Deep freeze

Midway through 2009, most commercial real estate developers say it is extraordinarily difficult to obtain financing for new projects.

“Lending is still getting worse, if you ask me,” said Michael DeMichele, principal of Milwaukee-based Willow Tree Development LLC. “Banks are less likely to lend now than they were three to four months ago.”

The credit crunch for commercial real estate has slowed development considerably. Most building projects that are currently under construction in southeastern Wisconsin obtained financing prior to the financial industry crisis that hit in 2008. As a result many building contractors are struggling to find work. Rick Barrett, managing partner for The Moderne LLC, which is working on a proposed 30-story apartment building development that would be constructed in downtown Milwaukee, said contractors return phone calls a lot faster today than they did during the housing boom a few years ago.

“(The contractors) really, really need work,” Barrett said.

The Moderne is just one of many development proposals that is struggling to obtain financing. Barrett said he has talked to 512 banks about financing the project.

“(The capital markets are) absolutely awful,” he said. “It’s awful on every front. There’s so limited money out there for development. We are trying every single angle there is.”

According to professor Mark Eppli, chair of the Robert B. Bell Real Estate program at Marquette University, there has not been a single commercial mortgage-backed security issued in the United States this year, “and there is none on the horizon,” he said.

In 2007 there was $139 billion in commercial-mortgage-backed securities in the U.S., Eppli said. A commercial mortgage-backed security (CMBS) is a security by the loan on a commercial property. A CMBS can provide liquidity to real estate investors and to commercial lenders. CMBS use rose in the U.S. as real estate prices rose a few years ago, but the collapse of the real estate and financial markets has ended CMBS activity in the U.S. for now.

“Additionally, there seems to be little appetite by banks and life insurance companies to refinance CMBS loans that were issued 10 years ago,” Eppli said. “The capital markets (for commercial real estate) are still broadly in lock down. The only funds being provided by any lenders are relationship-based and often only for refinancing, not new construction or permanent loans.”

‘Nothing out there’

In addition, the commercial real estate space markets are also slumping, a byproduct of the economic slowdown from the recession.

Doug Weas, president of Milwaukee-based Weas Development Co. said he does know how bad the capital markets are because the space markets are so weak he hasn’t sought financing lately.

“We haven’t had anything to do to even look at the capital markets,” he said. “There’s nothing out there to finance.”

The office and retail markets in southeastern Wisconsin are soft and the area’s industrial market, while stronger than office and retail, has weakened during the recession. According to Bethesda, Md.-based CoStar Group Inc. the Milwaukee area’s office space vacancy rate increased to 10.4 percent, and had a negative net absorption of 82,378 square feet of space in the first quarter.

The area’s retail space vacancy rate was 11.1 percent at the end of the first quarter, according to Boston-based Colliers International.

The area’s industrial space vacancy rate was 8.2 percent at the end of the first quarter, up from 7.4 percent a year before, according to Colliers International.

The national commercial real estate space markets are also down, Eppli said.

“The volume of commercial real estate transactions is down about 70 percent and still going in the wrong direction,” he said. “The news from the capital markets and the space markets is uniformly bad right now.”

One executive at a Milwaukee real estate development firm, who declined to be named, said financing can be obtained for developments, but developers have to work harder and put together projects that make strong economic sense to lenders.

No spec projects

Kristine O’Meara, a principal for Wauwatosa-based Irgens Development Partners LLC, said financing can be obtained for developments, but it is much more difficult to do so.

“The number of banks willing to finance real estate projects is way down,” she said. “And these are for good transactions. We’re not even looking at projects that are more speculative because we know the banks have no flavor for them. If we put out an RFP for these same projects a few years ago we would have had banks clamoring to lend money for them.”

“Money is more expensive and loan to value ratio is getting lower,” and as a result some developments no longer make economic sense, O’Meara said.

In a recent letter to Congress, Mark Irgens, manager and president of Irgens Development Partners, said the number of responses from lenders to loan requests from his firm has decreased from 100 percent a few years ago to 30 percent today.

“The majority of banks we have contact with are only willing to lend on projects that pose very little risk,” Irgens said in that letter. “In our experience to date we have seen virtually no loosening in bank lending. In fact, it still appears that the opposite is happening. Our experience is that financing for commercial real estate projects is still difficult to obtain and is only available on the high-quality projects with strong sponsorship.”

A looming problem hanging over the commercial real estate market is the “hundreds of millions” of commercial mortgage-backed securities loans that mature in the next few years, Irgens said.

“There seems to be barely enough capital available to support the current load of financing requests,” he said. “As these CMBS loans mature and need to be refinanced, there will be an increased demand for new loans, which will further stress the markets. Many of the previously originated CMBS loans were at historically low rates, included little amortization, and were sized when cap rates were low. As a result, it will most likely be difficult to refinance the entire outstanding loan amounts and owners will be required to put in equity or sell the project. Further exacerbating this issue is increasing vacancy in some of these projects and the fact that these loans do not have extensive options. This glut of requests for new loans could put pressure on the already stretched active lenders which could negatively impact loan availability and loan terms in general. It appears this refinancing risk for commercial mortgages may mirror the residential mortgage problems caused by the resetting of adjustable rate home loans.”

The deterioration of the capital markets has also hurt property values for commercial real estate, Irgens said. Some real estate developers and brokers are complaining that appraisers are overstating the drop in real estate values. Low appraisals hurt loan to value ratios and harm the viability of development projects.

“Appraisals are upside down, DeMichele said. “The appraisers have flip-flopped to being overly conservative and unrealistic.”

“Appraisers are so scared of over-valuing anything they are undercutting real estate values by 20-30 percent, and sometimes more, making it impossible for lenders to provide commitments,” said Cory Sovine vice president of retail for Milwaukee-based Siegel-Gallagher Inc.

Commercial realtors and real estate developers will likely have to hunker down during the second half of the year as few expect an immediate recovery for the commercial real estate market.

“While I personally believe that the pendulum has gone from one extreme to the other on the commercial real estate markets, at the current time there is little positive spin out of where we are,” Eppli said.

The remodeling option

Repairing rather than replacing, and remodeling rather than building new, were the two largest remodeling trends cited by members of the Milwaukee/NARI Home Improvement Council, Inc. in its most recent survey.

Those trends apply not just to residential, but also to the commercial sector, NARI members say.

According to Jim Klappa of JDJ Builders Inc. in Greenfield, the downturn in the housing market extends into the commercial market.

“I see people buying buildings at a reduced cost because of the economy.  There are some good bargains out there,” he said. “People are buying these corporate buildings at a deal, and then preparing the buildings so they can either move their business into it or make rental space for tenants.”

Klappa typically sees more businesses renting space than owning it.

“There are more vacancies now than there have ever been in the corporate sector,” he said. “Building owners interested in attracting tenants have come to remodeling contractors like JDJ Builders for help making the space more functional, adaptable, and appealing.”

Building owners are trying to land tenants, and they’re willing to make improvements in the buildings to do so, Klappa said.

“How much is the owner of the building willing to invest in you, the tenant? We find that owners are willing to offer more to the potential renter. They’re trying to get tenants in their buildings, and they’re willing to make improvements. But as far as ‘accessorizing,’ they stick to the basics – making it functional for an affordable cost,” he said. “Years ago, they wanted the ‘glitz and glitter.’ Today, it’s about functionality rather than luxury.” 

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