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The great financing drought: regulators turned off the funding spigot for developers and the commercial property markets are now trying to adjust.


"Never in my experience have I seen construction lending dry up as fast as it's dried up," says Ronald Poe, chairman of Dorman & Wilson, Inc. in White Plains, New York.

Poe and most other commercial property mortgage bankers primarily place permanent loans with insurance companies and other institutional investors. They do so several years after a bank or a thrift makes the initial construction loan for the project.

But recent troubles at S&Ls, the resulting thrift bailout law, and problems for real estate lenders in the Northeast and elsewhere have caused bank regulators to begin seriously scrutinizing all income property construction loans.

Poe thinks that it's healthy. He says the nation's current glut of office space will be absorbed "sooner or later," which will put more value into existing buildings. But it won't be without a cost.

"There will be some pain in 1990," Poe concludes. "About that, there is no question." As banks and thrifts quit lending to developers, "there will be some foreclosures."

An oversupply of office space is raising vacancy rates to more than 20 percent in some areas. Nationally, the average vacancy rate for central business districts was 14.8 percent at the end of June 1989, according to the National Association of Realtors.

"Most deals are very thin, profit-wise," says Arthur S. Moore, senior vice president of office developer Tishman West Companies, Los Angeles. He says "the cost to carry" many buildings today is higher than what they can be sold for. When money costs 10 to 11 percent and the return on the building is only 7 to 8 percent, that's "almost reverse leverage," Moore adds.

Mortgage bankers are affected

"Little pockets of real estate depression" throughout the country "cause faint-heartedness in institutional investors," says Kenneth Dickinson, president of Dickinson, Logan, Todd & Barber, Inc., Raleigh, North Carolina. Although insurance companies and other institutions have available funds to put into real estate, they are "not going to do anything reckless" in 1990, he says.

Mortgage bankers say their funding sources are looking for more equity in deals, a strong business track record and solid financial statements from borrowers, as well as pre-leased commercial projects.

If that sounds like basic lending, it's because it is. But in the past, such guidelines weren't followed. Jack Shaffer, managing director of New York's Sonnenblick-Goldman Corporation, says "deals that shouldn't have been made five years ago, aren't being made today."

In other words, the lending excesses of the past are being reversed now. Just as lenders played a part in the accumulation of government deficits and junk bonds, they also have built enough skyscrapers for a jungle full of Kings Kongs to climb. And the past is prologue.

Office developer Tishman West has cut back on its activities over the past five years, says Arthur Moore. He says the "capital-driven" 1980s "totally ignored supply and demand."

As a result, cities such as Denver, Dallas and Houston will be oversaturated with office buildings for five to eight years, Moore adds. And the troubles extend beyond just the energy belt. One economist estimates that Detroit and Philadelphia each built enough office space to last more than 50 years.

But the blame for such excess should not be shouldered completely by developers, adds John Levy, senior vice president of Richmond, Virginia-based Sovran Mortgage Corporation. After all, he says, those developments couldn't have started without a construction loan. If money is available, Shaffer adds, "builders will build in the Mojave Desert."

Past practices

Before the 1980s, the traditional practices of institutional lenders helped to rein-in these aggressive building tendencies. Levy explains that these "long-term" lenders essentially decided whether a project would or would not be developed.

A developer would first find a permanent lender-usually a life insurance company-who liked the deal. At that point, the developer would get a forward commitment in the form of a fixed-rate loan that would fund after the construction was finished in 18 to 24 months.

Only then would the developer look for a construction loan. Generally, a local bank or S&L would supply the loan, knowing that the permanent mortgage would "take-out," or pay off, its construction loan.

In that way, Levy noted, bankers knew that they would be repaid, and also had some expert guidance as to which loans to fund-as well as what amount to lend. But as interest rates began fluctuating early in the 1980s, forward commitments became rarer. Banks and thrifts were left more to their own judgment.

Unfortunately, while "running naked," they began to allow their enthusiasm cloud their prudent lending sense. For example, until recently, banks offered "open-ended construction lending to leading developers," Dickinson noted. Once these projects neared completion, banks would assume that a thrift or an institutional lender would take out the construction loan.

However, it didn't always work that way-especially in the Northeast. Sometimes, in fact, the results were disastrous. Martin A. Fenton, formerly senior vice president of Merchants Bank of Boston Savings Bank (since acquired by Bank of Boston) said a "desire to gain market share led Merchants on a five-year spree of almost writing anything that came in the door."

He recounts how Merchants thrived along with homebuilders who "branched into strip centers" as the homebuilders got larger. Early on, Fenton says, "bad deals got built and sold." With those early projects successfully completed and sold, Merchants' reaction to subsequent proposals was "sure, why not?"

Prior to the acquisition, Merchants Bank was rededicating its efforts toward residential lending because of loan losses, according to Fenton.

Merchants Bank wasn't alone. Twenty-two percent of Bank of Boston's commercial real estate loans were nonperforming at the end of the first quarter in 1990. Delinquency rates for commercial property mortgages held by life insurance companies averaged 2.42 percent at the end of 1989, according to the American Council of Life Insurance.

More oversight

Banks in the Northeast have taken most of the hits. Fleet Norstar Financial Group, Providence, Rhode Island, recently estimated that its nonperforming assets had grown 50 percent from the end of 1989 through the end of March.

And after being reviewed by regulators, Shawmut National Corporation, West Hartford, Connecticut, nearly doubled its estimate of bad loans held at year-end-to more than $1 billion. Shawmut Chairman Joel Alvord noted in The Wall Street Journal that one-third of those loans were "current as to principal and interest. Basically, we've got a new category of loans for us-the nonperforming performing loan."

Alvord's comments add fuel to the debate that bank regulators, after being surprised by losses in the oil patch and New England, now are cracking down on lenders too harshly. As a result, some industry experts say that bankers are afraid to make loans. In the last six months, the year-over-year increase of commercial and industrial loans by banks has nosedived from more than 7 percent to less than 3 percent, according to Mortgage Bankers Association Chief Economist Lyle Gramley.

Perhaps because of this growing sentiment, Federal Reserve Board Chairman Alan Greenspan, FDIC Chairman William Seidman and Comptroller of the Currency Robert Clarke-the nation's top bank regulators-recently met with officials of the American Bankers Association in Washington, D.C. At that time the regulators "urged banks not to curb lending in reaction to tougher supervision," according to The Wall Street Journal reports.

Kerry Keely, a vice president at Puget Sound Bank in Tacoma, Washington, says his institution's commercial property lending will decrease at least 50 percent this year due to tighter regulatory reins. "We can't do every deal we'd like to do," he says. Currently there's "a tremendous amount of regulatory oversight" on real estate loans, adds Jerry Guyant, executive vice president of Sovran Bank.

Banks also must adjust to last year's risk-based capital rules, which require more capital to be held in reserve for construction loans. "With so much pressure, from so many areas, why make real estate loans?" Guyant asks.

Thrifts were hit hardest by last year's regulatory lending strictures under FIRREA. Many thrifts simply can no longer fund commercial real estate deals, since the amount of a thrift's capital that may be lent to any one borrower has been reduced from 100 to 15 percent of the institution's capital. Total commercial real estate lending has a new ceiling of 400 percent of a thrift's capital.

Restricting these funding sources leaves a big hole in the commercial construction capital delivery system. According to the Department of Housing and Urban Development (HUD), thrifts lent more than $15 billion for multifamily construction and in excess of $14 billion for nonresidential building in 1989.

Current outlook

Despite the drought in construction lending, most commercial mortgage bankers expect the amount of business done in 1990 to be about equal to last year's volume. However, business in 1989 was down "25 to 40 percent" from 1988-"a very good year," according to Dickinson.

But keeping volume this year even with last year's pace will require better identifying the specific needs of both borrowers and investors, some mortgage bankers said. To help match them up, GMAC Mortgage's income property division uses computers, according to Vice President Joseph E. Kimm, Jr. in Bellevue, Washington. He adds that GMAC offers "a lot of variety in loans."

Dorman & Wilson's Poe says that mortgage bankers today need to have "a sufficient cadre of lenders to fit all of [their] clients' needs." He adds that institutional investors recently have started announcing "lending moratoriums" of three to six months in order to review their portfolios in response to the more cautious atmosphere. Because of these trends, Poe is "very definitely" looking for new lenders to add to those he works with now.

"We try very hard to stay in touch with our lenders," notes Henry S. Kesler, CMB, executive vice president at Salt Lake City's Hamman, Kesler, & Osburn, Inc. But sometimes the only way to get them exactly what they want is through trial and error. Kesler tells of one lender who professed an interest in Arizona loans, and then turned down three applications from that state.

Out of nine lenders for which Washington, D.C.-based mortgage banker Walker & Dunlop serves as a correspondent, only four or five are actively funding loans now, according to Executive Vice President Merrill Yavinsky. One Canadian company, he recalls, had "every deal underwritten as if it was in Houston."

The one bright spot is that developers also recognize that the premium currently rests on getting a deal done. Although it's "extremely competitive" in Washington, Yavinsky says developers are working with mortgage bankers who have performed well for them in the past, rather than shopping around for the best bargain.

Preferred properties

Investor preferences on income property types run in cycles, mortgage bankers noted. For instance, "most of the losses have been in hotels," due to overbuilding, Poe says. But he notes that five or six years ago, investors loved hotels because they presumed "you can raise rents every day." Now, he says, "everybody in the world wants to do industrial" deals. Poe adds that this trend will likely create too much development in that segment during the next few years. "It's a cyclical business."

Although everyone agrees that hotels are out today, some mortgage bankers are cautiously financing office buildings, Dickinson explains. Apartment buildings are also coming back into favor, says Sovran's Levy. However, he says, "what's hot now are regional malls."

Such shifts in institutional investor sentiment are typically widespread. One mortgage banker complains about the "herd mentality" common to lenders. He thinks these investors "could earn a lot more" by putting equity money into refinancings. Many deals today need equity in order to meet new, stringent underwriting guidelines. However, he finds the institutions aren't willing to take on the risks of providing equity funds.

Yet, some new loan types are emerging. Walker & Dunlop's Yavinsky reports he's doing "a few five-year construction/permanent loans." These consist of two years of construction funding and followed by a three-year permanent loan. This gives developers a chance to construct a project and get it completely leased, so that the building can be sold profitably.

Such financing arrangements are needed now, Yavinsky adds, "since most of the banks in the area are not doing any business. Credit is not available even to the best of borrowers." The credit crunch is helping push some developers with established track records into bankruptcy filings.

Opportunity knocking?

Are there opportunities for mortgage bankers as financial institutions leave a void in the marketplace? Here are some possibilities observed by three mortgage bankers: * Although commercial banks have

been competing with mortgage

bankers by offering fixed-rate, five-to

ten-year permanent loans, that

competition may soon lessen, says

Peter VanGraafeiland, president of

The Oxford Mortgage Corporation

in Raleigh, North Carolina. He sees

a "very significant shift from that

lending posture," as banks return to

shorter-term, prime-based lending. * Insurance companies eventually

might fill the $500,000 to $2 million

income property loan niche, which

thrifts previously dominated. Kenneth

Dickinson notes that such

loans, supporting businesses such

as "mom and pop stores," might require

personal credit guarantees

from the borrower, and not just the

value of the real estate as collateral. * As thrift lenders reduce their activity

in California, Henry Kesler is

finding "a lot of borrowers out there

who just don't know where to go."

His firm tries to bring "new alternatives

to the borrower" by offering

mortgages with higher loan-to-value

ratios than local institutions typically

have, providing short-term rates

at 1 percent above prime, and

through participating mortgages.

Kesler recently tapped pension fund money to grant a 10-year construction loan that featured a one-year forward commitment and an 80 percent loan-to-value ratio.

Underwriting guidelines

Before lenders will put money into a project, they want to know how well it's actually doing. For that reason, Poe says "no one is lending" unless a building has enough signed leases to service the debt.

To attract investors, strip shopping centers should have very few restaurants, says Barry Slatt, president of San Francisco's Barry Slatt Mortgage Company. Malls need anchor tenants, apartments are preferred with vacancies of under 5 percent, and medical buildings should be "close to a hospital" in order to readily find financing.

Beyond such general rules of thumb, lenders often look at the management's track record and the financial strength of the property owner. Sovran's Levy says lenders need to be able to estimate the value of the real estate, because developers' financial statements often are inadequate.

A potential borrower also should be someone the lender can trust. "If he says it's 10 percent vacant and you know it's 25 percent, you'd better get out of Dodge City," adds Levy.

From a lender's standpoint, an attractive deal for long-term financing would be a building that the property owner leases to itself, says Robert W. Sim, vice president for mortgages and real estate at Woodmen Accident and Life Company in Lincoln, Nebraska.

About one-third of the $15 to $17 million in lending Woodmen does this year will be in the form of forward commitments. The firm charges a fee for his company's 12- to 18-month commitments. "Not many companies will do it," Sim says.

Woodmen looks for debt service coverage ratios of 1.15 on 15-year amortizing loans and 1.26 on 27-year amortizing loans. Debt-coverage ratios show how much operating income is left after non-mortgage costs. For example, mobile home parks require ratios of 1.32 to 1.35, due to "our assessment of the quality of the income stream," Sim adds.

Most mortgage bankers report that life insurance companies currently expect debt service coverage ratios to be 1.2 or greater. VanGraafeiland says lenders today are "strengthening underwriting." This makes it harder to convert yesterday's construction loans into permanent financing.

VanGraafeiland adds that ratios were 1.15 a year ago. Although the rise in the ratio appears to be slight, it means borrowers qualify for smaller loans. For instance, someone who could borrow almost $8.7 million last year would find their limit now to be just $8.3 million. Therefore, the borrower "has to put more equity into the deal," VanGraafeiland notes.

Although other mortgage bankers report they have found lenders still using 1.15 ratios, the desire for more equity is apparent. Several factors are causing this equity squeeze. First, higher vacancies and rent giveaways of up to 20 percent mean less funds are available for mortgage payments.

Vacancies can effectively lower rental income by 25 percent on suburban office buildings, says Yavinsky. Such a property "is not worth what it was five years ago." When the owner then must refinance the existing loan, there's a "dramatic need for equity" to make the deal work.

Generally, all the property owner can do is try to refinance with the current lender. Mortgage bankers are doing many refinancings now, VanGraafeiland says, to renew five-to ten-year permanent loans on properties built in the 1980s. Because the mortgage banker made the current loan and has been servicing it, "he knows the property." Therefore, he can better determine the risks involved in its refinancing.

Other refinancings are needed to complete sales or allow owners to cash out equity on older buildings, as well as to replace construction loans or rehabilitate buildings.

Searching for sources of capital to help these deals reach the equity levels demanded today is a new challenge for mortgage bankers. Kenneth Dickinson is looking at offshore money and family trusts as potential sources. "Our commitment to [finding capital] is great," he says. "Our success is mediocre."

Other woes increase the need for fresh funds. For instance, loan-to-value ratios on many construction loans are higher than the 75 percent maximum generally accepted in today's industry.

Poe notes that institutional investors are finding some problems in properties they own, which makes them cautious about putting more dollars in other commercial buildings. For instance, owners today encounter financial binds when previous tenants leave and new ones want remodeled quarters. Normally, the new tenant's rate would be higher to pay for the remodeling. But rents aren't rising at the same levels today because so much office space is available.

Tough market

In 25 years of mortgage banking, "this is the toughest market I've ever been in," says Walker & Dunlop's Yavinsky. Previous downturns, he says, were caused by "single influences." But the combination of "regulators almost shutting down the banks" and insurance companies re-evaluating their real estate investments is unprecedented, he believes.

"We are in a time of tremendous flux," notes Sanford R. Goodkin, national executive director of real estate consulting at Peat Marwick Main in San Diego. He believes it will last for two more years. Levy agrees, saying "we're not at the bottom" of this market yet.

Sonnenblick-Goldman's Shaffer believes that fundamental changes, along with correctable cyclical events in today's commercial real estate market have caused the slowdown.

The shorter-term cyclical concerns include overbuilding and depressed local economies. Such problems have spread from Boston's high-tech corridor, through New York City and into suburban Washington, D.C. In addition, Chicago, Seattle and both Dallas and Houston are overbuilt, he says.

Changes that are more fundamental in nature have occurred in financial institutions and the tax structure, according to Shaffer. For instance, the shrinking number of thrifts in the commercial market leaves "a huge gap" of smaller and mid-sized deals - deals that banks and insurance companies traditionally haven't done.

Shaffer also sees bank retrenchment from commercial property lending as permanent, due to increased capital requirements and stricter regulatory oversight. In addition, Shaffer says, there are a lot of "gun-shy institutions" who overextended themselves to developers, third-world nations and leveraged buy-out financiers.

Beneath the surface, however, some mortgage bankers appear relieved that lender guidelines are getting tougher. Poe refers to the pragmatic attitude of bankers today as "a very positive sign. Excesses will dry up faster than anyone expected."

Another factor adding to the decline in commercial mortgage lending is the cutting of tax loss benefits on income properties. Combined with the loss of capital gains these events mean "there are no tax buyers," adds Shaffer.

Despite the barrage of changes affecting the industry, some mortgage bankers are thriving. After starting-up less than two years ago, Henry Kesler and his two partners expect to bring in $60 million in deals this year.

But, they say, lower rates would further improve business. "The uptick in interest rates [earlier this year] has made a lot of deals more difficult," Kesler notes. Poe adds that his firm has stalled applications totalling $150 million in its pipeline. The borrowers are waiting for lower rates before proceeding.

Because interest rates are obviously uncontrollable factors, mortgage bankers are looking for other ways to increase their business. Some are concentrating on the basics - trying to isolate specific investors' needs, helping them spot opportunities, and making sure loan applications are factually accurate.

Merrill Yavinsky reports that he's "spending more time underwriting the property and doing basic market research for lenders." He advises the firms on areas to avoid, and reports on competing projects that are coming to market. Quality control is also a priority.

Dickinson adds that in the last few years he has started helping institutions sell properties to other institutions. Because he works with firms he already knows, Dickinson says he isn't acting as a traditional broker.

An interesting development that may be a sign of what the future will bring in commercial mortgage banking is the recent joint venture announced by Sonnenblick-Goldman and Japan's Daishinpan Company. The Japanese credit firm, with $13 billion in assets, is owned by "five large banks and three large insurance companies," Shaffer notes. Observers say that Sonnenblick will be able to expand globally because of access to Japanese capital. Inking the deal "is the best thing that ever happened to us," states Shaffer.

Plans call for Daishinpan to sell portions of U.S. commercial properties to Japanese individuals. Shaffer says there's "an emerging, upper-middle class and corporate class [in Japan] that normally we couldn't [have access] to."

Observers add that getting that agreement was "extremely difficult to do." Says Dorman & Wilson's Poe, "I applaud, respect and envy the prominence they've achieved in the Japanese market."

Howard Schneider is a freelance financial writer based in Ojai, California. He frequently writes for Mortgage Banking magazine.
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Author:Schneider, Howard
Publication:Mortgage Banking
Date:Jul 1, 1990
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