Commercial Real Estate Lending Likely to Feel Spillover from Subprime Crisis
By Wayne Mascia
The commercial real estate sales market and the residential real estate market may or may not at any given point in time experience the same difficulties. The reason, of course, is that the forces that drive each sector are different. The commercial sales market is driven by returns and available funding through institutional lenders, and home sales area driven by available product and low interest rates through banks and mortgages companies. As only a cursory reading of the media, in August 2007, not only was residential real estate lending sent reeling by the credit crunch brought on by subprime lending, but because of that crisis, commercial real estate lending was also affected, albeit differently for the different categories of commercial buyers.
We all have come to understand the problems caused by the credit crunch in the residential market - defaults on loans, depressed housing prices, lending companies going out of business and huge losses at established companies - both here and abroad.
As a result, the commercial industry has had problems created for both buyers, developers, owners/users and investors. Each category, of course, has different goals, horizons and borrowing parameters, and these are beginning to become more apparent as we progress through 2008.
Developers, for example, purchase property to improve and either dispose of or lease it, ideally for a profit. They use short-term financing, typically from one to two years and priced on a variable rate tied to short-term indexes. Their perspective focuses on market indicators and property fundamentals, rather than on the cost of capital. While the recent Fed rate cuts are likely to make their cost of money more attractive, on the other hand, a slowing economy associated with those decisions is likely to have a more negative impact on the feasibility of any project in the year ahead. According to Mark Regoli of South Bay Development Company, the crunch and its aftermath will have an effect on project feasibilities: "We expect that buildings will be tougher to sell. There will be fewer buyers in the market," he speculated, "but at the same time, it will create opportunities for some."
For established, well-qualified developers, capital will be both available and attractively priced. Lenders, of course, will scrutinize projects to assure that they can perform in today's market. Owners/users, on the other hand, are buyers who intend to occupy the property to use in their businesses. They generally seek long-term financing with fixed rates since their horizon can be a decade or longer. Many make use of U.S. Small Business Administration financing that is both attractively priced and can be highly leveraged. They repay the loan out of the cash flow of the business.
Investors bring yet a different perspective to property purchasing and financing. Interest rates to this category of buyer are particularly important since their return is basically the difference between their cost of funds and the net operating income generated by the lease or leases on the property. Due to the inability of banks to place their securitized residential loans and the myriad of other costs associated with the credit crunch, inves- tors are likely to find capitalization hard to find and more expensive and, in turn, are likely to be the hardest hit of all the commercial real estate buyers, at least for the next several years.
As South Bay Development's Mark Regoli notes, "Investment buyers are going to have to accept lower yields and this, in turn, will lead to repricing of commercial real estate as an asset class."
Finally, we in the commercial brokerage community are likely to find the next year particularly challenging as we adjust and advise our clients to adjust to the new financial realities. In the perspective of history, Regoli put today's credit crunch in context: "We have seen how a lack of liquidity has impacted on markets in the late '80s and '90s and it seems to be repeating itself. Just like they told us in business school, real estate is a very cyclical business."
September 2008 Commercial Edition Issue