For a country whose economic growth has historically been dependent upon readily available debt capital, the United States’ economy overall, and its real estate sector specifically, has been suffering from severe restrictions on traditional sources of loan funds. The impact of these market conditions, pretty much present since 2008, has been to significantly decrease economic growth rates because of the combination of that debt which is available costing more and the need to replace debt with larger amounts of equity demanding higher yields. An overriding question for investors, entrepreneurs, developers, and operating businesses alike has been and continues to be – when will traditional lenders be sources for debt financing again?
To understand what it will take for the recent and current environment to change, it is important to understand how the financial markets got where they are today. As is typical with any economic downturn and consistent with the most recent major real estate related capital crisis that resulted from the failure of so many thrift institutions in the late 1980’s and early 1990’s, many of the problems result from the bursting of the bubble created by excessive lending, lack of true due diligence by lenders, overly optimistic assumptions regarding future economic conditions and the unequal sharing of risks between lenders and borrowers from undertaking financing in an overheated market due to the non-recourse nature of many of these loans.
Many of the markets which experienced the highest growth rates (e.g., Las Vegas, Phoenix, Florida) attracted the largest amounts of debt capital and, as the markets declined, suffered the most as debt capital became non-existent for both the refinancing of prior loans and for the financing of new investments. In essence, these markets became effectively red-lined by lenders either by choice, by regulatory fiat or by the lack of funds to loan as those financial institutions historically active in these markets suffered their own financial problems.
In addition, the nature of the lenders themselves underwent a significant transition as those traditional lenders (e.g., banks, insurance companies, thrifts) were bypassed as more and more borrowers pursued the use of securitization mechanisms attracted by their less restrictive terms, their
lower costs and the shorter time period for funding. The downside of these mechanisms, however, became evident as projects began to underperform and borrowers found it more difficult to negotiate restructurings given the large pool of investors owning each loan and the lack of a true final decision maker. This difficulty in restructuring troubled loans caused additional market stagnation.
Another factor creating the present environment was the over-allocation of debt capital to the real estate sector. As more and more homeowners began to use their home equity as a personal bank for investing and spending, developers incorrectly analyzed the amount of demand for retail and other commercial space causing overbuilding. Rather than remembering that real estate demand is dependent upon other sources of economic growth – manufacturing, technology, etc. – the market began to look at the real estate market as a stand-alone source of economic activity. Although constructing a building does create short-term economic benefits from the construction dollars, the true long-term value of that asset is only created when users occupy the space. Effectively, too many investment dollars spent were used to create empty buildings and vacant lots.
Past efforts to open up the debt capital blockage have been pretty much unsuccessful because, although the motivations of the actions taken were appropriate, the actual results did not match up with expectations. The most obvious example of this was the significant dollars invested in commercial banks as part of the Troubled Asset Recovery Program. Rather than making these funds available for new loans as was expected and because most of the banks chose to retain troubled loans on their books rather than disposing of them at a loss, most banks chose to use the funds to reinforce their own capital accounts and ensure compliance with regulatory requirements. The same effect also occurred with the two “Quantitative Easing” programs of the Federal Reserve.
To effectively open up the debt markets for borrowers in the future, all of the parties involved must change their expectations and demand the following actions:
Banks and other financial institutions will need to dispose of their troubled assets so as to free up their people to start seeking new business opportunities and to generate more transactions giving both investors and lenders comfort in the resulting pricing levels, whatever they may be. Remember that one of the true benefits from the creation of the Resolution Trust Corporation following the S&L crisis was that they forced the sale of properties thereby providing a floor to pricing and spurring significant new investment in real estate. Additional and/or creative sources of capital support may be required for these institutions in order to push them in this direction.
Banks and other lenders will need to emphasize better and more thorough underwriting and more assumption of risk by the borrower. This can be accomplished by more realistic loan to cost lending levels and more guarantees from borrowers, conditions which are typical of their loans to other industries. Too often the lender was funding almost 100 percent of the cost while being provided the lowest return. It became a win/win for the developer – major profits if the project was successful and no downside risk if it wasn’t due to the non-recourse nature of the loan and a win/lose scenario for the lender. Successful investing demands win/win scenarios or win/loss scenarios for all parties.
Regulators will need to no longer look at the making of a real estate related loan as a negative and a reason to punish the bank. Assuming the bank undertakes real estate lending in a manner consistent with other loans made by the bank (underwriting standards, credit analysis, etc.), there is no reason that the regulator should treat a real estate loan any different than a loan to an operating business. We have seen too many cases of lenders being afraid to make good loans backed by real estate merely because of the expected actions by regulators.
Finally, developers/borrowers/investors need to understand that the lending terms of the recent past are no longer viable and that they will have to accept the new reality – lower debt levels, more guarantees. Hoping for the past to return only delays the inevitable. Accept the new reality and operate accordingly. One area that will need updating will be the expected yields that an investor can expect from a real estate investment. In an environment of near zero inflation and low yields from stock and bond investments, the continued use of a targeted return of 20 – 25 percent only creates unrealistic expectations and limited transactional activity, further exacerbating the gridlock in the real estate markets.
It should be noted that those traditional lenders which did not lower their standards and continued to underwrite conservatively are those that survived the market decline and continue to be a source of funding today. Lenders will only fund real estate activity in the future when they can be assured that they are being properly rewarded for the risks they are taking and that the borrowers are also assuming the risk of the project.