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The credit crunch: the house of money falls.

The house of cards is tumbling down.

The financial balancing act that made real estate development a booming business in the 1980s no longer has the power to dazzle the lending audience into throwing gold coins.

Like it or not, real estate is going back to the "normal" lending environment of the 1970s, where developer equity and need-driven markets were more than slights of hand.

"We're going to see plain, straight deals with lots of equity and conservative underwriting, says one mortgage banker. "The 1980s will never happen again. Real estate is about to become much more boring."

The players all fold

The general collapse of available real estate capital begins with the S&Ls and commercial banks.

Big lenders on construction and some types of permanent loans, these institutions are retreading rapidly from real estate lending, spurred on by big losses in their real estate portfolios and higher capital-reserve requirements.

According to the fall 1990 issue of Real Estate Briefing, published by the Chicago office of Deloitte and Touche, lending by commercial banks fell by almost 1 percent during the first half of 1990. When loans made in the expanding western United States are excluded, the decline in construction and development loans was almost twice as high. Just four years ago, construction lending was growing at an annual rate of 20 percent. Declines in lending by S&Ls have been even greater.

Nor are current loans performing well. Bad debt is piling up. Nonconcurrent real estate loans in FDIC-insured banks increased from $8.1 billion in 1983 to $27.7 billion in June 1990.

A big part of these problems is in the office building sector, although all property types are affected.

"The mortgage foreclosure rates on office buildings are going to double to 2.5 percent annually by late 1992 or 1993," predicts Bernard Freibaum, chief financial officer at Stein & Company, a Chicago-based office developer.

Hanging tough

Faced with this grim news, banks are getting tough. A survey of 60 U.S. banks conducted by the Federal Reserve Board late last summer found that 75 percent reported that they were using tougher underwriting standards on applications for construction and permanent financing. The majority said they were reluctant to lend on any commercial real estate.

Those that are lending are requiring higher interest rates, additional initiation fees, much more credit information, more equity, and a longer processing time.

"Regulators have gotten really hard on real estate," says Alan Herbst, assistant vice president in real estate for the Bank of Baltimore. "A property can be up to date on loan payments, but if those payments are being subsidized by another property, the regulators will complain. They're looking over our shoulders all the time now."

While the Federal Reserve Board's recent decision to ease bank reserve requirements may soften the liquidity crunch, it may not be enough to provide the needed impetus.

The Bank of Baltimore has not had any foreclosures, but has seriously pulled in its horns, making few new loans in the last eight months. On the loans it does make, the bank requires more equity and more preleasing than previously.

"We're not doing any speculative construction deals at all," says Herbst. "You need 85 percent preleased space plus a guarantee of a strong, high-credit tenant before we'll even consider a loan. This business has really changed."

And no one is even considering approaching savings and loans for money. "I can safely predict," says one real estate observer, "that you'll never see S&Ls have funds for commercial real estate again."

Nor are foreign banks moving to fill the gap, according to Steven England, CPM [R], director of asset management for Bank of America Investment Real Estate in San Francisco.

"Globalization of funds is more a reality today than ever," England says. "Foreign banks know when markets are turning bad and when it is time to go elsewhere. Both European and Asian banks are pulling back from U.S. lending."

Playing close to the chest

The major players in the permanent financial market--life insurance companies--are being equally conservative. Life companies today are "realistic with a flavor of pessimism," according to Jack Cohen, executive vice president of Chicago's Cohen Financial Corporation, a loan correspondent for 17 life companies.

"Everyone is trying to face the realities of their real estate portfolios head on," continues Cohen. "They're examining their holdings in depth and finding that things are not as good as is being said, nor as bad."

The end result of this self-examination is a more conservative attitude. A July 1990 survey conducted by the American Council of Life Insurance of firms accounting for over 70 percent of commercial mortgages held by U.S. life companies found that at the end of the first quarter in 1990, the volume of commercial mortgages issued had dropped to the lowest level since the third quarter of 1984. And new commitments have fallen still further during 1990.

Overbuilding, the uncertainty in the Middle East, new tax legislation, and a crisis in the banking community have all contributed to this growing inactivity. And until some of these uncertainties are resolved, everyone is behaving tentatively. "Life companies are looking for problems as opposed to solutions," says Cohen.

And, following commercial banks' lead, life companies are making their lending requirements more difficult to meet. Most now require positive leverage, more equity, and higher loan-to-value ratios as well as greater coverage of the debt service by the property's income stream.

"We've always been conservative underwriters, and our underwriting hasn't changed," says Michael Curran, assistant vice president and regional manager in Washington, D.C. for Metropolitan Life Insurance Company. "But this year, we're going to be asking more questions and be even more thorough."

The need to ante up

In the midst of this anxiety and conservatism, life companies are faced with putting out what Cohen calls "a ton of money" into real estate over the next year. But in many cases, that money is going to specific refinancing needs.

Metropolitan, for example, expects to spend between $3 and $4 billion in 1991, primarily to refinance debt, says Curran.

At a meeting of 25 life companies held during the October 1990 Mortgage Bankers Association meeting in Chicago, most of the companies present had already met their real estate lending targets for 1990 and were planning to put in an equal amount in 1991.

Indeed, billions will be required to refinance deals life companies made in 1985 and 1986. These five-year, mini-perm loans were made in the heyday of real estate construction, and they are now creating a huge rollover in 1991.

At the same time, the willingness to refinance does not guarantee commitment of funds. Life companies will carefully scrutinize the projects they refinance, says Cohen. Some they will decide should never have been bought in the first place; others will not meet current portfolio needs. "The life companies do not want to expand their real estate portfolios," Cohen concludes. "They're primarily interested in restructuring what they have."

The unsuited properties will be swapped for "mismatches" from other life companies, creating a vast financial game of "go fish."

Only the money remaining after life companies have refinanced old deals will be available for other uses, leaving developers scrambling for the little money still on the table.

The absence of big players

Pension funds do not offer any respite from this capital shortage. Pension fund managers have been disappoited in real estate returns over the last several years and are unlikely to try to increase their allocations.

Indeed, pension fund manages who did invest in real estate after 1985 would have done better holding bonds or common stocks, according to Blake Eagle, president of the real estate consulting group for the Frank Russell Company, Tacoma, Washington.

For the 10 years ending October 31 1989, the FRC/NCRIEF index showed that counting cash returns and appreciation, pension funds made 10.5 percent a year on real estate holdings. For the last year, that return was only 6 percent, and based primarily on cash flow.

"These are lousy returns compared to what pension funds can earn in other investments," says Eagle. "There's simply way too much real estate."

Moreover, for these low returns, a fund ends up with an asset that is illiquid, non-fungible, and now non-financeable. Consequently, pension funds, like life companies, are not putting much new money into real estate.

"The silver lining may be that this withdrawal may create one of the greatest buying opportunities of all time," says Eagle. But even if pension funds become buyers, they are mcuh more likely to purchase existing buildings than fund new development.

So while pension funds will continue their long-term commitment to real estate, viewing it as an important diversification tool, the short-term prospects remain weak.

Foreign investors

leave the table

The overseas institutional investor, another big source of funding in the mid-1980s, is also temporarily leaving the real estate table. The cost of foreign capital has risen sharply, making returns on U.S. real estate less attractive.

"The cost of capital for Japanese life insurance companies has gone up 300 basis points in the last year," says Bernard Freibaum. "That make it less likely they'll be investing in U.S. real estate."

Foreign institutions also find the U.S. markets diofficult to do business in at the moment, says Jack Cooper. "There are many 'bargains' in the current market," he contends, "but that doesn't mean they're profitable for investors. You can have 100-percent occupancy, but with rental concessions, that does not necessarily mean good yields."

A new deal

With this shortage of capital, the fortunes of real estate look bad over the short term. But over the long term, real estate will not do badly, says John Oharenko, vice president of financial services at Cushman & Wakefield, Chicago.

"The last five to seven years were record times for income-property construction," Oharenko comments. "The volume of building was incredible. We're just now getting back to some level of normalcy."

And for players with cash to invest, today's overbuilt markets are not a problem but an opportunity. Oharenko, for one, reports that he brokered a record number of sales in 1990. "Lots of shrewd people are buying," he says.

Oharenko comments that prices of prime commercial real estate have dropped by as much as 20 percent from 1989 levels, with some properties selling at below replacement cost. This is bad news for developers.

"The small developer is really going to be hurt," says Allen Fuller, development manager, finance, for Harbert Properties Corporation in Birmingham. "We have $1 billion in assets and a strong balance sheet, and we're seeing a credit crunch with banks," he says. "For the small developer, it is really bad."

According to Fuller, banks used to fund 75 percent of a property's completed value with a construction loan. Now banks will fund only 75 percent of the property's cost, assuming they will make the loan in the first place.

"You have to come up with hard equity--cash--for the deal to be financed," he says. "But if you don't have the money, you're out of luck."

Owners of well-leased, existing buildings will find that they have to put more money in the deal to refinance. And if the lender doesn't require it, owners should increase equity on their own, Cohen advises. "Go for a low breakeven point on a per-squarefoot basis," he says. "Borrow less money at a cheaper rate. Then if you lose tenants, you can still make your debt service. You won't have to take any tenant that comes down the road."

Ready for the next hand

Those who survive the current crunch to finance again in the years ahead would do well to spend the time maintaining their property and trying to hold on to the property values until the storm blows over, suggests Steven England.

"This is one of those storms in real estate where you hold tight and try to manage your way through it," he says. "The name of the game today is property and asset management."

"The supply of space is so great and the demand is so low that just to hold on to tenants you have to offer something special," says John Oharenko. "For the last 20 years, the developers have controlled leasing; now it's the tenants."

To survive, developers should also consider offering supplemental services, such as tenant representation. Public and build-to-suit projects also offer some opportunities. For example, Allen Fuller reveals that Harbert is moving out of office development and into retail and build to suit.

But even for a larger developers such as Harbert, it will take hard cash to make the deals.

"If equity isn't part of a deal, it isn't likely to go forward," says Bernard friebaum. "We're going to have to get used to that dreaded 'E' word, again.


Natalie McKelvy is a freelance writer on business and financial subjects based in the Chicago area.
COPYRIGHT 1991 National Association of Realtors
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Author:McKelvy, Natalie
Publication:Journal of Property Management
Date:Jan 1, 1991
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