Developers, Investors Say There’s a Credit Squeeze
Call it overstatement--or even whining--but real estate developers and investors, spoiled by low interest rates and years of eager lenders, insist they’re facing a serious liquidity crunch.
Although some in the industry may be exaggerating the troubles they face, it is clear that the lending environment in Southern California and elsewhere in the nation is less hospitable than it was even a few months ago.
Many building purchases have fallen through. Development plans have been shelved or scaled back. And trophy buildings on the market that were once the object of intense bidding are now lucky to attract a second look from prospective buyers.
“Whereas before we might have eight to 10 bidders for a property, now there are only two to four,” says Stuart Rubin of Los Angeles-based Rubin Pachulski Dew Properties, an owner of hotels, office buildings and shopping centers. Rubin said he sold several of his firm’s properties to real estate investment trusts for hefty profits in the last two years.
The credit squeeze, whatever its dimensions, is a warning, analysts say, that people in the real estate business can’t get carried away like they did in the last boom.
“This is sort of a wake-up call,” says David Dale-Johnson, director of the real estate program at the Marshall School of Business at USC. “The markets are more in tune now, so I don’t think we’re going to get as overbuilt” as in the last cycle, in the 1980s.
Real estate money started becoming more scarce at the beginning of this year, when the specter of overbuilding and declining profits pushed shares of most REITs down precipitously, sharply limiting their access to Wall Street capital. Since January, Bloomberg’s index of REIT shares has plunged 21.5%. That blow was followed by an uppercut in recent months, when a large number of mortgage-backed securities hit the market just as U.S. investors were getting jittery and demand from mortgage REITs was cooling. The oversupply forced so-called conduit lenders, or lenders that bundle loans and issue securities backed by these, to promise huge spreads against yardstick 10-year Treasury notes. These huge spreads made it impossible for some lenders to turn a profit and drove many of them out of the business, leaving investors and developers with far fewer choices for funding.
Total real estate lending by commercial banks, of which commercial mortgage loans are just a part, fell to $9.2 billion from May through August, from $38.7 billion in the previous four months, according to PaineWebber Inc.
Those who are still lending money demand that developers shoulder more risk. Instead of financing 80% to 95% of a building’s cost, which was typical recently, conduit lenders now require developers to contribute about 30% of a project’s cost themselves.
And commercial mortgage loan rates are now priced a percentage point to a point and a half higher--sometimes totaling 8% or more, says Richmond, Va.-based mortgage banker John B. Levy.
“They want to make sure this time they don’t get hurt, and they want to make up for some of the losses they have been taking,” Levy says of lenders’ new caution.
This tightening has, in turn, put the brakes on development. If it’s not under construction now, analysts say, it may not be any time soon.
“We are getting more conservative in our stance,” says John Davenport, senior vice president of Spieker Properties, a Menlo Park, Calif.-based REIT. The company has a few speculative office projects underway in the Southland, but it has scaled back plans for other development here and elsewhere.
“The easy money has gone away. If developers are going to build, they are going to have to [sign tenants] first,” Davenport says.
Real estate lenders say talk of capital drying up is a gross exaggeration. Only the conduit lenders are getting out of the business, they say. Banks that hold on to their loans rather than securitize them have not instituted any draconian new lending guidelines, they say. And from a historical perspective, their rates are still relatively low.
“Candidly, rates are as low as they have been in--how many years?” says Molly McCabe, principal in Mill Valley, Calif.-based Bridger Commercial Funding. “Generally speaking, to get a loan under 9% is pretty good.”
But for investors who have little to put down or were aiming for a narrow initial profit margin, the collapse of the commercial mortgage-backed securities market has meant the collapse of deals.
A Wall Street investment bank pulled its financing in the eleventh hour on Santa Monica-based Kennedy-Wilson’s planned purchase of a Los Angeles office building, according to Nick Kanieff, president of the firm’s commercial property division. The bank later returned, saying it would offer funding if Kennedy-Wilson would put in more equity--$7 million instead of $1 million--and pay a higher interest rate. But those terms put the high-rise out of reach, Kanieff says, explaining that it would have been impossible for him to make a decent return on the project, and so he bowed out.
Nationwide, deals have been falling apart, brokers say, as lenders either refuse to make loans or try to renegotiate them under more stringent terms. And so many would-be sellers who had hoped to cash in at what they thought was the peak of the market are finding they’re out of luck.
“I’ve lost a few deals, and right now I’m trying to get one or two back together,” says Richard Plummer of brokerage Cushman & Wakefield in Los Angeles. “These are very challenging times.”
Some real estate investors, unwilling to play by tougher lending rules, have decided to sit tight for a while, waiting to see if such big investment banks as Nomura Holdings America, Lehman Bros. and Credit Suisse First Boston might begin making more commercial mortgage loans next year.
According to Eric Hamermesh, a vice president with Credit Suisse First Boston in Los Angeles, most conduit lenders are trying to figure out how they can make this securitized lending profitable again.
The only investors still actively looking to buy commercial real estate, analysts say, are firms with other sources of capital, such as insurance firms and pension funds, or the kinds of wealthy individuals who make up Rubin Pachulski.
“Cash is king,” Rubin says. “We are using that as an opportunity buy properties [left by] people that did get caught and couldn’t close.”
Increasingly, he says, there are more bargains to be had, as the tight lending environment has narrowed the number of buyers in the market.
Across the country, buildings are selling for anywhere from 5% to 15% less than sellers were originally asking, according to market observers. And here in Southern California, prices are just starting to inch down and should fall further in the next couple of months, brokers say.
Rubin says he thinks the current credit environment may force investors to consider buildings for their cash flow rather than for their potential. In other words, he says, lenders won’t extend credit on the theory that a bigger fool will come along to buy the property later.
Indeed, most people--even those buying and building real estate--think the current lending crackdown will be healthy for the market, discouraging foolish investment and unnecessary development, which in turn keeps occupancy and rents higher for landlords of existing properties.
“It’s the markets at their best, correcting themselves when there is an overabundance of capital in the marketplace,” Kanieff says.
