The Middle Market Recovery
December 3rd, 2013 by Diane Moore
Barely a day slips by without a new wave of captions concerning the commercial real estate market and its challenges.
Bank lending is limited to stellar credits. Slow growth or no growth in key areas weighs on market opportunities. Valuable classifications of tenants such as large banks and various financial companies resume cutting staff or are refusing to hire.
The United States regional banks also have basically moved away from commercial real estate lending. The merged effect of these trends is mounting debt illiquidity in both the middle market and the non-core division of bigger markets, which is a huge part of the commercial property market.
American money-center banks have returned to the market; however, with restricted capacity to secure their loans and additional regulatory difficulties. Instead, they are primarily gearing towards the lowest-risk, more core-like segments of the market.
Geographically coastal cities, like those in California, have led the way to recovery, particularly in major markets like San Francisco, Washington, D.C. and New York. The majority of the institutional-capital organized for commercial real estate has been focused mainly on these major markets, though the tide has started to reverse as prices in these markets have gone back to pre-boom amounts and investors turn to secondary markets for more appealing returns.
The Secret Story
In some regions, rents remain as much as 26% less than they were in 2007. Foreclosures have continued to have a humungous impact on many markets. Sales volume and leasing velocity both remain morbid.
Property owners in many parts of the country continue to propose considerable discounts to tempt tenants into renewing their leases. To comprehend the middle market story, it is vital to delineate the types of properties implicated.
Middle markets include the following:
- Class B and C properties, most that are older properties with functional damage or overdue capital expenses.
- Properties in secondary and tertiary-markets, such as smaller-cities and remote suburbs of metropolitan areas, where, in many instances, new commercial development was counting on fresh home developments that are currently either on hold or in foreclosure.
- Properties below $10-million, which signify a key segment of the general commercial real estate landscape.
- Properties leased to resident, non-credit tenants, such as unanchored shopping-centers and industrial properties.
There are various factors weighing-down the recovery of middle market properties. Firstly, though it appears the recession has formally concluded, and many larger companies have returned to the normal execution of operations, most middle market and small businesses are still in a recessionary frame of mind.
The NFIB, or National Federation of Independent Businesses optimism-index, is only gradually advancing out of the trench reached in 2009. In January 2012, only 24% of research answerers asserted that they were planning to make capital-outlays in the next several months.
Secondly, it continues to be tremendously taxing to finance middle market commercial real estate purchases with traditional debt financing. Commercial property loan-originations increased to their highest point since 2007 in the third-quarter of 2011; nonetheless, the majority of that financing is still aimed to the larger, steadier properties that sit outside of the middle market.
Lenders encouraging this growth in originations are mostly large banks, mortgage financiers looking for higher-yields with smaller risks, and life insurers. In the interim, local and regional-banks supplying the middle market are still working through disputes with their current commercial real estate portfolios. These banks had a larger part of their funds tied-up in commercial real estate; therefore, the return to a “normalized” lending situation will take more time.
Lastly, there is still a shortage of investor appetite for middle market commercial properties. The majority of available capital is concentrated on either stabilized core-properties or the attractive opportunities accessible in the distressed market.
Investors are worried about the basics of purchasing properties with non-credit tenants and have little chance of leveraging their purchases with debt financing. The result of these factors equals low-confidence amongst middle market businesses, restricted lending, and investor interest, which is stalling the recovery.
The Return of the Middle Market Still Looks Optimistic
Fortunately, there is an “upswing” to all the madness. There is a reason to have faith in the recovery process, which could soon get a much needed boost. A couple of years ago, the “expand and feign” policies of lenders and particular servicers produced a shortage of transaction-activity in the commercial real estate market.
Nonetheless, a new trend materialized in 2011 with banks more actively disposing of notes and real estate owned properties, starting foreclosures and designating receivers. Banks are taking the initiative and handling properties that have pined away over the last few years and now demand active management. It is a good sign for the market that there seems to be a “return” in a positive direction.
However, prior to any effects of a return can fully take hold there might be another crucial obstacle. Standard & Poor’s predicted that a complete 50% to 60% of the five-year term loans scheduled for maturity last year will fail due to refinance, which will likely generate a radical small increase in defaults of commercial mortgage backed-securities, sending alarms through the entire commercial real estate landscape.
Nonetheless, even with the impending challenges, there is no doubt that the commercial real estate middle market sector is on its way to recovery, and has seen considerable developments compared to a few years ago. Yet, things are still in the midst of the “return” process.
The news about Class-A real estate, multi-family properties, and assets in key metro-markets seems promising; however, it represents a small part of the overall commercial real estate industry.
Companies Offer A Hand To Middle Market Commercial Real Estate
There are a number of advisory groups providing debt financing, acquisition related services, and equity placement services to middle market commercial real estate clients. One such group, SSC, has estimated the targeted middle market commercial real estate sector required $1-million to $10-million in equity and $5-million to $50-million in debt.
The company owners have specialized knowledge in sourcing private-capital and bringing equity-partners and debt to quality deals.
Various companies have recognized the shortage of qualified advisors for developers and investors working in the middle market and completely comprehends the special needs of the market, where equity and debt requirement are not enough for institutional investors and too big for “friends and family” to help out. The idea is to “fill the gap” with trustworthy, committed resources.
Companies willing to assist those in the commercial real estate middle market view the present market conditions as positive for developers and owners to get hold of financing and refinance existing-loans. With so much fluctuation in the market during the past few years, borrowers are frequently stymied due to the inability to find new sources for their projects.
Fortunately, there are companies now willing to fill the demand with new and rising capital-sources that are vigorously looking to enhance their portfolios.
Another company, Ten Capital Management, is also jumping on the commercial real estate middle market bandwagon. The company’s objective is to deal with transactions that are too big for small under-capitalized investors and those that go unnoticed by larger institutional investors. The company will invest on a deal-by-deal footing and every investment usually requires at least $5-million to $20-million of equity.
In the last year, both independently and since beginning the middle market commercial real estate strategy, the partners of this three-year old company have raised and invested roughly $35-million of equity across even-investments throughout the US with co-investment partners incorporating a merger of high-net worth and institutional capital.
Commercial Real Estate Middle Markets On The Risk
Experts expect the commercial real estate market to continue growing progressively during the next few years but will begin to slow down after 2016 or 2017. Growth will still be in effect, but at a slower rate. Conclusions are based on research carried out by California real estate professionals in the investment and development divisions of the industry.
Known as the California Commercial Real Estate-Survey, the report is distributed twice annually by a local law firm and UCLA Anderson-Forecast. The survey proves that the market projection is adequately optimistic for 55% of the survey panel, or their associates, to start new multi-family residents in the next year.
Many of the newer apartments and mixed-used developments will be positioned near transportation centers. However, optimism is not as keen in the industrial division that incorporates manufacturing and warehouse-properties. However, the survey revealed that conditions are expected to get better through 2016, but not as much as in the housing and office sectors.
The survey is broken-down by California office markets, multi-family, and industrial markets. Industry experts are still hopeful about each market. One part of the survey stated…
“Since the conclusion of the recession, there has been developer optimism extended to every market and type of commercial space surveyed. Currently, there is the promising recovery in new commercial buildings that was predicted by the survey even in 2010.”
It is expected that the strongest growth will be in the commercial market, especially San Francisco. Half of the developers-surveyed in the Bay Area revealed that they plan to start building a new-project within the next year. Nearly 33% of the developers in Southern California agreed.
Residents throughout California can expect to see additional apartment-complexes and assorted use developments begin to pop-up. The survey revealed that multi-family real estate is expected to be quite strong for the next three-years around San Francisco, Silicon Valley, and Los Angeles.
Another area that is flourishing in middle market commercial real estate is Boston. One company, NAI Hunneman, has had great success with properties priced from $3-million to $30-million, selling more mid-market properties than anyone else within the Boston vicinity.
At present time, many of the groups in the Boston region purchasing these properties are in the private-client sector, meaning private individuals with a high net-worth or with smaller real estate private equity-funds.
Something that has stayed the same is the demand for yield along with a demand for investments in something besides the stock-market, which is a side-effect of the 2008 stock-market crash.
As a consequence, a lot of capital has been rounded-up to invest in real estate so that people, with a bit of luck, will have a better return than bonds, which are still at an all time low, and the stock-market. With that, rates are consistently low and appealing to new buyers. Some time ago, properties continued to sell though interest rates were at 7%. NAI Hunneman believes that it is not necessary for interest rates to be 4% for people to earn money.
Following the stock-market and economy crash of 2008, the recovery of commercial real estate has been concentrated on the top properties and the most exclusive areas. These districts normally include institutional-assets in the Boston and Cambridge area that are sold at a high price. Generally speaking, the company has amplified the quantity of square-footage in the middle market sector in the past year.
Conventional capital sources move away and are reinstated by new market participants. It is exactly in these conditions that experience, research, and fresh expertise can grasp opportunities to achieve significant gains in middle market commercial real estate. While certain sectors thrive, the middle market, which was the most unfavorably influenced by the great recession, is continuing a slow but optimistic road to recovery. The setbacks along the road are on full-display in many of the country’s secondary and tertiary markets.
Until the economy improves further, economic indecision lessens, and real estates fundamentals become steady, the middle market segment of the commercial real estate industry will disclose a depiction far less optimistic than the national headlines might lead the populace to expect, but will remain on the recovery road.
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