October 30, 1991 - From the October, 1991 issue

The Real Estate Credit Crunch: Its Causes and Market Impacts

The Savings and Loan (S&L) Crisis of the 1980's has led to a real estate credit crunch. As a result, developrs are currently facing extreme difficulties in having their development projects financied. Mark Golan, senior associate with First Boston, writes on the situation further and more.

The real estate credit crunch is now over a year old. As painful as it is, most real estate professionals agree that the current lack of available fi­nancing is necessary. Overly abun­dant credit was the primary culprit in the 1980’s development boom that left virtually every commercial mar­ket in the country overbuilt. Therefore, tight credit is needed to prevent further development and give markets time to absorb projects already built.

Anyone hoping that the credit markets will return to the conditions present in the late 1980’s is both mis­guided and unrealistic. Conditions today are much closer to the historical norm than the 1980’s. This does not mean, however, that the credit mar­kets haven’t overreacted; even good existing properties and development projects have trouble obtaining fi­nancing today. When this situation will end is unclear but there is hope it won’t last too much longer. 

Why did it happen? 

The credit crunch is the natural reaction to the problems caused by the excesses of the 1980’s. Capital is still available; real estate has simply become an unpopular place to put it. 

Government regulators have certainly had a major role in creating the credit crunch. The Savings and Loan (S&L) debacle caused a regulatory backlash that has not only put the thrifts out of the commercial real estate business but also forced them to liquidate their existing assets into one of the worst markets in memory. This makes even good S&L’s look bad since they cannot hope to obtain a reasonable price for their properties under these conditions. The flood of properties on the market has also had the effect of lowering both prices and rents, causing a further deterioration of market conditions. 

Another reason for the credit crunch is that the well-publicized problems in real estate have caused stock analysts to focus on real estate holdings when evaluating companies. Since the prevailing attitude is that real estate is bad, the less you hold, the better. Many banks and insurance companies are unwilling to make new loans, regardless of how secure or profitable, because it will not be well received by the analysts. The torrent of bad press has also made investors, including sources of capital such as pension funds and foreign buyers, unwilling to invest in real estate. 

Notwithstanding the above, the primary reason for the lack of avail­able funds is that few development projects make financial sense. Until the markets recover and rents rise, few new developments will be profit­able. In many respects, the so-called “credit crunch” on the development side is not about a lack of capital as much as a lack of viable transactions.

The availability of permanent financing has also decreased, although not to the same extent. Even though many insurance companies and other long-term lenders are out of the mar­ket, many others are still active. Some firms are actually complaining that they can’t make as many loans as they would like. 

The key to this apparent paradox lies in underwriting criteria. With the flood of capital available during the 1980’s, traditional lenders were forced to lower their underwriting standards to compete for business. This is no longer the case and as a result they are asking for more tra­ditional, conservative terms. Lend­ers are also being much more selec­tive about the type of properties they finance. Many owners who were able to finance their properties previ­ously find their buildings now unacceptable. Even if the properties meet today’s standards, owners are often unable to borrow as much as their current loan balance. 

How and When Will it Improve? 

Where will the capital come from to ease the credit crunch? In the case of development financing, the an­swer is commercial banks. Once the regulators are satisfied, once the stock analysts stop focusing on real estate assets, and once the banks work out their problem loans, banks will feel pressure to gradually reenter the market. Japanese lenders, who led the charge in the 1980’s, will probably be among the first back, al­though their underwriting criteria are likely to be much more conservative than before. In addition to the banks, regulators may eventually allow S&L’s to finance large multi-family residential developments again, freeing up bank capital for other commercial projects. 

Without S&L participation in most commercial projects, the amount of development financing available will be a small fraction of that available three years ago, but this should be sufficient to fund the few projects that are deserving. Al­though it is still difficult to predict, conditions should begin to ease for development financing by the second quarter of 1992.

In the case of permanent financ­ing, funds will continue to be pro­vided by mootly traditional sources. Insurance companies that are cur­rently out of the market will slowly return. Other investors, such as pension funds and credit companies, should also increase their activity. 

One source of permanent financ­ing that could become a significant factor is securitized financings (real estate backed securities that are given credit ratings and then publicly issued in the capital markets). Securitization disappeared in the mid-1980’s because less expensive, eas­ily obtained capital from private placement lenders made it uncompetitive. However, with today’s higher lending spreads, stricter underwriting criteria, and limited capital sources, securitization once again may make sense for some borrowers. 

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What Can Be Financed Now? 

Both development and permanent financing are available today if a project or existing property are fun­damentally sound and expectations regarding proceeds and terms are realistic. 

For permanent financing, the situation is hopeful. About half of the insurance companies are still lending to some degree. In addition, a number of credit companies are very active since they can now finance deals they could not get a few years ago given their higher rates. 

Development financing is far more difficult to obtain. A few banks continue to make loans; however, they usually limit their lending to long-term clients. Therefore, if de­velopers can get financing through a bank with which they already have a relationship, they should consider taking it even if it comes with difficult terms. 

New Criteria for Projects 

If a developer needs to find a new lender, it is possible to succeed, but both he and his project are going to have to meet a strict set of criteria. These include the following:

  • The project has to make financial sense. It must have some element that makes it stand out, such as ap­proval to build in a no-growth community or a long-term bond lease with a quality tenant. Even then, the numbers must work using conserva­tive underwriting criteria.

  • Multi-family residential, affordable single-family residential, industrial, and retail projects are usually preferred to offices and ho­tels.

  • The developer must have experience and a good reputation with a healthy balance sheet to stand behind the construction guarantee.

  • The developer must be willing and able to put up a large amount of equity. Generally, a minimum of 20% of the project’s cost is required, with many banks asking for 30% or more depending on the deal. Some of this equity can come from joint ven­ture equity partners but banks in­creasingly ask that developers put up some of the money themselves since they want the entity running the project to share the risk.

  • Significant pre-leasing is essential. Most banks will want at least 75% of the building pre-leased and will not lend more than can be serviced by the cash flow that tenants are con­tractually obligated to make.

  • A take-out commitment must be in place since banks do not want to take the refinancing risk given the market.

With these criteria in mind, some developers can still finance their projects today, but most will have to wait until their respective markets improve.

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