercial real estate lending with the Chicago office of BMO Harris Bank – about the steps that developers and investors are taking today to secure the financing for their projects.

John Petrovski

John Petrovski

Illinois Real Estate Journal: The presidential election is finally over. Have the results brought any – or will they bring any – changes to the commercial lending market in Chicago?
Sue Blumberg: The lending market has shifted a bit with the recent increase in interest rates. We are seeing a shift toward long-term planning versus short-term planning from borrowers. Even for properties that are in transition – they are being leased, under construction or in the planning stages – the rise of interest rates could affect them going forward. The plans of the developers and investors could change a bit depending on what happens with rates. That being said, those borrowers, those developers and investors who are familiar with real estate and who are long-term players, have been through cycles of higher interest rates before. They tend to be prepared for these kind of changes. There is no reason for concern on their part. There’s just more of a need for longer-term planning when rates go up.
John Petrovski: We’re moderately optimistic for 2017. We think that the U.S. economy will continue in the slow-growth mode. That’s a positive for commercial real estate. There are a few clouds on the horizon. We don’t yet know what the president-elect will mean for business and growth. That is unknown at this point.

IREJ: Were you surprised that interest rates after the election finally rose?
Blumberg: Not really. The way I see it, the rates didn’t rise solely because of the election. People expect there to be actual growth in the future. There has been actual growth in the economy. There has been growth in employment, wages and GDP. It feels like the Fed finally signaling a rise in interest rates is a good thing for the country. It is actually stabilizing. I think rates would have risen even without what happened in the election. It was time for a rise, and that should be thought of as a good thing.
Petrovski: We’re waiting to see what happens with interest rates in the long-term. Does the Fed see more inflation so that rates will rise faster? That has added a bit of uncertainty to real estate projects. So there are some clouds because of the uncertainty. Now, those clouds could become soft, puffy white clouds if everything turns out to be good. Or they could turn out to be grey storm clouds. We’re not sure yet.

IREJ: How much uncertainty do we face in the commercial real estate market today because of the election?
Petrovski: Every election is unique. Eight years ago, the stock market hit its nadir. Lehman had failed. Back then, we were in a dark time. Obama’s vision of hope and change resonated with people. It was a much harder time to get a real estate loan than it is today. The capital markets had frozen, had shut down. Today we are operating in a much different environment. Clinton was perceived more as the status quo, a way to continue down the same path. The Electoral College results, though, said that the country was ready for a different path. Trump presents more unknowns. He says he’s pro-business, but what does that mean?

IREJ: It might be a tough adjustment, though. I think people have gotten spoiled by these low rates.
Blumberg: Spoiled is right. It will take a bit of a lag time for everyone to swallow the rate increases. But, really, a 4.5 percent interest rate is really good. Deals should work at those rates.

IREJ: What do you look at today when borrowers are coming to you and asking for commercial financing?
Blumberg: Liquidity would be the first thing. Experience is number two. Has that borrower or the key principals been through a cycle before? How did they perform? Were they able to stabilize their projects or make things right when a down cycle hit? Chances are that everyone who comes to us has had a hiccup in their past. It’s how they acted during the hiccup that matters. Most lenders agree that if you did everything you could, acted honestly and forthright, that’s a good sign.
Petrovski: I’m fond of telling our younger bankers that it all starts with the client, their experience, their reputation, the strength of their balance sheet. People who have done 50 real estate developments learn something on every one that they do. They bring all that experience to managing costs, to managing the construction schedule. People trying for the second time? The risks are higher. There is a higher risk of the project going sideways. With us, it all starts with the clients and their experience.

IREJ: What kind of changes are you seeing today in the number and type of financing requests coming your way?
Blumberg: I think construction lending might be curtailed somewhat. It won’t be shut off, by any means. But there will need to be more equity going into the deals that we approve. We generally do business with borrowers who have liquidity and funds and can spot it in times of a trickle or a hiccup. We want to make sure our borrowers have enough skin in the game.
Petrovski: Banks in general have pulled back on their appetite for construction financing. It’s still there. You can still get a construction loan. But they are being offered on more conservative terms today. We are still getting requests for construction loans. We are still quoting acquisition loans. Our loan-to-cost ratio is down a notch from 18 months ago as we get more conservative.

IREJ: When looking at the projects themselves, what do you consider before approving a financing request?
Blumberg: The quality of the leases in a project really matter. When you’re looking at office projects, say, you look at whether the tenants in that office building have expanded, contracted or been there for a long time. For industrial, location is everything. Absolutely, location is key. For retail, we look at a bit of everything. Amazon has certainly changed that world. We are looking at retail centers today that are offering more of a lifestyle customer experience in the store. That has been an exciting change. We like to work with retail clients who are attracting a lot of customers who want to come to their shops for an experience. That’s how they are competing with online sales.

When it comes to a start-up or an entrepreneurial spinoff of large firms, we’ll look closely and carefully at the people behind it. What was their role in their former employ? Who is backing their new venture? What is their commitment to staying in business? The first-time deal for anyone is the hardest deal. We are still seeing a terrific flow and advancement of the entrepreneurial spirit today.
Petrovski: When it comes to the actual deal, it’s all about whether it’s a quality development that looks like it’s built to resonate with the current market. For apartments, are the units well-designed? How many closets does it have? What is the layout of the kitchens, the ceiling heights? The experienced developers know what resonates in their markets. We look for something we think will sell well in that market.

IREJ: What about the multifamily market? It still generates plenty of headlines for how strong it is. What do you look at when considering financing associated with multifamily properties?
Blumberg: Right now, it is all about looking at the historical operations of a building over the last several years. On an existing property with a good track record, it’s much easier to get financing. A solid asset can be trended and researched. Those properties that are in lease-up, it goes back to feasibility and absorption.

IREJ: I know it’s difficult to predict the future, but what do you see in the next several months when it comes to the strength of the commercial real estate market?
Petrovski: Let me tell you, every developer predicts the future. They are always doing the best they can to predict what is going to happen in their markets. We look at what they’re predicting. Do we agree? Some developments have a lot of profit cushions built into them. Others are priced to perfection. They have aggressive rents and they have to hit them. They can’t afford any cost overruns. In some respects, the deal talks to you. If the deal is too tight, maybe that deal shouldn’t be done.

Overall, though, the level of commercial activity has been robust. I don’t see it increasing. If anything, the level of activity will remain at a constant level or we’ll see it dialed back a notch. Fewer projects might start. There is some concern with the overbuilding of Class-A apartments with higher rents. Some developers might take on fewer projects as they grow worried about there being too much supply out there. That is the debate that is taking place not only in Chicago but in every urban market. What is the pace of job growth? What is the pace of new supply? Are they in synch?

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