Plymouth, Minn. will soon have a new orthopedic surgery center. Minneapolis-based Bridgewater Bank financed the shell construction in partnership with another lender, then wrote the buildout loan on its own. 85% of Bridgewater’s lending portfolio is in commercial real estate (CRE).
That might sound like a precarious position. The CRE industry had a challenging 2023 overall, says Charlie Dougherty, a New York-based economist with Wells Fargo. “The CRE market has come under strain as the Federal Reserve raised interest rates in response to higher inflation pressures,” Dougherty tells The Financial Brand.
That’s translated to lower valuations and less CRE lending. The CBRE Lending Momentum Index fell by 3% between Q2 and Q3 of 2023, and by nearly 48% year over year in the third quarter.
But Bridgewater is still finding success in CRE lending. So are some other banks. They’re combining local knowledge and relationships with a willingness to search for projects that they believe will succeed.
“I think the term ‘commercial real estate’ is used with a really broad brush,” says Bridgewater chief lending officer Nick Place. “Mainstream media might be talking about a skyscraper that’s only 40% occupied.” The Twin Cities area, he adds, is a unique market. “It isn’t like the coastal markets, nor like the Florida or Arizona boom-bust markets. People might think our portfolio is a bunch of empty office towers, but in reality it’s a bunch of 98% full apartment buildings in Minnesota.”
Bank and CRE market circumstances vary, sometimes by a lot. Even so, lenders can take a page from the three banks that shared the secrets of their successful CRE lending programs with The Financial Brand.
1. Know Your Local Market
Shawn Lipman, chief credit officer at Santa Cruz County Bank in Santa Cruz, Calif., says that understanding the local market is the key to the bank’s success with CRE lending. “We know our market and the microeconomies here. We’re looking at the borrower, the project, and where it fits in the economy.”
The bank recently financed the purchase of a retail space that has five current tenants, plus one unoccupied spot. It went in at a conservative loan worth 65% of the loan’s value for a customer that has other loans with the bank and can make the payments from cash flow with just three tenants.
The bank also underwrote the purchase of a local apartment building that needs work. “The property was undervalued and under-leased, given its location. It needed the right owner to do the improvements and get the right tenants in there,” Lipman says. Santa Cruz County Bank wrote the loan based on the property’s location and the borrower’s ability to do the necessary work — a skill the borrower had used in past projects.
“We know our market and the microeconomies here. We’re looking at the borrower, the project, and where it fits in the economy.”
— Shawn Lipman, Santa Cruz County Bank
The staff at the bank is careful to visit properties in person throughout the life of a loan. “During the pandemic, we still knew our market, but we weren’t going out and visiting everything as much as we had in the past. We’ve learned that you need to stay on top of deals, not just on top of the paperwork,” Lipman says. Official visits happen annually for loans of $1.5M and up — though the bank also does casual, drive-by visits to most of its borrowers, regardless of loan size.
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2. Lend to Existing Customers/Carefully Selected New Borrowers
Bridgewater Bank is a growth company, says Place, so new clients are important. Even so, he says, they’ve been selective about new client relationships in the past year.
Instead, Bridgewater is lending to existing clients, including the borrower for the orthopedic surgery clinic. “It checks all the boxes: a known history with a great borrower and a great demand for their product,” Place says.
3. Put Together Lending Consortiums
Bridgewater wasn’t the only lender backing the new orthopedic center. They were the lead bank on the construction, keeping more than half of the loan. One other bank participated. Bridgewater then handled the buildout financing alone.
Minneapolis-based Alerus is also working with other banks to back CRE deals, like a recent four-bank loan it organized to build a single-tenant corporate campus. It writes loans of $20 million to $25 million, then participates out the balance on deals that can range from $40 million to $60 million.
As deals have gotten bigger and more complex, it takes more banks working together to pull them off, says Alerus director of CRE lending Andrew Meelberg. Alerus spends as much time building lender groups as it devotes to seeking out new business, looking for banks that are lending but don’t have a concentration or constraint with a particular borrower.
“We put groups together before we send out a term sheet,” Meelberg says. “It would be great to find small deal sizes we can do on our own, but new construction opportunities are big enough with labor and materials costs that costs are going up.”
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4. Expect Deals to Take More Time
Market volatility means it can take longer to put a deal together, Bridgewater’s Place says. Loans that used to take two to four months might now need six. “Some deals our staff have been working on for 18 months. Maybe they’ll go in the spring,” he says.
5. Ask for More Borrower Equity
With interest rates up over the past year, lenders have required borrowers to contribute more equity to projects. “Loan-to-cost ratios are declining, and significant equity is required for a deal to pencil out,” Alerus’s Meelberg says. A loan-to-cost ratio that was once 75% disappeared when 65% became the new normal. Now deals are usually at 55% to 60%.
The underwriting metrics are different on a project that’s already leased to a single tenant because there’s less risk involved. With a high-quality tenant, Meelberg says Alerus might ask for 20% to 25% cash equity, compared with 40% on a speculative project.
6. Make Deposits Part of the Deal
“Any time we’re lending, we’re talking to the borrower about deposits,” Place says. For instance, if Bridgewater finances an apartment building, the project’s operating account is required to be at the bank. The rule helps Bridgewater gather deposits and also see cash inflows and outflows, spotting problems if and as they happen.
7. Roll With the Unknown in 2024
Falling interest rates in the coming year would improve the market for CRE lending, and Wells Fargo’s Dougherty thinks that’s likely. “I think the Fed will cut rates in 2024 and that will help relieve some of the upward pressure we’ve seen on capitalization rates,” he says. “If the economy holds up, that will lead to a slower but still solid demand environment for CRE.”
“If the economy holds up, that will lead to a slower but still solid demand environment for CRE.”
— Charlie Dougherty, Wells Fargo
Even if rates don’t subside, lower volatility would also improve the CRE lending market. “The difficulty with interest rates lately is their volatility, which is hard for real estate to stomach. If rates stayed put, then owners and investors would acclimate to those rates and solve the problems of those rates,” Place says.
Whatever the year brings, Place says he trusts customers to keep figuring out deals that work.
“Clients are resilient, smart, and conservative in how they approach things. They’ll continue to problem solve,” he says.
Ingrid Case is an award-winning journalist and ghostwriter in Minneapolis, MN. Her work has appeared in Bloomberg Markets, Money, AARP, and Financial Planning, among many others.