Market conditions mean more risk for investors and lenders.

Real estate investors and lenders alike face the challenge of an uncertain real estate market that is unlikely to change anytime soon. Factors contributing to the complexity include billions of dollars pouring into the marketplace, the wide disparity of economic forecasts and the rise in construction and energy costs as well as the Federal Reserve's two-year cycle of short-term interest rate increases.

In the following Q&A interview, Spencer Garfield, managing director of Hudson Realty Capital LLC (HRC), a real estate opportunity fund manager with $700 million in assets under management, and Karim Demirdache, director of HRC, look at trends in the commercial real estate market and discuss what's in store for lenders and investors going forward.

Q. Describe lenders and investors current appetite for risk. Are they seeking greater returns or liquidity of new investments?

Garfield: Lenders and investors are taking on more risk for the same return by virtue of the real estate cycle coming to an end.

Despite the fact that the Fed did not raise short-term rates at its last meeting, I would argue that we remain in a climbing interest-rate environment. However, solid investments are out there, and in this slowing for-sale housing market, many have turned their attention to other asset- types, including rental apartment, office, industrial, retail and mixed-use.

Recently, HRC provided a mezzanine loan for the construction of a retail/office center in Bucks County, Pa. The project proved attractive for a number of reasons, including the sponsor's 30 years of regional real estate experience and above average increases in population and employment in the subject property's surrounding area as compared to the overall regional performance.

Demirdache: The high level of competition in the commercial real estate market forces lenders and investors to be more aggressive.

If they lose out on one deal, they often take on more risk the next time around, not wanting to be left on the sidelines again.

Players are lending at higher LTV rates, and mezzanine financiers are going up higher in the capital structure. In a number of regions, equity and debt transactions carry the--same risk given the current market dynamics.

With that in mind, equity transactions are more attractive right now because the upside is not capped.

A recent example of that is an HRC transaction in Tempe, Ariz. After just a year of ownership, we sold a Class A, 150-000- s/f office building for a substantial ROI in conjunction with a well-respected local partner. The Tempe office market has dramatically rebounded over the past two years, and even though we were getting a great return by leasing the site, it proved the ideal time to sell the property.

Q. Will the influx of new players in both the lending and investing arenas subside? If so, how does it affect the flow of capital?

Garfield: The influx of new players will subside although there will be no shortage of money anywhere in the capital stack, which is due to the tremendous amount of money raised for real estate over the last seven years. Going forward, CDOs will continue to flood the commercial real estate market with aggressive capital.

Demirdache: The tremendous flow of capital--both institutional and private--will continue pouring into the market in the last quarter of 2006 and in 2007. Some new parties will enter the arena, particularly those who may have worked at a big fund and have now gone out on their own to raise capital.

Q. Has the slowdown of the condo development and conversion markets started to affect condo sale prices nationwide? If not, will it in the near future?

Garfield: The condo development and conversion markets have cooled considerably in nearly all regions, but especially in formerly high-activity regions such as South Florida and Southern California. Sale prices have not been widely affected yet, but velocity of sales has been affected. Currently, converters in specific markets are offering concessions, including unit upgrades. On a select basis, HRC is still active in the condo market. Recently, we provided a bridge loan for the acquisition and predevelopment of a building in Long Island City, N.Y. The investment proved attractive due to HRC's low basis in the land.

Demirdache: Although it depends on the region, in general, there has been a dramatic slowdown of the velocity of condo sales. For example, in Brooklyn, N.Y., sale prices of condos are off by 20 percent, primarily because of the unrealistic expectations of owners. In the near future, the combination of the growing inventory of unsold properties and the increasing number of days a property spends on the market will push prices down.

Q. Is activity in secondary and tertiary markets heating up? In which sectors?

Garfield: Although retail has declined a bit, the rental apartment and industrial sectors in many secondary and tertiary markets are getting stronger. Through our partnerships with local real estate investors and developers, we are able to get an accurate read on many regions and submarkets nationwide and source off-market transactions.

Demirdache: Local real estate investors and developers who were pushed out of their region's primary markets by the bigger players are focusing on the area's secondary and tertiary markets. The residential for-sale and rental sectors, as well as the office market, have heated up as a result of this added influx of capital in many regions. Spokane, Washington is a good example. Over the last two years, Spokane's condo market has appreciated tremendously--approximately 15 to 20 percent. In January 2005, HRC acquired a 349-unit apartment portfolio located on eight separate properties in partnership with a local real estate investment and management company. We converted one of the properties to condos and sales have been brisk. Currently, we are in the process of selling some of the individual communities and will convert others into condos.

Q. What should sponsors/developers look for when deciding upon an alternative financing source?

Garfield: Sponsors and developers need a capital source that offers surety of execution, particularly on complex, value-added transactions. At HRC, we know it is imperative to be as transparent as possible and quick and flexible in making decisions. This approach provides borrowers and partners with a more user-friendly source of capital.

Demirdache: Sponsors and developers can't afford to get bogged down--they need to get the funding done expeditiously. In addition to speed and surety of execution, factors to consider include finding a financing source with market expertise and a history of successful originations as well as strong partner and industry relationships.

Q. How can players protect the downside in this uncertain lending and investing environment?

Garfield: Lenders and investors should stick to what they know and what has worked before in terms of product type and regions. It is not a good time to be branching out. We continue to invest capital in markets where we have had prior success, specifically with local operators with whom HRC has a proven track record.

Demirdache: A key component in protecting the downside is finding projects that offer multiple exit strategies. As a mid-market player, we focus on transactions that fit our profile in the $2 million to $25 million investment arena. That strategy continues to serve us well.