Lenders, Investors See Opportunity in California’s Secondary, Tertiary Markets

California Centers Magazine

The top investors in any market have the greatest advantages: they can handle the most risk, carry the most clout and outbid their competitors.

In a down market, they can either bide their time on the sidelines or roll the dice on a few spicier deals. In an up market, it’s get out of their way. But where does this leave the rest of the players? Namely, the smaller guys who don’t necessarily want to compete with these behemoths, but would still like to cash in on what many consider to be an equitable market?

If they’re savvy retail investors in 2015, they’re looking to CMBS lenders to fund the purchase, refinancing and/ or redevelopment of shopping centers in secondary and tertiary markets. This play is particularly poignant in California, where competition for supremely located properties has been- and likely always will be extremely fierce.

CMBS lenders are very interested in lending on assets throughout California, including secondary and tertiary markets,” says Gregg Applefield, director of the Debt & Equity Finance Group in Mission Capital’s Newport Beach office. “Based on California’s strong demographics and growing employment market, fundamentals across commercial real estate assets in most markets are continuing to improve. Additionally, due to the fact that there continues to be limited to no new construction, lenders are encouraged to finance existing assets, and believe they will continue to remain competitive for years to come.”

Though the CMBS market hasn’t quite hit its 2007 peak, when Trepp says 38lenders generated $230 billion, recent market data shows this market is picking up steam at a rapid pace. Not only are the big players, such as J.P. Morgan Chase and Deutsche Bank, still completing issuances left and right, but the smaller guys are getting in on the action, too. Trepp notes there are currently 23 companies with a market share of less than 2 percent. This is up from only 18 smaller CMBS lenders in 2013.

New CMBS issuances ha ve totaled $73.7 billion as of early November 2014. Trepp also notes retail was the best-performing property type, with a delinquency rate this past April of only 5.6 percent. Mortgage originations for retail properties also increased by 11 percent in the third qua rte r of 2014 ‘ “‘hen compared to just a year earlier, according to the Mortgage Bankers Association.

With about $65 billion in CMBS loans set to mature over the next 12 months – and the Urban Land Institute and Ernst & Young estimating about $88 billion-worth of CMBS issuances will close out 2014- the market is primed for retail players who want to make a move.

Experts point to the Inland Empire, High Desert, Central Valley and Sacramento Valley as the regions ripest fur opportunity.

“We expect substantial sale transaction and CMBS volumes in Southern California’s Inland Empire through 2017 or 2018,” says Philip D. Voorhees, senior vice president in CERE’s Newport Beach office. “This market enjoyed tremendous growth in the last cycle, and many of the loans issued on these properties were CMBS and for a 10-year term. Considering the cost of housing per square foot relative to average household incomes, the Inland Empire provides a compelling value proposition. This will drive residential growth and fortify this already strong trade area’s fundamentals as density increases.”

One recent deal to come out of this market was the $3.8 million refinancing of The Hub, a 12,700-square-foot retail property in San Bernardino. The center is located at 1060 Harriman Place, adjacent to a Sam’s Club, near Interstates 10 and 215. The new loan features a 10-year term and a 30- year amortization structure. It was arranged this past November by David Blum, senior vice president and

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senior director in NurthMarq Capital’s Newport Beach office, through the firm’s relationship with a CMBS lender.

“We were able to close despite a dark anchor tenant,” Blum says. “The tidal wave of CMBS loan maturities is starting now. If a borrower requires higher leverage, coupled with non-recourse financing, CMBS is the likely candidate. With today’s current low interest rate environment, coupled with the ability to get an interest-only period, this is an extremely attractive product type for borrowers. The CMBS product is ideal for secondary and tertiary markets not only in California, but nationally.”

Less competition and a willing source of creative financing are two obvious factors that make California’s secondary and tertiary markets so appealing to smaller investors. Though there are still plenty of deals to be had, the scurry is definitely attracting attention.

Total investment volume in major markets fell by 12 percent in the first quarter of 2104, compared to the first quarter of 2013, according to Rea 1 Capital Analytics. This volume rose by 20 percent, however, in secondary markets, and by 32 percent in tertiary markets, over the same period. Retail also experienced the most growth out of the four sectors, increasing by 71 percent and 60 percent in secondary and tertiary markets, respectively.

Voorhees believes there is more to this trend than a simple case of available financing and a more balanced playing field.

”More so than in urban or infill areas, properties in secondary and tertiary markets pushed the ‘reset’ button in the last cycle,” he explains. “Tenants that should fail did. Rents for struggling tenants were reset, and strung performers emerged as category leaders. Consequently, many comparatively new assets – built in the last cycle – in secondary and tertiary markets are valued at or below land-inclusive replacement cost. To lenders and investors, strong assets in these markets feel solid.”

Centers that received facelifts within the last cycle have also warranted a second glance from investors and lenders. The 104,811-square-footSierra Commons community shopping center in Palmdale, a High Desert community about 60 miles north of Los Angeles, Was built in 1994 and renovated in 2005. It boasted a 90 percent occupancy and a tenant roster that included Ashley Furniture, Michaels, BevMo!, Coffee Bean & Tea Leaf and Pacific Dental when the center’s leasehold-interest was sold in late September 2014 to an investment group led by Progression Real Estate Investments for $18.3 million.

The seller, Grae Palmdale Landlord LLC, was represented by Patrick G. Kent and William B. Asher of Hanley Investment Group (HIG).

“It’s historically been one of the best locations for retail in the Antelope Valley,” says Kent, a senior vice president at HIG. “Sierra Commons is ideally situated between the Antelope Valley Mall and 14 Freeway – that’s ‘Main and Main’ for the entire Palmdale/ Lancaster area. It’s fundamentally great real estate. We were able to procure a highly qualified 1031 Exchange buyer that understood the leasehold characteristic of the property and was capable of assuming an existing CMBS loan with over 11 years remaining.”

Location and a strong tenant roster also played roles in the July sale of the 48,324-square-foot Maywood Village Square convenience strip center in the third-smallest incorporated city in all of Los Angeles COtmty. Located in the county’s Gateway Cities region, the 1.2-square-mile Maywood may be a far cry from some its bustling county brethren, but it presented a solid opportunity nonetheless.

A new tenant, Fib1e55 19, had just agreed to lease 9,000 square feet at the property, bringing Maywood Village’s occupancy to 94 percent. The health club joins other notable retailers like O’Reilly Auto Parts, Subway, US Bank, Yoshinoya and Western Dental Services.

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The asset was acquired for $11.5 million by a high-net-worth, locally based private investor who targets infill retail assets in Los Angeles County. The buyer, represented by Voorhees and the National Retail Investment Group – West team, assumed a non-recourse CMBS loan maturing in October 2013. The in-place loan provided excellent principal reduction thanks to its 25- year amortization schedule, according to Voorhees. He and his team also represented the center’s developer and seller, Watt Companies. The loan also eliminated the near-term interest rate risk exposure that comes with a maturity date of October 2030.

“Maywood Village Square is the quintessential LA County bread-and-butter strip center,” says Voorhees. “It’s a hard corner location with owned pads and synergy from a nice mix of restaurant, retail and service tenants, which make the property a very dependable, long-term asset.”

Voorhees said that the higher loan-to-value and non-recourse attributes of the CMBS financing appealed to the buyer.

“The above-market interest rate on the existing financing provided a higher cap rate and a higher yield opportunity for the buyer, a conservative investor with a long-term investment horizon,” he says. “For this investor, the fully amortizing loan fit perfectly.” If the recent past is any indicator of future performance, “the perfect fit” may just be the appropriate term to describe the blending of alternative lending vehicles with California’s secondary and tertiary retail markets.

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