Banking into the Teeth of the Storm

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How will you compete?

In this business segment, being consistently reliable and responsive are ways to differentiate yourself. Like some other regional banks, we are focusing on the relationship segment of the business, so it is important to identify clients who value execution and will do repeat business. A successful relationship is one where both parties understand the other’s business and what each side needs to make a deal work. Even with existing relationships, you can’t win all deals. We will win one in three or four. We are targeting opportunities where we think we understand the markets, are comfortable with the sponsor and can propose a structure that mitigates the risk we see. So if someone comes to me and says, ‘I have a San Mateo apartment project, and it’s stabilized and I need a 10-year loan,’ I know commercial bank money is not the most competitive. If he comes to me and says, ‘I just bought a 30-year-old apartment project, and we want to upgrade it and put in another 30 percent,’ that is a situation where I can compete. What I have observed is that depending on the market and the sponsor, you find out which lender is hungrier for the deal.

Compare the lending environment now to before the bust.

Competition is still fierce for good projects, but the underwriting is still more conservative as mostly expressed in equity-to-debt ratios. Developers have now accepted that a bank may be unwilling to go above 65 to 75 percent loan-to-value. Everyone recognizes that leverage levels above 75 percent caused a lot of stress for both lenders and borrowers in the last downturn.

The deals are more focused on re-margin rights, recourse and pricing. Re-margin rights give the bank the ability at some point during the loan term to re-appraise the project in case market conditions changed in any way that might affect the property’s value or cash flow at maturity, and both parties agree that the borrower might have to write a check for more equity. I am looking at my point of exit. Who is going to take you out of your loan? The next lender has to make sense of the deal.

The good news is a great deal of equity capital is available for any good sponsor and good project. As long as real estate continues to offer higher yields compared to other options, I don’t think developers will have much difficulty raising equity capital.

How hard is it to get repayment recourse?

It depends on the project but generally speaking, construction projects require recourse, while stabilized, low-leverage income properties in good markets do not. Completion guarantees are not an issue; I am not aware of any lender that embarks on a construction loan without a guarantee that a borrower will finish a building as agreed. The worst outcome for us is a half-finished project. The negotiations tend to focus on how much repayment recourse the bank needs: 100 percent? 50 percent? Do you start at 100 percent recourse and go down? That is the judgment part, where the relationships come in.

Recourse can be a real pain point [for borrowers], but I’m not sure that anyone has come up with another way to mitigate the risky end of the deal spectrum and still use debt. The properties we see most often are transitional plays, and that segment is riskier by definition. Repayment recourse is the lender’s last line of defense to prevent loss because the real estate by itself doesn’t always. You can be so conservative that you never win a deal and be right, too. I am looking at the macro picture, the U.S. debt, the money printing and inflation, and the lack of national job growth, and reconciling that with underwriting a local loan to a good sponsor. Recourse from a strong sponsor helps bridge that gap.

How many players are swimming in the pond of borrowers?

Before the downturn, there were a lot of active private regional developers. Some have retired. Some are doing smaller deals. Others are putting in more institutional capital. On the whole it is a smaller group than it used to be, but I think it is growing again. At this stage of the recovery, we need to look at some of the younger players if we are looking at the long term.

What types of projects are you seeing?

Basically, a little bit of everything: office and apartment construction; industrial refinance, retail refinance and some for-sale development requests. Given the strength in Silicon Valley, many investors are buying office and [research and development] properties to take advantage of increasing rents and leasing. Since many of these projects have leasing risk with tenants potentially leaving, they are good candidates for shorter-term bank loans. We have quoted on several apartment construction loans, which tend to have more aggressive structures and pricing given the strong underlying fundamentals. I am still bullish on multifamily in the Bay area over the long term.

What deals are you doing?

We have a speculative office building on University [Avenue] in [downtown] Palo Alto, a construction loan for an apartment project in Oakland, plus many acquisition loans. Right now there is more demand for rehabs versus new construction. Rents have moved up in San Francisco and Silicon Valley, making a lot of this activity attractive for developers and investors; the question is, will rents keep going up or at least remain at these levels? The lead-time to buy, renovate and lease is anywhere from 12 [months] to 18 months. As a lender, you always worry about what could go wrong during this period. What if we experienced another downturn? Is it a 10 percent drop in rents or 30 percent? It’s the balance between potential downside and winning a deal. My job is to identify risk and underwrite it. With razor thin margins, banks can’t afford to lose principal.

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