By MICHAL T. MAKAR L.J. Melody & Co.

By almost every standard, this has to be the best of times for commercial real estate and commercial real estate finance in the Puget Sound area. It is a period not without its negative aspects and risks, however. Those of us who just can’t seem to have a good time no matter what the news feel compelled to put at least a light Seattle mist, if not rain, on the parade.

On the capital markets side, there is some legitimate longing for the good old days of say, a year ago. There has been a 150 basis point (i.e. 1.5 percent) increase in the rate on U.S. 10-year Treasuries in the past year and there is currently an inverted yield curve with the 30-year cheaper than the 10. I have read no definitive explanation for the latter but historically it means the market is jittery about inflation and is expecting corrective action. This all sounds bad, and some borrowers are taking to the sidelines staying with floating rates waiting for long-term rates to fall later in the year.

But looked at historically, rates aren’t as daunting. The current 10-year Treasury is still below the 10-year trailing average, and in line with rates of 1994-1997. There is plenty of money available; life insurance companies loaned more than $42 billion in 1999 and Wall Street loaned more than $67 billion. The competition for loans brings down spreads, taking some of the sting out of the Treasury rate rise. Interest rates on good quality commercial mortgages can still be less than 8.5 percent today, a rate that should provide positive leverage on well-conceived new development.

Further, there is currently 7.4 million square feet of new office under construction, which many saw as too much. Much of this has been spoken for, however, by firms like Amazon.com, Drugstore.com, Voice Stream and Infospace.com. In Seattle alone more than 2.3 million square feet will be completed during the year 2000, but according to an unpublished resource by my good friend and business associate, David Stinebaugh, over 1.5 million of the space is already preleased. This means the new "available space" is only 800,000, or less than the average absorption of the last three years. This phenomenal absorption seems far in excess of what would have been expected by a cooling local economy with the relatively modest growth of only 2 percent in wage and salary employment for 1999, and only 1.1 percent expected in 2000.

One major component of the demand, high-tech and particularly Internet companies, form an intersection for concern for both fundamentals of the market and the financing of local real estate. Most of us follow the stock movements of the high-tech sector, marvel at the NASDAQ gains, at the market valuations of new companies and the new billionaires and multimillionaires appearing daily. We simultaneously wonder how can the stock market be so foolish as to bid up prices on firms hemorrhaging cash with advertising budgets in excess of sales, and wonder how we can get in early on the next hot idea and ride it ourselves.

Understanding, the equity side of these companies is one thing, but financing buildings where they are a major or primary tenant uses a very different form of analysis. A lender looking at such a building will listen patiently for maybe 10 minutes while hearing how great the future looks. Then they coldly look at the traditional elements of judging a building, elements such as quality, location, space design, reusability. They gauge their exposure, usually on a dollar per square foot basis, and then look for any tangible additional security such as lease deposits, letter of credit or guarantees of reliable parties.

As one lender said, "In making a loan, I can only lose or tie. A tie means I get my money back. I don’t get more money back if the company is wildly successful; my loan just gets paid back."

In real estate, there is not an equivalent of a participating debenture, nor a mortgage with warrants to buy stock in a major tenant. If the landlords are getting stock or warrants, they are not being passed on to the lenders, and if they were, the lenders would not know what to do with them and would probably persist in their cold, traditional method of loan underwriting. In some cases, buildings dominated by weak credit, high-tech companies are finding tepid interest from lenders. This office space may be getting leased but it may not as easily be financed or sold.

On the macro issue of real estate fundamentals, the high-tech companies also present a risk, albeit a less immediate one. In the past year or two, my informal tabulation supports that more than 2 million to 3 million square feet of office space in the Puget Sound area has been leased to high-tech firms of dubious credit (note: this phrase was in the past used to describe McCaw Cellular, now AT&T Wireless).

While developers can insulate themselves from financial risks of leasing to high-tech companies with tenant-funded tenant improvements, lease deposits and letters of credit, there is nothing any of us can do about the latter macro risk except continue to cheer at each new IPO and each new stock market record, and hope it continues.