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Pick up the metropolitan newspaper's business section or a regional real estate industry tabloid these days and the headlines speak of troubles in the Washington, D.C. marketplace. After highlighting other regions' real estate misfortunes for the past decade, it seems that the current media focus is to illuminate the negative trends of the Washington area's local economy.

Hardly a day passes when a financial institution, real estate developer or real estate brokerage firm isn't reported to be saddled with a real estate "opportunity" of one undesired sort or another. These headlines distract us from the essential fact that the Washington real estate market is not as bad as one may be led to believe. But then again, nor is it as robust as it once was. It remains, however, one of the strongest markets in the United States and will continue to be so.

The current market can best be described as complex. Factors on a micro as well as a macro level have converged to create an environment very different from what has been typical in the past. Beginning in the early 1980s, the development, leasing and financing community unleashed its pent-up demand within the local economy in just about every real estate sector. We have lived through in recent times a period of change not seen in the Washington area since the years following World War II. During this time, housing boomed, office demand skyrocketed, the real estate industry expanded and the Washington area was "discovered," nationally and internationally, not only as the capital of democracy, but also as an outstanding business and investment environment. It was hard not to prosper during this period if you were in the real estate business. This period was on par with a Wall Street-style "bull market."

Today, the real estate cycle is going through a different phase - one that in the long run will be healthy for the industry, but that in the short run is perplexing. That is not to say we are in a bad market; quite the contrary. The greater Washington area boasts the best-educated labor force in the nation: 38.1 percent of adults 25-years old or older are college graduates. More than 60 institutions of higher learning are located in the area.

The market boasts what some economists would call "full employment" with more than 63,000 jobs created in the past year, 70 percent female labor force participation, and a 2.5 percent unemployment rate. The local work force has expanded by an average of 83,000 jobs per year since 1983.

As one might expect, during this period of stunning job growth, there has been a corresponding rise in commercial activity. The value of building permits issued in 1980 was less than $800 million. In 1988, the value was close to $2.7 billion. But in 1989, commercial building permits issued dropped almost $700 million and in the first month of 1990; the value of non-residential construction dropped 37 percent from January of 1989. Although these broad market statistics are significant, they certainly do not indicate a good market gone bad. However, the importance of the last statistic is unmistakable because it clearly portends a curtailment of the development fervor of the past decade.

There are many reasons behind this slowdown in local real estate development. The forces affecting the market are as varied as the Washington market is enigmatic. We will briefly explore some of the factors currently fostering the Washington development lull. Experience has shown that following any period of rapid expansion there will be a natural pruning of growth. The Washington area could not continue to build at an average annual rate of 25 million square feet of construction (for the past 10 years) and not go through a period of indigestion.

The all too familiar excesses and abuses by some in the savings and loan industry and the concomitant costs to society have a ripple effect on all financial institutions. Not only has an all too willing source of capital been curtailed by the Financial Institutions Reform, Recovery and Enforcement Act (FIR-REA), but also, for the past six months, regulators from the Office of the Comptroller of the Currency (OCC) have altered the lending practices of the local banking community.

While much has been written about the "peace dividend" (which some would argue is peace itself), a slowdown in the federal government's defense expenditures means a diminution of defense contracts and consequently defense contractors' expansion needs.

The collapse of Drexel Burnham Lambert and the resulting influence of that firm's demise on the junk bond market has had a large impact on availability of capital for mortgages at some insurance companies. Consequently, the supply of long-term financing is not as great as it recently had been.

A sudden, unexpected surge in U.S. Treasury yields, (the benchmark, "risk-free" investment against which most commercial mortgages are priced) was experienced during the first and second quarters of 1990. This event stifled the groundswell of demand for long-term financing germinated in the low interest rate environment of the fourth quarter of 1989.

Taken together, these forces have had a curious effect on the Washington area market. Some people have found the effects debilitating, others perplexing and still others are successfully adapting to the new market conditions.


In 1980, the U.S. Census counted approximately 3,250,000 people in the District of Columbia and the 15 surrounding cities and counties that comprise the Washington Metropolitan Statistical Area (MSA). Today the count is somewhere around 3.9 to 4 million persons, representing a 20 percent increase in population.

Concurrently, the number of jobs has risen almost 39 percent to a total of approximately 2.25 million. The share of federal government employment, however, has declined from 25 percent 10 years ago to 16 percent last year, meaning that much of the employment growth was in the private commercial sector.

Best estimates are that during the same period, approximately 100 million square feet of office space was added to the metropolitan area inventory, increasing the total stock of office space to around 175 to 200 million square feet today. At the start of the last decade, the office vacancy rate was extremely low with perhaps 97 to 98 percent of office space occupied. As evidenced by the past 10 years' growth, there was pent-up demand largely attributable to extremely high interest rates during the late 1970s and early 1980s that inhibited development. Once rates abated, the market did not stop to catch its breath until now.

Since 1982, office space has been absorbed at an average rate of 10 million square feet per year - the rate was lower in the early 1980s when less space was delivered, while hovering closer to 12 million square feet per year for the past five years.

Today, the occupancy rate for the entire metropolitan area is generally conceded to be about 86 percent, although it is much higher in some submarkets and lower in others. This rate compares very favorably with the occupancy rates of most every major metropolitan locale. Year-to-date absorption patterns indicate that the District of Columbia will continue its three million square-feet-per-year appetite, while the Northern Virginia and Maryland suburbs will absorb perhaps five to six million square feet of office space in 1990.

In 1989, most developers sensed a slowdown in suburban tenant demand and shelved speculative development, as illustrated by the 25 percent drop-off in construction activity from 1988 to 1989, although in many instances warning signals were ignored. For the balance of 1990 and into 1991, it is likely this trend will continue, as indicated by the 37 percent decrease in the value of permits issued for the month of January 1990 compared to January 1989.

The rudimentary contraction phase we are going through today affects many segments of the real estate community. For instance, it goes without saying that construction-related companies are reducing their staff or focusing on different market segments (such as the residential rehabilitation market) because of decreased commercial demand.

The drop-off in projected absorption of existing space and the reduction in the amount of new space to lease will create fewer opportunities for office leasing agents and will dictate a shifting in the structure of brokerage firms. For example, assume that of the estimated 1,200 licensed commercial agents working in the Washington area (a number generally agreed to be accurate), 60 percent are office leasing agents. Assume further that 10 million square feet will be leased this year at an average rate of $20 per square foot for five years. On that basis, one would expect that, on average, leasing agents would generate approximately $41,600 in gross commissions to cover overhead and salary, assuming a standard 3 percent commission rate schedule. With "desk costs" of anywhere between $50,000 and $100,000 per year, it is obvious that there will continue to be an adjustment in this sector of the real estate community.

Financial circumstances

In this period of arguably normal industry contraction, the local economy's adjustments are being exacerbated by the effects of legislation and regulation. FIRREA has drastically altered a traditional source of financing for residential and commercial construction. Loan limits per individual borrower and project, and increased capital adequacy ratio requirements have curtailed the scope of the savings and loan industry's influence on construction and permanent financing. As thrifts adjust to the new law, it has become very difficult for developers to find land development or construction financing for all projects. Also, land loans maturing during this cycle cannot be refinanced and consequently are offered for sale or taken back by the mortgagee. As a result, development goals and objectives are being re-evaluated, which typically means projects are being delayed until the winds change.

For the small- to mid-size commercial project in need of permanent financing or refinancing, there are fewer available sources of financing. This is because: 1) There are fewer savings and loans in business today; 2) FIRREA is limiting what savings and loans can and cannot do; and, 3) Saving and loans cannot, size-wise or rate-wise, compete with the life insurance companies' cost-of-funds. While that is good news for life insurance companies, it is bad news for developers, because there are fewer life insurance companies placing mortgages on small- to mid-size projects for reasons of economy of scale. Also life insurance companies are adverse to the risks of construction financing.

Some would argue that banks also are being affected adversely by the regulators. Regulators, however, are trying to apply to banks' lessons learned from their experiences in other regions and from the troubles of the savings and loan industry.

For the past several years in the Washington metropolitan area, financing for acquisition and development was easy to come by. In the rush to outperform the competition, whether it be a banker or developer, there was a lack of balance exhibited, typical of the real estate industry cycle. The OCC is making the rounds of local banks in an attempt to prevent from occurring here what happened to several well-publicized New England, Texas and southwestern banks. The immediate result of these OCC visits is an audit of banks' real estate loans, the declaration of a higher proportion of non-performing assets than previously reported and the set-aside of larger loss reserves.

What is evident from some of the loans being placed into non-performing status is that aggressive assumptions about lease-up, a willingness to fund free-rent concessions and aggressive land prices have caused many projects to fall short of projections. Free rent concessions in the Washington marketplace are a recent outgrowth of the accelerated expansion. Five years ago, such a concession was unheard of in this market. Today, the worst examples of free rent are seen in those areas that have experienced rapidly expanded office and "flex" space inventories. Unfortunately, it is not uncommon to see two years of free rent on five-year leases in certain suburban locations. This phenomenon will not continue as the available supply of space is absorbed and it certainly is not endemic to all Washington submarkets.

The upshot of this double whammy on traditional sources of financing is a new-found difficulty in obtaining credit for project construction or acquisition. It is currently impeding new development, which, in time, will return some economic sanity and balance to those market segments currently out of kilter. But for the short run, Washington is undergoing a capital crunch.

Federal spending

Contracts let by the Pentagon and defense-related agencies hit an all-time high in the mid-1980s. These contracts are now being trimmed back. During the past decade, many contractors expanded their office or flex space based upon contract awards. However, the search for space to accommodate the fulfillment of the contracts typically fell short of being a well-planned corporate strategic initiative. Now that the federal budget has been allocated away from defense spending and overall defense procurement has been trimmed 17 percent, those same defense-related consultants who prospered during the Reagan years are now consolidating and/or cancelling planned expansions.

Needless to say, these cutbacks have had a deleterious effect on the suburban office markets. However, the argument can be made that the categories of funding that are being reduced or eliminated altogether are tied to hardware-oriented contracts parts, supplies, military base funding and personnel, for example. Further, in this new age of warming Eastern European relations, surveillance and intelligence contracts - so prolific in this area - may actually undergo increased federal expenditures. That trend will not, however, be impetus enough to fill the empty office space anytime soon. By most accounts, there may be as much as a two year's supply of office and flex space product in two metropolitan area markets alone - western Fairfax and southeastern Loudoun Counties. This over-supply cannot be attributed entirely to a slowdown in federal spending, though; the fundamental cause is overbuilding.

The junk bond market

On a national scope, another development that has affected the institutions that finance the commercial property markets was the demise of Drexel Burnham Lambert. This event has had far-reaching effects on many institutions that found themselves over-exposed to the attractive high yields of "junk bonds." Some of the biggest investors, as has been well-documented by the media, were savings and loans.

What is not well known is the fact that some insurance companies, who had been very active in providing permanent financing for commercial properties, are also caught up in the junk bond market. Some of these companies were using guaranteed investment contracts, that is, the promises life insurance companies make to provide a specific yield over time typically to a pension fund, as the source for acquiring bonds as well as placing mortgages. When the junk bond market collapsed, the values of the junk bond portfolios plummeted significantly. Now, pension funds are not renewing maturing guaranteed investment contracts with institutions who were reported as having heavy exposure in the junk bond market. As a result, because of the erosion of junk bonds' principal value, the capital to repay the pension funds is coming from other life insurance company sources. Generally, this results in little or no availability of funds from these companies for mortgages. Also, this means a reduction of permanent finance options for developers and investors with refinance needs.

Permanent lending environment

Some life insurance companies that are not beset with troubles from the junk bond market exposure may be faced with lower credit ratings as a result of having placed too much money into real estate (nationally) in the last five years. Accordingly, internal guidelines will reduce the amount of money available for real estate until portfolios are balanced among various investment alternatives. However, those life insurance companies with little or no junk bond exposure, and with balanced investment portfolios, are actively looking for real estate mortgage investments. There are plenty of solid transactions available in most property types: apartments, urban office, retail and bulk and distribution warehouses.

Though underwriting criteria has stiffened, there is an ample supply of funds for these product types. Typically, non-residential product is underwritten with a 1.20 debt service coverage on an interest-only or 30-year amortization schedule, and a maximum loan-to-value (LTV) of 75 percent. Multifamily loans can be underwritten with a 1.15 debt service coverage and 80 percent LTV. For high quality projects, these terms can be improved.

But as luck would have it, the anticipated continuation of the low interest rate environment (9 to 9.5 percent range for five-year funds) that prevailed in the third and fourth quarters of 1989 did not materialize. In fact, borrowers who were readying themselves for refinancing at the beginning of 1990 saw interest rates jump 100 to 125 basis points in a few short weeks. Transactions that worked in the mid-nines suddenly became very skinny. Now rates are beginning to drop back to levels just above where they started the year, and borrowers' appetites are picking up. But some lenders, sensing a diminution of competition and/or arguing that the spread differential between a risk-free investment and the yields achieved on mortgages is insufficient compensation for the risks inherent in real estate, are increasing those spreads. In early June, rates for three-to ten-year financing hovered between 9.625 and 10 percent, with rates for small loans as high as 10.5 percent.

During the past decade, the Washington metropolitan area enjoyed unprecedented growth, drawing national attention and attracting developers from around the world. The D.C. area experienced more new construction than anywhere else in the world. Despite enormous expansion, the marketplace remained extremely healthy throughout the 1980s. During this period, many factors contributed to the expansion: a healthy population increase, an aggressive lending community, a robust local economy led by the federal government's presence, combined with a greatly expanding private sector economy and an influx of capital fueling local and national developers' building fury.

A recent chain of events, however, amidst unsustainable growth levels, abruptly halted the expansion. While the current real estate environment is one far different than that experienced during the past several years, it is an environment that should have been anticipated by anyone looking at the fundamentals underlying the market's prior boom. In addition, the impact of various economic and regulatory forces has amplified the market's consolidation in the short run.

From a mortgage banker's perspective, there are plenty of opportunities for refinance, and rates are not expected to increase this year from current levels. Accordingly, projects that have sound economic fundamentals will be financed at attractive rates. Projects that suffer from over-exposure, developer illiquidity, or asset deterioration will be considerably more difficult to finance. For the future, a downward adjustment in land values, a slowdown in space being delivered to the market, a slower but steady absorption of existing space, and a return to a balanced market will mean a healthier economy and even greater stability. In the meantime, there will be an ongoing realignment of the industry's accustomed operating procedures.

Guy T. Stewart, III is vice president of Walker & Dunlop in Washington, D.C., one of the largest commercial mortgage banking firm in the U.S.
COPYRIGHT 1990 Mortgage Bankers Association of America
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Title Annotation:real estate lending in the Washington, D.C., area
Author:Steuart, Guy T.
Publication:Mortgage Banking
Date:Jul 1, 1990
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