But California also has a number of challenges, and housing is arguably the most pressing. About 1.3 million renter households in the state, or 22%, are classified as extremely low income, according to the National Low Income Housing Coalition. And the state has a shortage of nearly 1 million homes that are affordable and available for these people, defined as those who earn less than 50% of the area median income.

A report this past December in The Wall Street Journal delved into the regulatory maze that has stalled many affordable housing projects in California and made them more expensive to complete. In San Jose, the cost to build a single unit of low-income housing in 2022 was $983,700, up 24% from the previous year.

San Francisco granted less than half as many housing permits last year as New Braunfels, Texas, which has one-eighth the population of the City by the Bay. And in one extreme example of a project that has been delayed by political battles and financing hurdles, a 49-unit apartment building in Los Angeles is reportedly set to open later this year after the nonprofit developer acquired the land in 2007.

Gov. Gavin Newsom recently signed several pieces of legislation that are expected to benefit developers of mixed-income multifamily projects. One of these bills is designed to streamline the approval process for qualified housing developments in jurisdictions that don’t create enough new supply by removing the need for an environmental study.

California has an estimated $68 billion budget shortfall across its current three-year fiscal forecast that’s tied in part to weaker-than-expected personal income tax revenues. The 25% decline in tax collections during the 2022-2023 fiscal year was “similar to those seen during the Great Recession and dot-com bust,” state legislative analysts wrote.

Still, California’s gross domestic product grew at an annualized rate of 2.9% in third-quarter 2023, close to the U.S. average of 3.5%. As of this past August, California’s nonfarm payroll employment exceeded its pre-pandemic level by 447,600 jobs. Employment gains in sectors like logistics, technology, construction and health care have surpassed job losses in other industries.

Silicon Valley is a hotspot for data center investments. CBRE reported that all of the new data center supply delivered in Silicon Valley during the first six months of last year was preleased. With an inventory of 410.7 megawatts at midyear 2023, Silicon Valley was the nation’s third-largest market for data centers, trailing only Northern Virginia and Dallas-Fort Worth.

The Golden State’s largest office markets continue to struggle. Newmark reported that San Francisco had a vacancy rate of 27.3% and asking rents reached a six-year low point in third-quarter 2023. In Los Angeles, office-using employment dropped by 3% during the first eight months of last year and 44% of all office buildings had vacancy rates of more than 20%. ●

Nowhere has the cooldown in U.S. industrial real estate been more apparent than in California’s Inland Empire, centered around the cities of Riverside and San Bernardino. A midyear 2023 report from Colliers showed that the metro area, which is the country’s largest industrial market, posted negative quarterly net absorption for the first time in more than 13 years.

Third-quarter 2023 data from Cushman & Wakefield showed a negative absorption figure of 1.8 million square feet (msf) from July through September. But absorption during the first nine months of the year remained positive at 1.2 msf. Asking rents in the Inland Empire at the end of Q3 2023 stood at $17.96 per square foot, down from a peak of $18.85 in Q4 2022 but still well above the national average of $9.73 for industrial space.

Cushman & Wakefield also reported five industrial sales valued at more than $25 million in the area during the third quarter. The priciest deal during that time was BentallGreenOak’s $144 million purchase of nine buildings totaling 458,000 square feet in the Chino submarket.

What the Locals Say

The resort markets along the coast — including the Coachella Valley, Palm Springs and Palm Desert — have done phenomenally well. They’ve far surpassed what they were doing in 2019 and have enjoyed record top-line revenues and record net profits. We’re now seeing those markets start to taper off.

On the other end of the spectrum are the downtown hotel markets that are heavily reliant on commercial business, and that’s gone in the opposite direction as people have continued to work from home. You have fewer employees in the downtown market, so that’s definitely impacted guest stays, as well as food and beverage, at those hotels.

We publish a biannual survey, and through the first six months of 2023, individual hotel sales transactions in California were down 53% from where they were in 2022. That is a record decline. We’ve been tracking sales for over 20 years and it’s even surpassed what we saw in the first six months of 2009. And that’s just tied to a huge disconnect between the buyer and seller expectations.

Hotels have not yet seen value declines of 70% to 80% like those seen in office space. But a classic example would be two of the largest hotels in downtown San Francisco. They’re both Hilton products, and in 2016, those hotels appraised for $1.6 billion. The publicly traded REIT that owns them has given the keys back to the lender. The debt is $725 million.

3 Cities to Watch

Irvine

This Orange County city has added a whopping 100,000 residents since 2010 to reach a current population of 314,000. Irvine serves as the home base for fintech firms like Acorns and Cloudvirga, as well as a number of startups in the software, digital media and real estate sectors. Three Nobel Prize-winning researchers hail from the University of California at Irvine, which has a highly diverse group of students and faculty.

Oakland

After losing its pro football and basketball teams in recent years, Oakland received another economic blow this past November when the Athletics baseball team announced its pending relocation to Las Vegas. Affordable housing is a key issue in the East Bay hub. Brooklyn Basin, a major redevelopment project that would build 3,700 new homes on the site of a former shipping dock, is still many years away from completion.

Sacramento

From agriculture and health care to education and clean energy, the California state capital has a diverse economy that produces more than $160 billion per year in goods and services. Colliers reported that the $773 million in commercial real estate sales across the metro area in first-half 2023 was down 63% year over year. Industrial and multifamily deals accounted for a respective 39% and 24% of this six-month sales volume.

Sources: Allen Matkins, Built in LA, CalMatters, CBRE, Colliers, Cushman & Wakefield, Executech, Forbes Advisor, KQED, National Low Income Housing Coalition, Newmark, SFist, The New York Times, The Wall Street Journal, UCLA Anderson School of Management, University of California at Irvine, Visit California, Wisevoter

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JLL’s U.S. retail outlook report for third-quarter 2023 stated that 145 million square feet of retail space has been demolished in the past five years. What has been the result of this change?

The reality is we are in a sub-5% vacancy environment right now. There’s literally no new space to lease. At the same time, there is a significant amount of retail demand for growth and expansion, and that is putting a lot of upward pressure on rents.

This year, we’ve seen rent growth in retail, something that hasn’t been achieved for a really long time. Compounding that is just the lack of new retail construction. If you go back to the 2006 through 2008 time frame, we were delivering about 150 million square feet of new retail space each year. But in the past couple of years, it’s been closer to 15 million square feet.

Do you see retail construction increasing this year?

In the short term, the answer is no. There are limited construction starts that are permitted and approved, or are already in the ground for 2024 and 2025. Given that there has been a reset in land values over the past 12 to 18 months, perhaps there will be an increase in retail construction. But it will have to be in 2026 and beyond. Costs have significantly increased, so it’s just really hard to make the economics work for new retail construction in primary and secondary market locations.

What do you see for the retail sector in 2024?

Rents are going to continue to rise in 2024, but the growth in retail is going to slow down a bit. I think we are still coming out of the pandemic-fueled environment, with retailers having great balance sheets and a lot of pent-up demand from consumers. But the consumer is coming under a little more pressure today, so I think that retail is going to continue to be really healthy, but consumers will be less exuberant and more realistic in their buying.

How will retailers handle the lack of new space?

Healthy retailers are going to be looking for creative ways to expand their footprint. They may retrofit vacant spaces that aren’t their typical prototype in order to build new stores. They may go into secondary and tertiary markets where they otherwise might not have gone before. You are likely to see some consolidation of retailers and that, perhaps, will create some opportunities either for expansion or addition through subtraction. If rates cooperate and we are in a lower interest rate environment — and given the amount of new capital that wants to be in retail — there is going to be a ton of investment activity in the retail space.

The JLL retail report showed that malls were still suffering due to negative absorption in 2023. What do you see happening with malls this year?

What’s happening in the mall space is continued bifurcation between models that are thriving and properties that require reinvention. The best-in-class, fortress-style malls are actually seeing increased productivity and really strong same-store sales growth. In most instances, the best of the best assets are performing as well, if not better, than they ever have.

How are malls reinventing themselves?

In some cities, you continue to see multifamily developments at malls. You will also see more medical offices. Malls are sort of living, breathing organisms, and I think they drive a lot of traffic. So, they have the ability to sustain and generate other uses at the mall as well.

A lot of the better-quality malls have more outward-facing food, beverage and entertainment elements to them. It’s not just pass through a door and enter a cavernous mall space today. There is a lot of activity in terms of repositioning and redevelopment, including creating exterior spaces around entrances. It is not just an inward-facing product anymore. ●

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And while nothing close to an apocalypse has occurred, retail did take another turn in its long journey. Staples of 20th-century shopping such as Sears and Bed, Bath & Beyond have largely shuttered their doors. Others, like JCPenney, are doing whatever they can to stay afloat. Many malls have permanently closed, with others on the chopping block. And even some power centers and neighborhood centers have either closed or sit half empty.

When we look at the long-term national-level performance and development data, it is hard to find many bright spots. Construction of retail property has been anemic, with less than 100 million square feet of space added over the past decade, or less than 5% of total U.S. inventory, Moody’s Analytics found. For context, office-sector inventory grew by about 10% during the same period. As for rent growth, retail assets have fallen well short of inflation, even prior to the recent run-up in consumer prices.

But all of that is in the past, and while the retail sector will continue to see changes, we do see a new equilibrium on the horizon. The industry has somewhat rightsized itself, finding ways to appeal to consumers who desire the more social aspects of shopping and entertainment while also providing “showrooms” and customized spaces to enhance the online experience.

How have the performance metrics fared recently? As the accompanying chart illustrates, the U.S. retail vacancy rate has stabilized at a shade over 10%, while effective rent growth has picked up. This data shows that the sector still has plenty of room for further growth, but the aggregate statistics also mask some interesting pockets of positive activity.

One of the most startling statistics is rent by vintage. In the majority of metros around the country, there is a rent premium of 50% to 100% for properties built in the past decade — and recent rent growth has followed suit. Metro-level differences are also noteworthy. The areas of the country that have not seen large population or income gains tend to have elevated vacancy rates, often due to the disproportionate amount of older properties that are tied to a lack of development funding.

Some of the clearest examples of this trend include Indianapolis; New Orleans; New Haven, Connecticut; and Syracuse, New York, each of which have retail vacancy rates of more than 15%. Creative, modern developments in these metros may have great potential given the older stock.

Where does this ever-evolving property type head from here? Well, e-commerce is likely to continue growing. The online share of all retail sales has been trending around 15% for a while, and Moody’s Analytics expects it to jump to 20% by the end of the decade. Along with continued shifts in population and consumer preferences, this will sustain some of the same nuances for sector.

The national-level metrics will stay similar to where they are now, while older inventory will make way for trendy developments that incorporate more of the experiential and omnichannel needs of modern society. As always with commercial real estate (and maybe most importantly with retail), a close inspection of the asset, the tenants and the location are vital for a successful investment endeavor. ●

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Known as a top tourist destination because of its warm climate, sandy beaches, historic sites and enchanting cities, Spain is a nation of nearly 47.5 million people. Beyond tourism, Spain’s top industries include auto manufacturing, agribusiness and energy.

During the year ending in second-quarter 2023, Spanish investors proved to be quite interested in U.S. commercial real estate. During this period, some of Spain’s top companies acquired 17 U.S. properties totaling more than $2.2 billion, according to MSCI Real Assets. This amount alone is impressive enough. But the shocker is that the figure is 5,000% more than what Spanish investors spent from mid-2021 through mid-2022.

The increased activity vaulted Spain to fourth place on MSCI’s ranking of the top 25 sources of capital into U.S. commercial real estate. Spain trailed only Japan, Singapore and Canada on this list. Spain’s ascent has been meteoric as it ranked No. 7 in calendar year 2022 and No. 25 in 2021.

One of the main reasons for this considerable growth in activity was the real estate expansion of Pontegadea, a multinational investment company owned by Spanish billionaire Amancio Ortega. He made his fortune by founding the fashion retailer Inditex, the largest fast-fashion group in the world and the owner of the multinational clothing chain Zara.

Pontegadea, which is developing a large real estate portfolio, has been spending hundreds of millions of dollars to acquire a variety of U.S. properties. These range from Amazon-leased office space in Seattle to warehouse and distribution centers in California, Florida and Pennsylvania.

According to MSCI, Pontegadea acquired 12 industrial properties and one apartment complex in 2023. The main seller of the industrial assets was Blackstone, one of the largest landlords in the U.S. Pontegadea appeared to be capitalizing on Blackstone’s need for cash amid the commercial real estate downturn. Blackstone was known to be selling parts of its portfolio, including casino assets and various industrial properties that were performing well.

In 2022, Pontegadea acquired five logistics centers located in Tennessee, South Carolina, Virginia, Pennsylvania and Texas. The largest single U.S. deal by Pontegadea in 2023, according to MSCI, was the August acquisition of a 45-story apartment complex in Chicago for $231.5 million.

Pontegadea isn’t the only Spanish company that has recently expanded its real estate empire. The Mallorca-based travel conglomerate RIU Hotels & Resorts acquired a six-story office building in Manhattan for $173 million. The October 2023 purchase was an intriguing move for RIU, which owns 96 hotels in 20 countries. The building was slated to be demolished to make way for a hotel tower, but the previous owner was unable to secure permits from the city. It will now be up to RIU to convince officials to back a new plan.

Only time will tell if Spain’s major investors continue to find U.S. apartment complexes, offices and industrial space enticing. But it seems like a safe bet that the wave of acquisitions by Spanish investors has yet to end. ●

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The danger is that the current high interest rate environment will make refinancing the loans on devalued properties difficult and expensive, resulting in waves of defaults and more pain for everyone involved. A lot of numbers have been bandied about concerning the volume of loan maturities, but according to the Mortgage Bankers Association (MBA), of the $4.6 trillion in existing commercial real estate loans, about $2.6 trillion will mature in the next four years.

This issue became real in February 2023 when Canadian real estate conglomerate Brookfield walked way from $784 million in loans connected to two office towers in downtown Los Angeles. At the time, media outlets reported that Brookfield had made it clear months earlier that it might not be able to refinance debt obligations on the properties. Brookfield was described as a bellwether for where the office market was headed — and it wasn’t alone. That same month, Columbia Property Trust defaulted on about $1.7 billion in debt tied to seven major properties.

The defaults by two high-profile landlords helped to solidify a sense of foreboding, which has continued to this day. In this issue of Scotsman Guide, in fact, author Rob Finlay writes about the refinancing problem (“Scale the Wall of Maturities” on Page 30) and discusses what mortgage originators can do to help mitigate the impact.

What’s unclear is how large this massive wave of refinancing needs will be. Yes, the default rate is up and there have been a few high-profile cases, but the disaster has yet to hit commercial real estate on a wide scale. Is it possible it won’t?

Jamie Woodwell, the MBA’s vice president of research and economics, explains that there are aspects of this problem that industry watchers need to keep in mind. This includes the fact that loan maturities are spread over a long period of time, in a wide variety of industries and in every geographic location, so the results will be as varied as the properties in question.

Other factors may help to lessen some of the damage, or at least spread it out. For instance, Woodwell found that of the $4.6 trillion in commercial real estate debt, nearly $2 trillion is for multifamily properties, a relatively strong sector with typically longer loan terms than other asset classes. Less than 10% of multifamily debt was set to mature in 2023, but there will be more in later years. For instance, about 16% of current multifamily debt will be due in 2032 when the economy is bound to look much different than today.

Woodwell remembers when the MBA began creating its lending survey during the global financial crisis of the late 2000s. There were worries then, too, about a wall of maturities combined with limited capital availability.

“One of the key takeaways that we found then, that I think continues to be true today, is that commercial mortgages tend to be a relatively long-lived asset,” Woodwell says. “You have an awful lot of loan types out there and, among them, commercial mortgages tend to be longer in nature. So, even now in the peak of 2023, with the greatest volume of maturities in our survey, it’s still only 16% of the total outstanding balance.”

Inflation was also reported to be falling quickly at the end of 2023 and Federal Reserve members have said that rate cuts are in the offing. Such a move would greatly lessen the sting of refinancing.

That’s not to say that commercial real estate isn’t stressed. Property values have cratered, with Capital Economics recently estimating that overall commercial real estate values fell 11% in 2023 alone and are expected to shed another 10% this year. The office sector, alone is expected to lose another 20% in 2024.

Woodwell says there’s a great deal of uncertainty about where property values stand. But it’s clear that delinquencies are on the rise. Woodwell points out that, through the first 10 months of last year, delinquencies rose in all asset classes, with the office delinquency rate exceeding those of hospitality and retail for the first time since the onset of the COVID-19 pandemic. “We are seeing stress in the market,” Woodwell says. “Pretty much every capital source has reported an increase in delinquency rates.”

One sector that may do better than expected is retail. Capital Economics expects retail valuations to increase by 6% per year through 2028. Plenty of retail sites remain under stress, but Chris Angelone, the co-leader of JLL’s national retail group, believes that poorly run operations have already been flushed out, so the owners now in place at the better-performing malls are often the best operators. Lenders would be loathe to take back those properties when quality operators are already in place.

“I think, generally speaking, that lenders are going to work with their borrowers on performing assets,” Angelone says. “But obviously, the valuations are going to be much different than before.” ●

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Some of the notable factors contributing to this systemic change include a sustained federal financial spending policy, continued growth of wages and labor shortages. Other factors include a vacillating energy transition from fossil fuels to carbon-neutral sources and intensifying geopolitical concerns.

“Commercial real estate credit is attractive since it offers equity-like returns with lower levels of risk due to its seniority in the capital stack.”

Considering this new macroeconomic backdrop, a popular question is, what does this mean for investor portfolios? One prudent move would be to increase allocations in collateral-based cash flows backed by hard assets such as real estate.

More specifically, it makes sense to increase one’s exposure to private real estate credit as banks, which traditionally have been leaders in commercial mortgage lending, have restrained their lending practices. This has created opportunities for nonbank lenders to gain market share from bankable sponsors eager to get their projects financed.

At the same time, the asset class’s expanded revenues have created a compelling risk-adjusted yield, whereby when inflation moves up, so does revenue. This is a major change from the past 10 years when the theme was long growth, long duration and fixed income. We are now in a different environment where the playbook has changed and investors need to adapt.

Investment solutions

The ability to generate stable, inflation-linked income through commercial real estate credit offers a positive solution for investors who might be facing financial obligations or challenges. This asset class offers substantial variations in strategies, risk levels and the ability to invest across the capital structure, including both senior and junior positions. It also allows investors to tailor allocations that align with their long-term goals.

Pension funds, for example, typically seek low-risk credit funds that tend to lend against stable-yielding assets. These assets can generate cash flows that match required payments to their beneficiaries.

That said, not all investors are the same. Many have liabilities that are subject to cost-of-living adjustments that may result in higher payments when inflation rises. Traditional investment approaches typically use long-duration bonds to manage the long-duration liabilities.

During the recent market cycle, however, traditional approaches showed weakness as inflation and interest rates rose quickly. For instance, it is common practice to use swaps and other derivatives to replicate the bond positions necessary to hedge liabilities. As interest rates increased over the past two years, the values of these leveraged derivative positions declined, generating significant losses and creating a short-term liquidity crunch for investors who utilized substantial leverage.

Rethinking bond exposure

Historically speaking, if stocks go down, then bonds rally and investors seemingly always have a shock absorber in their portfolios. But this notion is changing.

Banks had more than $600 billion in unrealized losses at the end of 2022, according to the Federal Deposit Insurance Corp. The Federal Reserve, meanwhile, has about $1.1 trillion in unrealized losses in its System Open Market Account, with a large percentage of that total tied to U.S. Treasury bonds.

Therefore, every time there is a rally in bonds, what will the Fed do? Many believe they will sell, thus driving bond prices down. Moreover, Japan, which happens to be the largest foreign holder of U.S. bonds, is mimicking this playbook. These sales will eventually lead to an increased bond supply, along with investors such as banks and the Fed being underwater in their bond portfolios.

These conditions mean that investors need to think about how much they own in stocks and bonds, with a particular emphasis on the bond market. Alternative products such as commercial real estate credit can help them earn a bond-like yield without the same duration or volatility associated with traditional fixed-income products.

Finding yields

Private real estate credit vehicles that generate stable income while having some inflationary protection can help investors reduce surplus volatility. Investors can also earn higher yields to better achieve their capital-deployment goals with less complexity.

Furthermore, commercial real estate credit is attractive since it offers equity-like returns with lower levels of risk due to its seniority in the capital stack. Tighter capital standards, unrealized losses and higher loan-loss reserve requirements are forcing banks and other financial institutions to hold more capital and issue fewer loans, which is providing opportunities for nonbank lenders to fill the gap.

The multifamily housing sector is an excellent example of this trend in the commercial real estate market. There is a shortage of about 6.5 million single-family homes in the U.S. right now, a result of many factors that include a slowdown in construction dating back to the 2008 financial crisis. Even if multifamily rental units are included in this equation, there is still a deficit of about 2.3 million homes.

The lack of housing, coupled with the need for lenders to step up and fill the gap, provides an abundance of opportunity for well-capitalized nonbank lenders. They can deploy capital into high-quality loans at attractive spreads using relatively conservative underwriting metrics. Commercial real estate credit also offers a strong inflation linkage, produces recurring cash flows and helps to protect returns in a more volatile environment.

Having stable cash flow and the ability to grow income in today’s inflationary environment is highly attractive for investors. This cash-flow resiliency has been particularly true across sectors that private investors currently favor, such as built-to-rent homes and industrial warehouses.

● ● ●

The Federal Reserve appears to be putting a pause on interest rate hikes for the time being, but many experts believe that the commercial real estate market will deal with what is being described as a “higher-for-longer” rate environment than what was originally expected. In the past, the Fed, the European Central Bank and the Bank of Japan used quantitative easing as a road map to indicate their desire to be protective against elevated rates.

Today, they don’t have that visibility as wages, the transition to clean-energy sources, geopolitical concerns and other fiscal issues are all disruptive variables. One thing being learned in the U.S. is that there’s more money in the system than many people had expected. The consumer economy continues to show strength, the services economy is swelling and wage growth has been only nominally subdued. Fed policymakers may not be done with their job until they inhibit the growth of the labor force.

As a result, this higher-for-longer rate environment has created unparalleled opportunity for commercial real estate credit. By staying patient, disciplined and at the forefront of the market, private lenders are strategically positioned to be major players among the sources of mortgage capital and should therefore have a place in every investor’s portfolio. ●

The post Protection Against the Elements appeared first on Scotsman Guide.

This also holds true for commercial mortgage brokers. Having ironclad agreements with borrowers is an essential part of the business. Those who have such agreements must make sure they are enforceable as intended. When it comes to these contracts, the devil is in the details.

“The broker agreement should have a description of the services that will be provided, as well as those that won’t.”

Imagine a mortgage broker who is approached by a developer seeking an eight-figure loan on a commercial property that it’s planning to build. If the broker successfully connects the developer with a funding source and the loan is closed, the fee to the originator is likely to be substantial.

The agreement states, however, that it is not a commitment to fund a loan. After all, that would be the decision of the lender, and the broker might not find a willing money source if there are problems with the deal that are identified during the due-diligence process. Also, the broker might decide after looking closely at the proposed transaction that it’s not worth shopping around.

Nightmare scenario

In an actual legal case that had a similar fact pattern, the court decided that even though the broker connected the borrower with a funding source and the loan closed, the broker was not entitled to compensation. The reason is that, at the last minute, the developer terminated the agreement. As a result, there was no obligation to pay the broker because the agreement was not a commitment.

The moral of this story is that the agreement was unclear about what was (and wasn’t) covered under the contract. Of course, the broker does not commit to fund a loan no matter what. But the agreement should have been clear that the developer, once the broker connected their project with a funding source that led to a closed and funded loan, irrevocably agrees to pay the broker’s fees, even if the agreement is terminated by either party. Crystal-clear agreements are essential for safeguarding each party’s rights.

The business of putting people together to achieve an objective can be ephemeral. Contracts must be clear about which services are being offered and which are not. A broker (usually) does not guarantee that a client will find a lender. But if they do, the broker expects to be paid for the referral.

In the example above, the court determined that the payment of a due-diligence fee (essentially, compensation for the broker’s out-of-pocket expenses in vetting the borrower before approaching any lenders) was the only fee that needed to be paid. Since the agreement was terminated, it was judged that the broker should not profit from the 100-basis-point fee on the closed loan.

Time to act

No one would reasonably argue that this kind of agreement should not have a termination section, or even a term for the length of the services being rendered. After all, nobody wants to be bound forever to support a hopeless case.

In either the term or termination section of the contract, there should also be a survival clause in which each party agrees that the payment of a success fee is required even after the contract expires or terminates. The end of the contract should be the end of the broker’s search for a funding source, but it doesn’t mean that their success in locating a funding source does not merit a fee.

The survival clause needs to be based on any sort of closed transaction between the borrower and lender, or any affiliate of either party. The final deal could turn out much smaller, be unsecured, or even involve a different property that replaced the one originally intended. To ensure there is no confusion, mortgage brokers should make sure their email trails reflect the arrangement. Email is evidence, after all.

When writing a contract, be sure to include the important word “irrevocable.” In other words, the borrower must pay the subject fee without conditions. The broker did his or her job and should be compensated, even if there were five years of starts and stops on the deal. If there are any other fees in the arrangement (such as a due-diligence fee, attorney fees or expenses for lien searches), these should be carefully described as a reimbursement for the broker’s time and labor, rather than any sort of success fee.

Legal details

The broker agreement should have a description of the services that will be provided, as well as those that won’t. For example, the broker could agree to speak to at least 10 funding sources but not more than 15.

The broker may offer a proposed structure to a potential lender, but the final deal could be much different. There should be no implied promise of a lender accepting a proposal. After all, since the funding source bears the risk, it should be allowed to make any changes it finds acceptable.

Beware of applicable laws. For example, if a broker includes an equity component, they need to comply with any laws relating to the solicitation of a securities offering. They must also be aware of usury restrictions or any states with consumer disclosure laws that apply to commercial transactions.

Agreements can address these issues or be silent, depending on a broker’s strategy to govern their services. One approach would be to have both sides promise to obey the law (which they must anyway), and include an indemnification from the borrower if the originator unknowingly and non-negligently incurs civil penalties through the violation of applicable laws.

Whether this is enforceable will depend on the state involved, whether it is the broker’s, the borrower’s or the location of the project. A better approach, potentially, is to include a general indemnification from the borrower that it will reimburse the broker for any losses borne by them in the provisions of their services, except those resulting from the broker’s negligence.

A final piece of caution: Whoever signs the agreement must exist and have assets backing them. A promise of indemnification from an entity that does not yet exist is most likely worthless. If a special-purpose entity without any assets signs the contract, but the ensuing transaction is with a different special-purpose vehicle, legal entity or person, you may have great difficulty in obtaining any fees.

● ● ●

Many businesspeople think that contracts exist purely to enrich attorneys. That view is, at best, ignorant of the facts. There are plenty of examples of businesses that have entered into oral contracts in which the transaction ended with one side taking advantage of the fact that no written agreement existed. If written properly, the contract binds the parties to the terms of the deal.

It is incumbent upon commercial mortgage brokers and the other members of a contractual agreement to ensure that their rights are protected. This requires the development of a properly written contract that clearly outlines all fees to be paid and the circumstances governing their payment. Without these legal protections, you may find yourself out in the cold. ●

The post The Devil Is in the Details appeared first on Scotsman Guide.

“To remain competitive, originators also need to embrace the role of technology in streamlining the lending process.”

Whether working with multifamily properties in city centers, suburbs or more rural settings, it is crucial for commercial mortgage brokers to be aware of market trends and to tailor financing solutions that align with the evolving needs of borrowers and lenders. By delving into the details of a project, originators can better meet the demands of today’s dynamic markets.

Financing strategies

One of the most important issues for commercial real estate investors is to develop the right financial strategy. Mortgage brokers must be adept at crafting financing strategies that not only meet the financial needs of borrowers but also align with the risk appetite of lenders. From government-sponsored programs to bridge loans, traditional bank loans and other products, the array of financing options can be overwhelming.

The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, are quasi-governmental entities that guarantee third-party loans and purchase loans on the secondary market. Loans guaranteed by the GSEs tend to offer attractive terms such as competitive interest rates, higher leverage and favorable underwriting standards. Borrowers who qualify for GSE loans benefit from lower costs and extended repayment periods.

While GSE loans are popular, not all borrowers qualify. Traditional bank loans, even though the underwriting tends to be more stringent, can provide alternatives. But these mortgages often come with higher interest rates and lower leverage. For borrowers who may not meet GSE or bank loan criteria, the exploration of alternative financing vehicles such as private equity or nonbank lending institutions becomes essential. These options may offer more flexibility but often come with higher costs.

Consider a scenario where a small-scale multifamily development project doesn’t meet the criteria for a GSE or bank loan due to its size. In such cases, commercial mortgage brokers can showcase their ability to address diverse financing needs by guiding clients toward alternative financing solutions, such as private loans, crowdfunding or community development programs.

Risk mitigation

A paramount consideration in multifamily housing finance is risk mitigation. Originators must conduct comprehensive due diligence on both the property and the borrower. This includes an evaluation of the property’s location, local market conditions and potential for income generation. Protecting a client’s investment and minimizing potential risks requires a proactive approach.

For instance, consider a multifamily project that’s located in an area prone to natural disasters. Implementing risk mitigation strategies — such as being prepared for how underwriters will assess a property, securing robust insurance coverage, incorporating resilient building materials, and conducting thorough feasibility studies of the property and geographic area — can enhance the project’s ability to withstand unforeseen events.

In a real-world scenario, a 50-unit apartment complex faced significant challenges. It was the borrower’s first venture into property management, so lenders had concerns about the efficiency of the operation and the future satisfaction of tenants. These concerns left lenders worrying about the long-term value of the asset.

Strategic approach

With this particular deal, a mortgage originator who was equipped with a strategic approach to risk mitigation recommended forming a partnership with an experienced property management firm. The strategic partnership contributed to improved tenant satisfaction, resulting in lower turnover rates and increased lease renewals.

Daily operations were streamlined, ensuring timely maintenance, rent collection and adherence to regulatory requirements. A rigorous tenant screening process was implemented to identify potential challenges. Historic data from the property management firm demonstrated successful tenant retention, efficient operations and increased property value over time.

The proactive screening process led to a reduction in tenant-related issues, fostering a more stable and harmonious community within the multifamily complex. Continuous improvement encouraged the borrower to invest in ongoing education and training in property management practices. In time, the borrower developed a proficiency in property management, addressing initial challenges and building a solid track record. Over a three-year period, the property’s annual appreciation rate grew from 5% to 20%.

By leveraging historic data, introducing proactive measures and fostering a commitment to continuous improvement, the broker helped the borrower reach his goal while also contributing to the long-term success of the multifamily project. It underscores the importance of comprehensive risk assessment, as well as the power of data-driven decisionmaking, to ensure the viability and profitability of a multifamily investment.

Regulatory landscape

Beyond strategic planning, commercial mortgage originators must also be aware of the regulatory environment. The multifamily housing sector is subject to a complex regulatory system that varies across jurisdictions.

Originators have to stay informed about local, state and federal regulations that govern multifamily housing developments. It is imperative that properties are always in compliance with zoning laws, building codes and environmental regulations.

For instance, consider a scenario where a neighborhood opposes the development of apartments. This resistance might stem from concerns about increased traffic or noise, or changes to the community’s character.

In such cases, effective communication and collaboration with local authorities, community leaders and residents become crucial. Providing examples of successful resolution strategies, such as community engagement initiatives or modifications to project plans, can shed light on the navigation of regulatory challenges.

In another regulatory context, understanding the intricacies of affordable housing tax credits and how they can be used to incentivize multifamily development in certain areas can be instrumental. By incorporating such details, mortgage originators can highlight their expertise in navigating complex regulatory landscapes.

Changing technology

To remain competitive, originators also need to embrace the role of technology in streamlining the lending process. The integration of digital tools for loan origination, document processing and communication can enhance efficiency and reduce turnaround times.

Consider a scenario in which a mortgage company adopts artificial intelligence (AI) systems to streamline the initial stages of the loan application process. Through AI-driven chatbots or virtual assistants, prospective borrowers can engage in real-time conversations to share basic information, such as income, credit history and property details. This not only expedites the data collection process but also provides a more user-friendly and accessible experience for applicants.

Furthermore, the integration of blockchain technology in document processing can revolutionize the verification and validation of financial documents. Blockchain’s decentralized and secure ledger system ensures that all parties involved — including borrowers, lenders and regulatory bodies — have access to the same unalterable information. This significantly reduces the risk of fraud and errors in document handling, leading to a more transparent and trustworthy lending process.

Communication is another critical aspect of the lending journey. The use of cloud-based collaboration tools allows mortgage brokers to communicate seamlessly with clients, underwriters and other stakeholders. For instance, adopting a secure platform for document sharing, virtual meetings and real-time updates ensures that all relevant parties are on the same page throughout the lending process. This enhances communication efficiency while also contributing to a more collaborative and transparent client experience.

Economic perspective

Like technology, the economic landscape plays a pivotal role in the success of multifamily housing projects. Mortgage originators must be aware of economic indicators, interest rate trends and overall market conditions.

For instance, during an economic downturn, originators might proactively advise clients on interest rate locks to secure favorable terms. Providing examples of past economic scenarios and the corresponding strategic decisions made can offer valuable insights into the importance of economic considerations in multifamily finance.

During the Great Recession, the real estate market faced unprecedented challenges. Multifamily projects were particularly vulnerable as tenants faced financial hardships. In this tumultuous environment, a savvy mortgage broker advised a client to pivot from high-end luxury apartments to affordable housing.

By utilizing historic data that indicated a surge in demand for affordable housing during economic downturns, the originator guided the client through a strategic shift. The result was not only a successful weathering of the recession but the establishment of a profitable portfolio of affordable housing units.

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Mortgage originators who successfully navigate the multifamily landscape understand the intricacies of market trends, employ strategic financing approaches and mitigate risks. They also stay abreast of regulations, leverage technology and factor in economic considerations. To be competitive, originators need to embrace these insights and craft innovative solutions that contribute to the growth and success of multifamily housing projects. ●

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“The wall of maturities represents a critical crossroads for the commercial mortgage market, impacting both borrowers and originators.”

This impending wall of maturities has far-reaching implications that will disrupt the financial landscape. It will potentially lead to a shortage of financing options, an increase in defaults and a decline in commercial property prices. While this problem is serious, there are strategies that commercial mortgage brokers and borrowers can employ to mitigate the cash-flow and financing challenges that lie ahead.

Looming crisis

This phenomenon of maturing loans within a concentrated time frame arises for several reasons. Key factors include a surge of originations during the low interest rate environment of the early 2010s, a tendency among borrowers to lock in favorable rates with longer maturities, and the cyclical nature of the commercial real estate market.

As a result, these loans are now reaching maturity simultaneously, coinciding with a period of higher interest rates and economic uncertainty brought about by hawkish monetary policy. The wall of maturities represents a critical crossroads for the commercial mortgage market, impacting both borrowers and originators.

With so much market turbulence, looming defaults and few deals transacting, one of the most significant concerns is the valuation gap. Lenders are minimizing proceeds and prospective buyers are seeking discounts for asking prices.

There is little middle ground for borrowers to account for debt-service-coverage ratio stresses, leading to reduced loan-to-value ratios and a potential decline in commercial real estate prices. Morgan Stanley estimates that commercial property values could plummet by as much as 40% from their recent peak, which would have a cascading effect on the industry.

Lender reaction

It’s important to note that the impact of these maturities are likely to vary depending on the type of asset. For example, office properties are expected to be hit harder than industrial or multifamily properties.

Responding to the rising default risks, banks are setting aside substantial provisions for loan losses. This approach could make them more cautious about lending money in the future, creating tighter lending conditions. Even the government-sponsored enterprises, Fannie Mae and Freddie Mac, are likely to be impacted, which will further complicate the refinancing of loans.

In response to the increased risk of default, lenders may impose higher spreads on interest rates and become stricter with underwriting requirements. This will restrict leverage and make it more challenging for borrowers to meet the necessary criteria, potentially exacerbating the financing crunch.

For borrowers, current loans with impending maturities also raise concerns regarding stresses tied to increased escrow and cash-reserve costs. As financing becomes scarcer and more expensive, the strain on borrower cash flow and liquidity adds another layer of complexity to the situation.

Mitigate challenges

Mitigating the cash-flow and financing challenges posed by these impending maturities requires a multifaceted approach. Mortgage brokers should communicate openly with borrowers and offer advice to help them successfully navigate the financial risks while also reducing risk to the lender.

First, consider cash-flow management. Borrowers have begun deferring payments and distributions to investors and equity holders to preserve cash, making it easier to meet other financial obligations. Additionally, selling noncore assets (such as vacant properties or underperforming assets) can help raise necessary funds.

Next is asset optimization. To enhance the value of their properties, borrowers must continually evaluate benchmark data for their respective markets. Making capital improvements to properties can increase their values and make them more attractive to potential lenders. Offering competitive rents, strategic marketing and exceptional customer service can further fortify a property’s position in the market.

The third is debt optimization. The dramatic shift in interest rates calls for a fresh approach to debt optimization. Instead of maximizing loan amounts at low rates, borrowers must focus on minimizing new infusions of equity and limiting capital calls to investors. With today’s higher-for-longer rate environment, as well as general uncertainty for both the short and long term of the yield curve, being proactive is essential as continued rate volatility will keep borrowers on their toes.

Running sensitivity analyses based on the forward curve can help borrowers assess their options effectively. If feasible, borrowers should consider fixed-rate loans with shorter terms or cash infusions to buy down interest rates. If permissible, they can seek to extend terms with their existing lender. The latter approach should be tailored to the loan type and lender, with borrowers presenting a compelling case to justify the extension.

Take action

The key to navigating the situation is proactive planning and preparation. Borrowers and brokers should start taking action now to prepare for the impending challenges. Here are a few steps they can take.

• Seek rescue capital. In some cases, borrowers may need to secure rescue capital or new equity investors. This infusion of funds can help address financial shortfalls and provide a lifeline to properties that face financing challenges.
• Plan and prepare. The impending wall of maturities will arrive swiftly, so planning and preparation are critical for borrowers and brokers. As lenders and servicers grapple with increasingly imminent extension and modification requests, maintaining open lines of communication and demonstrating consistent effort will be essential.
• Be realistic. It is crucial to have a realistic outlook on the future of an asset and the owner’s sources of funds. Loan extensions, discounted payoffs and principal paydown options may not be readily available without a well-thought-out plan.
• Stay informed. With attractive loan options limited, mortgage originators should keep clients informed about terms and rates. Defeasance consultants and third-party specialists in debt markets, hedging and interest rate derivatives can help clients create individualized strategies that take their personal circumstances and risk tolerance into account.

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These oncoming maturities are a critical challenge facing commercial mortgage originators and their clients. The potential consequences, from a drop in commercial property prices to a reduction in lending options, are severe and should not be taken lightly. But with proactive planning and the adoption of effective strategies, mortgage brokers can help borrowers mitigate the risks and emerge from this challenging period with their financial stability intact. ●

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“Today, small-business lenders are potentially facing increased costs for expanded data requirements.”

Since the late 1970s, banks and other lenders have been reporting key pieces of information regarding lending practices to regulatory authorities under requirements of the Community Reinvestment Act (CRA) and Home Mortgage Disclosure Act (HMDA). The goals of these programs are to increase transparency in lending and to ensure that banks are meeting the needs of the communities in which they are located.

Today, small-business lenders are potentially facing increased costs for expanded data requirements. The Consumer Financial Protection Bureau (CFPB) has issued a proposed rule for Section 1071 of the Dodd-Frank Act that, when finalized, would require financial institutions to collect and report more information about small-business credit applications.

The draft of the regulation released last year states that the new rules are intended to provide a comprehensive view of small-business lending, and to make sure that banks and nonbanks are serving small businesses fairly. The new rules also call for reporting on minority-owned, women-owned and LGBTQ-owned businesses.

The prospective rules to Section 1071 face various legal challenges, some of which argue that the proposal is too burdensome and expensive. At the same time, there is a congressional push to block the CFPB’s proposal, with the House and Senate recently passing a joint resolution to overturn the new Section 1071 rules. President Joe Biden reportedly intends to veto the legislation.

Automation efficiencies

Whatever the final rule requirements end up being, it appears that more scrutiny of small-business lending data is on the way. This has resulted in many bank and nonbank lenders turning to data validation automation as an alternative to scaling up compliance and quality control teams.

Recent legal challenges may have put the timing of the final ruling in flux, but preparation is still crucial for financial institutions. They must address increased regulatory requirements in a challenging macroeconomic environment that also demands finding creative ways to cut costs and become more operationally efficient.

Confidence in data accuracy is key for the preparation to comply with Section 1071. Bank and nonbank lenders should assess their current workflows, identify any gaps — including their ability to collect data — and identify any limitations in their current business systems. It is vital to understand the capacity, constraints and requirements for 1071 reporting while also understanding the organization’s banking systems and how data is currently collected and stored.

A common challenge for mortgage lending workflows is having an efficient way to request and organize borrower documents into a loan origination system (LOS). Automation can ease the inefficiencies tied to document organization by automating the classification step. This will help ensure that documents are in the right place and allows the system to automatically place documents in folders, repositories or loan origination systems. Many times, documents are received and combined into one file, such as a large PDF format, that must be broken down into individual sections and filed into their correct digital folders.

Furthermore, loan processes often require manual “stare and compare” of borrower documents. In other words, mortgage professionals are forced to look at documents side by side and visually discern the differences. This method leads to mistake-prone loan documents, frustrated borrowers and lengthy processing times.

Decreasing manual steps

Automation drastically decreases the time spent on manual labeling, sorting, stacking and reviewing of loan packages, and it eliminates manual data entry. It provides a lift for the underwriting team by automatically extracting key information from small-business financial documents, including tax returns, and allows for faster credit decisions.

Automated loan processing and onboarding, in addition to the collection and validation of data, simplifies downstream audits such as preclosing and post-closing checks. It will also help with compliance audits from HMDA, CRA and the expected regulations in Section 1071 of the Dodd-Frank Act.

Machine learning can automatically extract key data from loan packets, check for missing information or signatures, and compare it to the system of record. It can also make sure the data is congruent across both the systems and final loan package.

The automation process can take these audits even further by triangulating data points across multiple sources. For example, in the case of a compliance audit, data validation processes will be expanded to look at the documents, the LOS, a document repository and, ultimately, a compliance report such as the CRA loan application register or a future Section 1071 loan application register. The method ensures higher-quality reporting, storage of documents and accurate data across multiple systems.

The typical time and cost savings from automated commercial mortgage lending improves margins by cutting expenses on a per-loan basis. As time spent on tasks decreases dramatically, so can the cost per loan. This will allow financial institutions to position themselves to be fully prepared for audits, changes in the market and expansion opportunities. It will also speed up the adoption of changes in regulatory requirements by creating a completely scalable compliance review and reporting process.

Managing labor costs

To satisfy upcoming CRA modernization and Section 1071 requirements, commercial mortgage lenders are faced with the option of greatly increasing the size of their teams (and adding the associated costs) or investing in automation for a fraction of the cost. Not only can automation easily find, consolidate and track reported data points under the expected requirements to comply with Section 1071, but it also allows lenders to retain key compliance employees while attracting new and experienced compliance professionals.

Compliance professionals carry the heavy burden to report accurate data, which can lead to mountains of manual data reviews. Such work can create a vicious cycle of burnout and rising costs. There is a significant amount of change management required for institutions to train commercial mortgage originators, underwriters and others to ensure all data points are collected at application.

The use of automation drastically reduces human errors, providing data integrity and confidence in meeting regulatory requirements. Consequently, compliance professionals can focus on higher-value tasks and lenders can avoid investing in additional compliance personnel in a challenging labor market. Efficiencies created by automation bring cost savings across the commercial mortgage lending process, supporting loan growth without the need to hire additional employees.

Avoiding risk

The legal fight involving Section 1071 will most likely be decided by the U.S. Supreme Court. However the case ends, there still exists a ticking clock for commercial mortgage lenders to prepare their data for the level of accuracy required to meet government regulatory criteria. If the data is not properly managed, prepared and presented, it could adversely affect lenders through reputational risk and large fines.

Risk mitigation is undoubtedly the most important aspect of increased compliance regulations. Future-proofing with automation allows for a full loan review instead of having to use a risk-based approach of sampling. Automation reduces false positives by limiting human interference, so humans only look at exceptions instead of all documents, further decreasing risk for the institution.

The automation of compliance with CRA and Section 1071 regulations ensures high rates of accuracy. Consequently, financial and reputational risks are mitigated by ensuring that fair lending analyses are conducted with accurate and timely data.

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As lenders cautiously prepare for future regulations, a solid foundation of automation will provide them with the confidence needed to emerge from the new regulatory requirements with more efficient methods of operation. Financial institutions owe it to their customers and employees to be ready for the changing regulatory environment. Those that adapt with new ways of solving challenges will emerge with a competitive advantage in the world of small-business lending. ●

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