December 10, 2009
Need a loan? Here’s what you should know
By JEFF COATS
Peter W. Wong Associates
At times in the universe of commercial real estate, money grows on trees. Such was the case a few years ago. However, history has shown us that real estate is cyclical. For the wise investor who was keenly tuned in to the forces that control this market, those trees have been harvested, the fields have been plowed, and the ground has been prepared for a new crop of money to be made.
But it takes money to make money. There is no questioning the power of positive leverage, but where does the savvy investor find leverage, any leverage, in today’s market?
How we got here
My colleagues often roll their eyes these days when I wax on about similar problems that occurred during the savings-and-loan crisis in the early 1990s. I believe that history most often repeats itself and therefore it is important to understand how we got into this mess.
Today’s financial market collapse, at least at this point, compares modestly to the S&L crisis. In total, nearly 1,400 banks failed between 1988 and 1990 and the problem assets of troubled banks between 1990 and 1993 totaled nearly $2.4 trillion. By comparison, there have been 150 bank closures between Jan. 1, 2008, and Nov. 20, 2009; and for the period between January 2008 and September 2009, the problem assets for these banks totaled $520 billion a big number indeed and one that will undoubtedly continue to rise.
The comparison between what we are experiencing today and what was experienced in the early 1990s is still fair and strikingly similar.
The failure of S&Ls and thrifts in the early 1990s led to a capital vacuum similar to the one we are experiencing today. Back then, banks dried up, credit companies that had previously made loans on commercial properties vaporized, and life insurance companies tightened their real estate underwriting standards.
Seeing an opportunity to make a buck in the early ’90s, Wall Street seized the moment and the commercial mortgage backed securities (CMBS) market was born. As the bonds gained acceptability by bond investors, the price to the end user (the property owner) became more and more competitive and the popularity of the product skyrocketed. Borrowers couldn’t borrow enough and CMBS lenders couldn’t lend enough.
There was a general feeling of entitlement among borrowers as they chose between several competitive quotes whose only noticeable differences were a few basis points. The gap, or spread, between marginal deals and exceptional deals narrowed to the point of nonsense, and the fragile relationship between risk and return was lost.
The party ended in 2007 when the residential sub-prime market started to show cracks in its foundation. The CMBS market followed suit.
Ironically, in this financial tragedy of Shakespearian proportions, Wall Street created a savior in the early 1990s in the form of the CMBS market that in the end became a villain. For supply-and-demand fundamentalists, this was financial theater at its best. For those of us on the front lines, it was a painful reminder of how dispassionately markets correct themselves.
The landscape for commercial real estate lenders today is only for the brave of heart a characteristic generally lacking in the genetic fabric of lenders to begin with, especially in those that are still in existence. But before blaming lenders, consider the overwhelming issues they face in today’s market:
• Commercial real estate value declines are currently estimated to be anywhere from 20 percent to 50 percent off of their 2007 peak prices.
• According to data provided by CoStar COMPS Analytic, today’s commercial real estate values are equal to or less than they were in 2004.
• Commercial real estate loan delinquencies are increasing at an alarming rate, which will likely lead to a barrage of foreclosures. This will necessarily translate into a bulge of lender-initiated distressed sales in the market, which will put further downward pressure on values across the board.
• Increased vacancies and the resulting lower rents will put additional pressure on the bottom line of each property, particularly those properties that are burdened with high existing leverage by today’s new standard.
The result in the capital markets is a nasty downward spiral in the underwriting of commercial real estate loans as lenders try to forecast the depth of the fall. This leads to arbitrary, more conservative loan underwriting. More conservative loans in the marketplace leads to fewer borrowers with the cash to buy property, which leads to lower sales prices, which leads lenders to question their underwriting again, and so forth.
Some good news
The confluence of several factors could prove to define the bottom of the commercial real estate market sometime in the near future, which will add much-needed stability to the commercial real estate lending market:
• Economist and market investor Benjamin Graham said: “Wall Street people learn nothing and forget everything.” Is that a pulse in the CMBS market? Driven by the Federal Reserve’s Term Asset-Backed Securities Loan Facility, which was opened up to newly issued CMBS in June, Goldman Sachs recently securitized a $400 million portfolio of shopping centers owned by Developers Diversified Realty. The word on the street is that the top-rated securities were oversubscribed.
• According to the MIT Center for Real Estate, commercial property prices sold by institutional investors rose in the third quarter of this year for the first time in more than a year, inferring that the commercial real estate market may have already hit bottom, at least for institutional-quality property.
• CoStar indicated that 2009 will likely mark the slowest year for new development in the modern era, suggesting that the supply of new commercial real estate has been curtailed.
• There appears to be concurrence among most economists that the U.S. economy is in recovery. The impact on commercial real estate will be clear as tenants take advantage of today’s depressed rental rates by extending existing leases or expanding into larger spaces to accommodate growth.
• U.S. Federal Reserve Chairman Ben Bernanke recently indicated that the Fed will continue its stance on holding interest rates as low as possible, perhaps for a longer period of time than originally expected due to the rising jobless rate.
The year 2010 could mark the bottom of the commercial real estate market as values reach rock bottom prices while the economy is simultaneously in recovery. Although cash will be king, the patience of savvy buyers who have hoarded cash may be rewarded with attractive buying opportunities. Greed will have to trump fear, not only for the investor but also the lender.
Life insurance companies have always been the most reliable source of capital for the commercial real estate borrower. Although life companies have had their issues to deal with these days (see AIG), for the most part they remain on solid financial footing. Life insurance companies are dealing with rating agencies and responding to questions from the insurance commissioners which regulate them. They remain a conservative, long-term, relationship driven, rate-competitive option for the well-qualified borrower.
Many regional and community banks today are crippled with solving problems on existing loans and are in no position to make new loans. They are committed to shoring up their balance sheets for regulators, analysts and stockholders. The few banks that are healthy enough to make new commercial real estate loans are restricting their lending to existing, well-heeled clients, or doing so through their business banking channels to owner-occupants.
Credit unions can be a source of commercial real estate debt, but they too are under the watchful eye of their regulators. Without the safety net of the FDIC, they are in essence a self-insured group which has had to shore up its share of reserve funds. Credit unions can provide term and balloon debt, and some can even do so without any prepayment penalties, which is rare in this market.
In today’s market, finding a commercial real estate lender is a daunting task. It may seem as though lenders search for reasons to decline loan requests, rather than looking for reasons why they should approve them. In more reasonable times when the lending pendulum was at equilibrium, there were mitigations which outweighed the circumstances or risks surrounding a deal.
Today, the risk itself is enough to decline a loan request and mitigations mean little. It takes a bulletproof deal to pass the test. Any lender can identify risk. It takes a real pro to evaluate risk. The challenge today is to find a lender in the latter category.
A good mortgage banker can sift through the myriad of sources in the marketplace, present options to the borrower, and more than ever add value to the process through thoughtful consulting.
The pendulum has swung dramatically to the conservative side. Come on gravity, do your thing!
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