By Michael Holling
Managing Director-Associated Bank
As we look back on 2013, it was another year of fits and starts for the economy and, by extension, for the Midwest commercial real estate sector. The broader economic recovery continued its slow and uneven pace, inhibiting any prospect for a dramatic CRE rebound. However, while slow, the pace of economic recovery has been significant enough to generate increased interest and activity in key areas of the commercial real estate sector. In fact, we expect an increase in commercial real estate capital funding overall in the coming year, primarily from traditional capital providers, with some notable movement among ancillary players.
First, where will the capital be headed? The most significant new construction financing activity is likely to continue to be in the multifamily sector. Associated Bank syndicated more than 20 commercial real estate transactions in 2013, more than 50 percent of which were construction loans for apartment projects. Multifamily also accounted for more than 40 percent of our new commercial real estate loan activity in Chicago in 2013, and we continue to see significant capital demand for new projects in this sector. We anticipate other property types to draw increasing attention from investors in 2014 as the economy continues to recover and institutions begin to broaden the scope of their lending activities. That includes the hospitality sector, evidenced by numerous hotel projects cropping up in and around Chicago’s Loop. Recently announced proposals include the Residence Inn by Marriott at 11 S. LaSalle, the Hyatt at 28 N. Franklin and the Godfrey Hotel at 127 W Huron. The retail segment is exhibiting some new signs of life too, such as Mariano’s planned expansion throughout the Chicago area. Suburban Chicago office properties are generally expected to continue their very slow recovery, while the downtown market will likely continue to get tighter, as traditional buildings are retrofitted for other uses (such as the aforementioned hotels), which could justify financing for new development in this space.
In addition to activity in Chicago, healthy markets in our upper Midwest footprint including Minneapolis, Indianapolis, Cincinnati, suburban Detroit, St. Louis, Milwaukee and Madison will remain active, particularly in the multifamily sector. The pace of activity in these and other secondary markets will be slow but consistent. While the recovery in certain coastal areas has been more substantial, this is consistent with the relative volatility these areas have exhibited in past cycles.
Sources of commercial real estate capital funding in 2014
According to the Federal Reserve through Q3 of 2013, banks continued to account for more than half of the funding for commercial real estate ventures in the U.S. Look for banks with improved balance sheets and increasingly healthy loan portfolios to demonstrate renewed eagerness to lend. Many banks still have meaningful capital on hand that they’re eager to deploy, though we will likely see a shift in how new deals come together. While some banks will see the increasing interest rate environment as an opportunity to increase profitability, expect many to tighten spreads in order to be more competitive, providing an opportunity for borrowers.
The increased competition may manifest itself in a slight loosening of lending parameters among various institutions. Expect terms to remain considerably more conservative than those that existed in 2007, but banks will also be looking at new opportunities outside of blue-chip deals. Developers in secondary markets, those interested in non-institutional property types or those seeking financing for some non-traditional deals, may see increased interest among commercial banks.
Following the commercial mortgage-backed securities (CMBS) market’s decline in the wake of the financial crisis, insurance companies stepped in and significantly increased their investment in commercial real estate, a trend that continues. As such, we expect to see increased commercial real estate funding activity from insurers this year as well. Their focus will continue to be longer-term (i.e., 5-plus years), high-quality debt. While the CMBS market has struggled post-crisis, and we do not expect a near-term return to pre-crisis levels of funding, we do anticipate CMBS issuers will play an increasing role in 2014, particularly as investors seek higher-yield investment alternatives in a sluggish economy.
The balance of 2014 CRE capital funding in the Midwest – less than 20 percent according to the Federal Reserve –will come from a variety of other players, including REITs, private equity funds, pension funds and foreign investors. REIT activity has increased year-over-year for the past three years, and it may slow slightly from the quickened pace of 2013 since many refinancings have already occurred. We also expect an uptick in foreign investment, though this will primarily benefit first-tier markets such as Chicago and the coasts. Finally, we also anticipate more activity among private equity firms, as well as certain pension funds.
Much of the Midwest region’s expected activity for 2014 will be driven by pent- up demand due to the slow economic recovery. The availability of funding will be contingent on the recovery maintaining a positive trajectory. Any significant steps backward could have a cooling effect on commercial real estate investment. However, we are optimistic that the recovery will stay on track based on the stable market fundamentals through much of the Midwest region, which should offer lenders and borrowers plenty of opportunity for a fruitful 2014.
Michael Holling is a Managing Director and Head of Loan Syndications for Associated Bank N.A.