Navigating Credit Issues in 2008-2009

Lender Demands Changes in Pre-Agreed to Loan Terms
A large development company headquartered in the southeast and working both inside and outside of the U.S. had this to say: “In our U.S. business, we felt the subprime problems directly when we tried to close a loan under pre-agreed-to terms, which the lender now considers unfavorable. Fortunately, we were able to close the loan, but the lender forced us to accept some revisions to the original terms. “Fortunately, most of our business is done abroad, where the subprime problems are not as severe. We have not experienced any problems with our foreign business related to subprime issues. I do expect the subprime problems to get worse this year because the interest rates on so many mortgages will be increased. My advice would be to recognize that financing contingencies are very risky now. If you are depending on another party to secure financing, it behooves you to carefully research and evaluate their ability to do so.”

The Pendulum Rarely Stops in the Middle
A Midwest developer: “Subprime problems are definitely spilling over into commercial real estate because the pendulum rarely stops in the middle. When there are problems in one sector of the credit market, it usually creeps over eventually into the other sectors. “We are now seeing impacts on property values--negative impacts! We are seeing it in the difficulty of getting loans. And the loans that we do get are requiring more equity on our part. So this clearly is not isolated to the housing sector alone. To get through these tough times, you need to be prepared for financing to take longer than anticipated and to find partners with more ‘patient’ capital. There is a whole emerging mezzanine level of debt that is represented by more patient capital. That was starting to happen regardless of the subprime mess. Pension funds typically have a longer time-horizon, but that usually comes with a higher cost down the road. Another thing, the difference between cap rates and interest rates had really become compressed. We are seeing that widen—as the cap rates get higher, the values go down.”

Less Interest in Purchasing Commercial Real Estate
A multi-market developer headquartered in the Midwest: “Subprime problems are everywhere. I’ve seen them as I have traveled around the country, particularly in some communities that were growing rapidly. In a California town I visited, which had grown from 20,000 to 120,000 in the past 10 years, the local newspaper had six pages of legal notices on foreclosures on one day.

“There is not as much interest in buying commercial real estate right now as there was in the recent past. We are just at the front edge of a major increase in cap rates. We have seen them bottom out and in some cases people are having more trouble financing properties. We have seen a slight uptick on cap rates on things we were thinking of buying. We have not had any issues with our lenders. We maintain a relationship with probably 20 lenders. I think that has been a key for us in that we have had a very good, long-term relationship with our lenders. As a seller of properties, you want lower cap rates. As a buyer, you want higher cap rates. We are buyers not sellers so we think that there will be some great opportunities to pick up properties that we probably could not have gotten a year ago.”

Subprime Issues Affect Vacancy Rates
A West Coast developer’s bottom line has been directly impacted by the subprime debacle. “There is no difference in financing in my world yet, but the subprime mess has had an impact on my business nevertheless. I had a number of tenants who were affected by these problems. They could not pay their rent and either they went bankrupt or came to us and said they would declare bankruptcy unless we let them out of their leases. We are probably down 10,000 square feet from that. These were people who handled mortgages, title insurance, real estate brokerage agencies and home warranty companies.

“I think this is longer than temporary and I think we will have to deal with it for the next 24 months. We have not seen the worst of it yet. I think the worst will come later in 2008. When we do start to recover I think home mortgages will be done in a different way. We are going to have to come up with far more sophisticated ways to get a mortgage. Instead of all of those different mortgage brokers that are out there, there will be more use of the Internet, more comparable services where all of the ins and outs of a deal are listed so that a buyer can compare the deals--from closing costs to points to all of the details of the mortgage including callability and adjustability. It will have to become far more transparent so that even people who only refinance once every 10 years understand what is happening.

“A partner of ours has started a company and his idea is that commissions that real estate brokers have been charging are way out of line with the level of service and the professionalism of the industry. His company has a transparent process in which one checks off the services one needs. That is, you are charged an hourly rate for assistance with the sale of a home. Each service is broken out and transparent. They are completely changing the model from commission driven to fee driven.”

Good Buying Opportunity at Hand
A major eastern developer/owner, who is a net buyer of properties, sees a good market ahead: “We are seeing consistent demand, even with the credit market dislocation. We have pretty full occupancy and long-term leases so this should insulate us over the current market cycle. We service good core, diverse industries. We continue to see good growth in technology and bio-medical. On leases that are expiring in 2008, generally people are renewing and staying where they are. We will see flat conditions over the next year and we are controlling operating costs. As a buyer, I think the best is yet to come. There is a fair amount of poorly underwritten debt in the market. If the capital markets continue to be illiquid, it will provide a good opportunity for us.”

Give Your Company an Economic Health Checkup Real estate investors, developers and service companies need to prepare for a tougher business environment due to problems with subprime residential mortgages, according to Stan Ross, chair of the University of Southern California Lusk Center for Real Estate in Los Angeles. No one knows what will happen to the economy, the credit markets, or oil prices in 2008, “but real estate companies shouldn’t wait to see if a storm will hit, or how intense it will be,” he said. “They need to start their contingency planning today.” Ross said companies can begin by assessing the current health of their organizations. Then they can consider how to maintain the stability of the firm under different risk scenarios such as the economy’s sliding into a recession or property markets weakening further. A health checkup includes a diagnostic of the organization itself and analysis of the external forces including the economy, business environment and especially local market conditions. Ross suggested that companies conduct ongoing market assessments and evaluate the impact of market changes on an organization’s health. Key areas to consider are: Internal Development pipeline Land inventory: land owned or under option Proposed developments Development deals under negotiation Deals closed but not yet under development Development projects in the pipeline Assets Existing inventory: location, type, acreage, number of lots, square footage, etc. Market demand by location Status of commercial lease renewals Income Property sales Rental income Other income streams Costs Land acquisition and development costs Operating expenses Liquidity Cash on hand Access to capital (from lenders, governmental bodies, outside investors) Financing Debt outstanding Debt covenants Debt service Financing costs External Economic Business Property market Regulatory Consumer confidence For more information Lusk Center for Real Estate: www.usc.edu/schools/sppd/lusk/pressroom/item.php?id=1049