TREB | Capital Providers Crowd into Texas

www.REBusinessOnline.com

July 2014 • Volume 10, Issue 5

INDUSTRIAL MARKETS ARE HUMMING

DFW’s industrial vacancy is at historical lows; Houston’s industrial boundaries are expanding due to land prices.

Interviews by John McCurdy and John Nelson

PM Realty Group is developing Westchase Park II, a 300,000-square-foot speculative office building in Houston on behalf of Clarion Partners. Completion is expected late this year. While lenders have become more aggressive in Texas, they’re wary of financing pure speculative office, which requires developers to finance projects themselves.

Capital Providers Crowd Into Texas

Several factors have led to generous financing terms for commercial real estate investors and developers.

By Joe Gose

B

y all accounts, commercial real estate values in Texas have largely surpassed their peak before the financial crisis. So far, however, that hasn’t persuaded debt providers to use anticipated rent increases or other aggressive underwriting tricks to justify high debt amounts — the likes of which fueled the valuation bubble in first place.

But it’s hard to argue that lenders are remaining buttoned down.

Mortgage bankers and other observers say that loan terms are as good as anytime since the financial crisis, as the availability of interest-only payments, mezzanine debt and other borrower-friendly terms continues to grow.

“The capital markets are pretty flush with equity and debt,” says Del Kendall, a managing director in the Houston office of Real Estate Research Corp.

(RERC), a national commercial real estate research valuation and consulting firm. “We see a lot of bidders for properties and many cranes on the horizon.”

Inside the Numbers

Commercial property investment sales in Texas totaled $12.7 billion through the first five months of 2014, according to Real Capital Analytics. So far, that’s off the pace of the $40 billion that traded hands during 2013, thanks largely to a lack of available product, say observers.

On average, capitalization rates across all property types dropped in the first quarter this year from the same period in 2013 in Houston, Dallas and Austin, according to RERC. In Dallas, for example, the cap rate for office buildings in the central business district averaged 6.8 percent during the first quarter, a year-over-year decrease of 70 basis points.

Additionally, roughly 8.4 million square feet of industrial space and more than 15 million square feet of office space are under construction or close to breaking ground in Houston, Dallas and Austin, according to Jones Lang LaSalle.

B

enefitting from a central U.S. location and a bustling economy, the industrial markets in Dallas/Fort Worth and Houston are faring well with strong fundamentals and even some speculative construction in key submarkets.

Dallas/Fort Worth’s vacancy rate is at its lowest point in the last several years, with powerhouse companies such as P&G and LG expanding their footprint by more than 1 million square feet in the Metroplex in recent months.

Likewise, in Houston large companies are leasing space in top submarkets, and several third-party logistics firms are laying down roots in the city’s upand-coming submarkets. The booming population and job growth in the market are driving up land prices for development as well, which have forced developers to expand their sights to submarkets on Houston’s periphery.

To get a better glimpse into the two industrial markets, Texas Real Estate Business recently conducted interviews with Jeff Thornton, senior vice president of Duke Realty’s Texas operations, and John Talhelm, senior vice president of JLL’s Houston office. The following is an edited interview: Texas Real Estate Business: Of all the reasons that Texas is such a hot market right now, which macro trend is having the largest effect on your local market’s industrial property sector? In what tangible ways have you seen the market change as a result of that macro trend?

Thornton: Our central location in the United States and our growing population are a strong one-

see CAPITAL, page 20

see INDUSTRIAL, page 22

INSIDE THIS ISSUE First phase of CityPlace in Houston will include 440,000 square feet of office space. page 13

Retail Snapshot: Houston Market page 16

Student Housing: San Antonio page 17

Anticipating Growth in Data Centers page 18

Capital Providers Crowd Into Texas Determined Debt

CAPITAL from page 1 Build-to-suit projects account for a healthy portion of the office deals, such as ExxonMobil’s 3.5 millionsquare-foot campus near The Woodlands submarket in Houston. But any pre-leased office project in Dallas in which more than half of the building is still available is also finding construction financing for up to 70 to 75 percent of cost, a departure from the recent past, says William Ross, president of NorthMarq Capital.

“Today, construction lenders will take a bet on an office building that’s 30 percent pre-leased,” he says. “You probably couldn’t get that done 18 months ago.”

That’s in the face of an average vacancy rate that had dropped to 22.9 percent during the first quarter, just 50 basis points lower than it was at the end of 2012, according to real estate research firm Reis.

Back then, lenders typically avoided making construction loans for office buildings with substantial empty space due to a lack of confidence in the leasing market and overall economy, adds Ross, who is based in NorthMarq’s Dallas office.

To a large extent, the growing aggressiveness among lenders in Texas mirrors a nationwide trend amid historically low interest rates and growing competition between CMBS conduits, government-sponsored enterprises, banks and insurance companies.

The commercial mortgage-backed securities (CMBS) market has played a significant role in the improved lending landscape, mortgage bankers say, even though securitizations aren’t rebounding as fast as hoped. U.S. CMBS issuance totaled $28.4 billion through the end of May, $6 billion off the pace set at the same time last year, according to New York-based Trepp.

Nevertheless, CMBS lenders are offering cash-out refinancing, fullterm interest-only loans and floating interest rates on mortgages as long as seven years, say mortgage bankers, which has put pressure on other lenders to become more competitive.

Those observations are on par with findings that 57 percent of permanent loans completed during the first quarter of this year included interest-only payments for part or all of the term, up 10 percentage points from the fourth quarter of 2013, according to CBRE’s June 2014 U.S. Lender Forum.

Eighteen months ago, you could get a year of interest-­only payments, and now it’s available for the full term.

— Brant Smith, senior vice president in the Austin office of Berkadia

This spring, for example, an affiliate of New York-based Interventure Advisors borrowed $80 million from Goldman Sachs Mortgage Co. to refinance debt on the 420,000-square-foot Three WestLake Park office building in Houston’s Energy Corridor, according to a prospectus for a $1 billion CMBS pool filed with the Securities and Exchange Commission.

The mortgage featured a loan-tovalue (LTV) ratio of 66 percent and an interest rate of 4.6 percent. The owner is making interest-only payments for the first half of the 10-year term, and it also used the proceeds to make distributions to investors in the fully occupied building.

“Eighteen months ago, you could maybe get a year of interest-­only payments, and then it turned into two,

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then three and five, and now it’s available for the full term,” says Brant Smith, senior vice president in the Austin office of Berkadia. “Certainly it has become more prevalent, which has made everyone else step up.”

Still, lenders aren’t as agnostic as in the past, especially when providing interest-only payments are for a loan’s entire term, adds Wally Reid, senior managing director in the Houston office of HFF. “It’s only available for the newest and well-leased buildings in core locations — the best apartments, industrial deals, office project or grocery-anchored retail deal,” he says.

“Back in 2007, there was no distinction between the class and location of properties.”

Meanwhile, a growing number of mezzanine lenders are also becoming more active, according to Reid and Smith. Depending on the sponsor, property and location, borrowers may be able to secure a first mortgage with a LTV ratio of 75 percent and use mezzanine debt to raise the total LTV to 85 percent or higher.

In that scenario, mezz lenders would typically charge an interest rate of 11 to 13 percent, says Smith, and the borrower would have a blended rate of approximately 6 percent. “It’s a very competitive space, and every mezz lender is looking to increase the amount of business this year over last year,” he says.

I N C .TM

While lenders have become more ambitious nationwide, much of the country lacks the job creation engine that Texas enjoys. The Eagle Ford Shale formation in the south central part of the state fuels a boom that is bolstering Houston as the global energy capital of the world, while financial and technology firms drive more diverse economies in Dallas and Austin.

During the 12-month period that ended April 30, Dallas-Forth Worth added 106,800 jobs and Houston added 82,300, placing both in the top 10 employment growth markets in the country, according to Marcus & Millichap, based on data from the Bureau of Labor Statistics. Austin added nearly 30,000 jobs during the same period.

Add to that momentum a pro-business and affordable living climate,

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If you look across the country and what’s really leading the recovery, I call it the ‘Two T’s’ — one is technology and the other is Texas. We are making a conscious bet on the state.

— Tim Wang, a director and head of investment research at Clarion Partners

and it’s no surprise that commercial real estate capital is targeting the state. Foreign investors, for example, ranked Houston as the fourth most attractive global city for investment in 2014, according to an annual survey conducted by the Association of Foreign Investors in Real Estate (AFIRE).

That’s a notch better than 2013, says the Washington, D.C.-based trade group, which has a membership that holds more than $2 trillion in real estate assets.

New York-based Clarion Partners, a real estate investment adviser with more than $30 billion in assets under management, has been bullish on Texas for at least a few years.

Clarion Partners paid $255 million for a 50 percent interest in the 1.7 million- square-foot Wells Fargo Tower in Houston in 2011. The real estate investment firm has built a portfolio of 35 million square feet valued at more than $2.2 billion in the state.

“If you look across the country and what’s really leading the recovery, I call it the ‘Two T’s’ — one is technology and the other is Texas,” says Tim Wang, a director and head of investment research at Clarion Partners.

“We are making a conscious bet on the state.”

Indeed, among other endeavors Clarion Partners is nearing completion of Westchase Park II, a 300,000-square-foot speculative office building adjacent to its fully occupied Westchase Park I office structure in Houston. Lenders aren’t interested in financing speculative office unless it is substantially pre-leased, so Clarion Partners is funding the building with cash, says Wang. PM Realty Group is providing development services for the project and leasing it.

In May, the investment advisor targeted the Austin commercial real estate market by acquiring two office buildings totaling 171,872 square feet and a 59,546-square-foot single-tenant retail property occupied by Whole Foods Market.

Houston Apartment Froth

Clarion Partners is avoiding core apartment properties in the Houston market, a segment that has become too frothy even though the real estate fundamentals are still strong, says Wang. Indeed, the going-in cap rates

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for apartments ended the first quarter at 5.8 percent, a year-over-year decline of 40 basis points, according to RERC. Moreover, recent sale prices for the better apartment properties reflect an average cap rate of around 5 percent, says Kendall of RERC, and some core properties have traded below that figure. He acknowledges that some would-be buyers are sitting on the sidelines due to the rich environment.

“That’s pretty aggressive,” says Kendall. “Houston is in new territory.”

Additionally, construction lenders are becoming wary of the Houston apartment market, especially when it comes to projects exceeding $30 million, mortgage bankers say. Banks with multifamily construction loans

on their books today are more cognizant of their exposure than they were before the financial crisis, says Reid of HFF. “If bank X makes an apartment construction loan in a submarket, it’s going to think long and hard before making another one in the same market until the first one gets leased up,” explains Reid.

Roughly 13,700 apartment units have been completed during the last three years in Houston, according to Reis. But as many as 34,000 new units could be completed over the next two years, according to Richard Campo, CEO of Camden Property Trust, which owns 59,641 multifamily units primarily in the Southeast, Southwest and Washington, D.C. The REIT’s Houston apartment holdings represent 14 percent of its portfolio.

At the same time, he says, developers are confronting higher land prices, labor shortages and construction costs that are climbing faster than rent growth. Subsequently, it can take 16 to 20 months to complete a project instead of 14 months, which along with higher building costs can eat into a developer’s return, says Campo.

That should eventually slow development, he adds.

Still, Campo points out that multifamily construction dissipated dur-

ing the Great Recession even though Houston didn’t suffer economically as much as other cities. What’s more, roughly 4,000 to 5,000 older units have been removed from the market this year, primarily to make way for higher-density apartment projects.

So far, the new units are getting absorbed thanks to strong tenant demand. Houston’s average apartment vacancy rate stood at 5.5 percent during the first quarter of 2014, down 50 basis points from the fourth quarter of 2013, according to Reis.

In 2013, the average asking rent rose 4.2 percent from the previous year to $876 per unit.

Campo forecasts that Camden’s revenue growth in the Houston market will be around 4.5 percent this year despite the new supply. The metro area is expected to add 90,000 jobs in 2014 after adding nearly 200,000 during the past two years. As a rule of thumb, he says, five new jobs generate demand for one unit.

“We’ve been in an apartment shortage position in Houston for the last two-and-a-half to three years, and we’re probably still in that position,” he says. “As the economy improved, we weren’t building enough units to fill the demand that was being created by jobs.” n

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Frank Heifrin, CCIM, Broker (979) 696-1444 | fgh@stalworth.com Texas Real Estate Business • July 2014 • 21