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Growth In Commercial Markets Remains Hampered By Lending

January 30, 2013

Amid a backdrop of moderately positive economic growth, demand for commercial space is rising and availability is declining across all property types. A main driver of the rebound comes from low levels of new construction in recent years, which have prevented a run-up in supply. The other drivers are rising employment in office-using industries, increased international trade, and a housing market which has turned many owners into renters.

On the investment side, sales volume has been growing, along with rising prices and declining cap rates. According to Real Capital Analytics, more than 13,000 major properties valued at $2.5 million or higher traded hands in 2011. Sales volume increased 51 percent over 2010 to $205.8 billion, with the lion’s share of lending funds coming from big banks.

However, the investment market remains split along property values, due to the new lending environment. This is especially pertinent for small businesses and investors looking for properties in secondary and tertiary markets. In the wake of the post 2008-09 recession shakeout and new regulatory environment, large banks have been reluctant to underwrite commercial real estate investments. In addition, smaller local and community banks, whose concentration of commercial properties composed a large portion of their portfolios, have also taken steps to reduce their exposure.

According to the REALTORS® 2012 Commercial Lending Survey, almost 70.0 percent of REALTORS® in commercial reported having a deal fail due to financing issues, over the past 12 months. In addition, 75.0 percent of REALTORS® mentioned that lending standards are as tight, or more stringent than a year ago. Adding to tight underwriting, down-payment conditions also require substantial commitment — 72.0 percent of closed sales required a down-payment larger than 20% to secure financing, with 7.0 percent of loans requiring 50%-60% loan-to-value ratios. Not surprisingly, cash transactions accounted for almost 30.0 percent of sales.

The main sources of financing for small business and smaller transactions are local banks—accounting for 64.0 percent of closed sales. Private investors and regional banks were the other major sources of funding, with 45.0 percent and 44.0 percent of sales, respectively. The Small Business Administration provided funding for 29.0 percent of closed transactions. By contrast, large national banks represented only 21.0 percent of commercial deals.

Additionally, the survey revealed several issues that continue to hamper commercial properties in smaller markets. A majority of respondents indicated that the net operating income (NOI) of leased or sold properties declined between the fourth quarter of 2007 and the same period in 2011. The NOI declines ranged from 10.0 percent to over 50.0 percent. In turn, REALTORS® report that half of their clients failed to refinance a property over the past 12 months. Out of those troubled properties 48.0 percent still failed to refinance, even after owners provided a new or existing property lease with higher NOI (pre-2006 levels).

When asked about the most relevant causes for lack of sufficient bank capital for commercial lending, REALTORS® pointed to the regulatory uncertainty as the number one reason. Reduced NOI, property values and equity came in a close second, followed by new and proposed legislative and regulatory initiatives. Given that the Dodd-Frank Act continues to be the main source of many of those regulations, the restrained level of capital availability is likely to constitute the new normal going forward.

A notable detail of the survey pointed to a significant interest in commercial properties from international investors. International investors have always been attracted to the quality and stable fundamentals of U.S. commercial properties.

After the 2008-09 recession, and given the financial turmoil in the Eurozone, the percentage of cross-border investments in U.S. markets has risen from 6.0 percent in 2009 to 10.0 percent in 2011, based on data from Real Capital Analytics. In comparison, 20.0 percent of REALTORS®’ sales of commercial properties were made to international clients and investors, according to the 2012 survey. An increased interest from cross-border buyers is also likely to be part of the new normal for the short to medium term.

For the full report of the Commercial Lending Survey, visit www.realtor.org/reports/commercial-lending-survey.