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Joe Cavaluzzi is contributing editor of Real Estate New Jersey, from which this article is excerpted.

While capital remains plentiful for New Jersey commercial real estate, it is more expensive than a year ago and underwriting terms have tightened. A number of economic and market factors have made the sources of capital–both debt and equity–more conservative.

For one, office market fundamentals have been lackluster with overall vacancy for Northern and Central New Jersey remaining around 17%, and substantially higher in some key submarkets. Unemployment is up slightly from a year ago and the office jobs being created of late seem to be focused along the Hudson River waterfront. Interest rates, while they’ve backed off a bit recently, are significantly higher on the short end than they were a year ago.

As with all changing markets, that which creates pain for some creates opportunity for others. While those on the fringe–the small private investors and borrowers with floating-rate debt–may be hard-pressed to find favorable interest rates when they refinance, hedge funds and opportunistic lenders are poised to take advantage of that distressed debt. This year, the capital available for commercial real estate may be defined better by anomalies than normality.

Traditional investors have not turned away from commercial real estate even though the spreads between interest rates and the five- and 10-year Treasuries have shrunk almost to the point of disappearing. For real estate brokers, opportunity in this market has come from corporate dispositions as well as economic growth.

And while the Fed and many economists insist the US economy is strong, some in the real estate finance business are gearing up for increasing loan defaults and bank workouts. To paraphrase one attorney specializing in foreclosure law, the real estate and finance markets are closely tied, and after five years of seemingly unstoppable growth the commercial real estate markets are about to run out of steam.

On the surface, real estate capital seems unchanged. Despite the fact that vacancy rates haven’t changed dramatically since 2002, money continues to pour into New Jersey commercial real estate. Jahn Brodwin, the partner in charge of Schonbraun McCann Group’s New York office, is one who says that little has changed in the availability of capital over the past year.

“It’s available in all different shapes. The equity stack is deep,” Brodwin says. “The traditional hedge funds are making a bigger foray into the real estate world. They tend to be more open ended than traditional real estate funds so people have the ability to go in and out as they need to. That’s not new but they are more relevant now.”

Cushman & Wakefield is enjoying a fourth record year in investment sales, even though the underlying fundamentals in New Jersey office real estate haven’t been strong, according to Andy Merin, vice chairman of Cushman & Wakefield of NJ and head of its capital markets group. The group had closed 34 investment sales of properties 100,000 sf or more with a total value of $1.8 billion through August and had another $1 billion worth of properties on the market. That’s comparable to last year’s 58 sales worth $2.9 billion and twice the volume and value of the firm’s 2002 investment sales.

“The sources of capital haven’t changed dramatically,” Merin says. “We see opportunity funds, real estate advisers–typically pension money–REITs and, for the right product, foreign investors.”

So far, recent interest rate increases haven’t had a great impact, but the potential to cause pain is very real for some investors and borrowers. “Rising interest rates are more likely to hurt private investors,” Merin says. “We’re approaching the point of negative leverage, where the cap rate you buy the building at is lower than the interest rate you have to pay for the loan. Plus, if and when interest rates start to move up, alternatives to real estate start to look better. We’re also seeing banks get a little tougher in their lending terms, in their requirements for reserves, in tenant rollover and in the amount of principal they lend.”

For private local investors the fact that higher interest rates and limited property offerings haven’t stemmed the flow of capital in the state’s real estate markets is making life more difficult.

“Unfortunately, the rise in Libor rates has had no impact on the funds flowing into real estate, particularly from the institutions, the real estate funds and fund advisers,” says Gary Sopko, managing director capital markets/acquisitions for Advance Realty, Bedminster. “So even though we’ve seen a rise in short-term interest rates and a much less dramatic increase in long term, it’s making it more and more difficult for us to be competitive. Three or four years ago, we always managed to be in that final group [of potential buyers] and we probably closed on more deals.”

Advance, which has bought out its institutional partners over the past several years, has relied on joint ventures to enhance its competitiveness. That took the company through last year. Since then, however, Advance has been able to make only one acquisition.”That was on a direct basis. We went to the ownership and offered what we felt was a fair price and a very short due diligence process in order to take that asset off the table,” Sopko explains.

And as far as the interest rate impact, one is that increasing rates have helped shrink the spread between cap rates and Treasuries. In early September, the one-year Libor was at 5.4%, up 1.44 percentage points from a year ago. The spread to five- and 10-year Treasuries was just over .6 of 1%. Meanwhile, the CMT index, the Fed’s index of a variety of Treasuries, was at 5.08%.

The real estate risk premium over five- or 10-year Treasury bills has probably been squeezed to half of what it was five years ago, according to Sopko, and deals with spreads of only 200 basis points are not uncommon now.

It takes a little longer for interest rates to affect commercial real estate than residential, but many in New Jersey’s commercial markets see problems coming when current loans come due and owners can’t get terms to refinance them as favorable as those available to them three to five years ago.

“We do a lot of work in CMBS and people in that arena tell me there are a lot of loans that are going to be maturing over the next several years. There are going to be a lot of loans that have problems,” says attorney Scott Tross, a partner in the Newark office of Herrick, Feinstein LLP. “The CMBS market is a little over 10 years old, but it seems to get bigger every year.”

Tross, who several years ago authored a treatise titled “New Jersey Foreclosure Law and Practice,” expects to see an increasing number of defaults and real estate workouts, although today both are at historic lows. That increase in defaults should put more properties on the market and drive property values down to some extent.

“I don’t think anybody expects that the commercial real estate market will fall apart,” he says. “But it’s fully valued right now and it wouldn’t surprise anyone if the prices come down a little bit. The real estate and finance markets are closely tied, and both have done remarkably well for the past five years. With higher interest rates, it’s reasonable to believe that the commercial market is going to run out of steam in the very near future.”

Real estate owners on the fringe, with heavily leveraged properties and floating-rate loans, are discovering they have run out of steam when they approach lenders to refinance. However, with interest rates backing off a bit in August and early September, some have been able to stay in the game.

“I’m working with three clients right now who felt shut out of refinance opportunities a few months ago but are back in the market right now,” says Brodwin of Schonbraun McCann.

This year, people in real estate are much more focused on the cash flow. “People who make the most profit today will be those who buy property with the best cash flow opportunity,” Brodwin concludes. “The ones relying on the compressing cap rates are sitting on the sidelines.”

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