Nobody is going to build condos. Mezzanine financing is a dead issue. There was a full lack of understanding of the interconnectivity of markets. Those were just a few of the bold comments that experts spouted in The Real Deal’s Q & A on lending this month.
While banks have slowly started lending to each other again, financial analysts, academics and commercial real estate insiders are not taking the new lending landscape lightly. One said he was fearful that the lending freeze would “go on indefinitely.” Another said that middle-market entrepreneurs, which are a big part of the real estate engine in New York City, would get boxed out by banks and would not have access to the leverage they need to get projects moving.
Still, most of those interviewed this month seemed to think that while the vast majority of new construction on the drawing board in the city is being shelved, projects in mid-construction would get built. That’s because banks, even those that are struggling, have nothing to gain by cutting off funding 70 or 80 percent of the way through a project.
“They will fund till completion because if they stop, there will be lender liability litigation that they will undoubtedly lose,” is the way one NYU professor put it.
And, if there is any kind of upshot to having Wall Street turned on its head in these last few months, it might be that the new lending paradigm will keep the market less volatile in the future.
“It’s a little like rebooting a computer [and] starting again with very conservative lending,” said the head of a real estate investment bank.
Plus, there may be opportunities for investors who actually have liquidity. For more, we turn to our panel of experts:
Lawrence Longua clinical associate professor, NYU Schack Institute of Real Estate
With lending at a virtual standstill, what area of real estate development do you expect to be most affected in New York City?
Nobody is going to build condos. The question is the uncertainty of value in any deflationary economy. [People think], ‘I’m not going to buy anything if I am concerned that it might deflate in value.’ In commercial development, any new development is driven by rents. Looking forward, I see a reduction in rents. The ground-up construction lenders have substantially shut down. Any [lenders] that are still in the market are making loans capped at 50 to 55 percent of cost, and that is too much equity for almost any developer to put into a deal.
What is your biggest concern about the lending freeze?
That it’s going to go on indefinitely. A major provider of debt capital has been commercial mortgage-backed securities, especially in 2006 and 2007. In 2006 in the U.S., CMBS [provided] $203 billion, in 2007 it was $230 billion, in 2008 it was $12 billion, and there are perhaps two deals in the pipeline that might bring it up to $14 billion. This source has virtually shut down.
What surprises you most about the lending environment today?
If there is anything I am surprised about, it’s how severe and how sudden this was. There was full recognition that there would have to be a leveling off of the prices of single-family homes, but the thought was that it would be something of a soft landing. The fact that it has spread globally and into every asset class is stunning. There was a full lack of understanding of the interconnectivity of markets.
What kinds of projects, if any, are still able to get lending today in New York?
For development financing, probably nothing. If they are fully uncertain of values and value is heading in the wrong direction, any lender wants 35 to 40 percent in equity. Even lenders with low loan-to-value are requiring some kind of recourse. Even real estate investment trusts, in many cases with market caps of billions of dollars, are being made to come up with some form of recourse.
And how long will it take until New York developers feel the impact of the bailout?
A long time. It might take longer than the rest of the country, in part, because this town is so heavily driven by financial services. Job losses on Wall Street have a ripple effect throughout the economy. Existing properties are hurting; shadow and sublet spaces create some real problems, especially on highly leveraged properties.
Will we see projects in New York partially complete and left hanging because banks will start canceling construction loans?
Most of my career was as a construction lender. They will advance the loans as construction takes place. Once they start funding, they can’t stop. They will fund till completion because if they stop, there will be lender liability litigation that they will undoubtedly lose. If it is not finished, the property will not be generating money. Unfortunately, when it is complete they find that the value of the property may not be what they thought it would be.
What do you expect for the short- and long-term future of mezzanine financing?
Mezzanine financing [which can supplement a primary loan] is a dead issue for the foreseeable future. There might be funds that will purchase existing mezz financing, but I doubt that the market will provide new mezz financing for commercial real estate. One reason why mezz financing exploded over the last eight to nine years was that mezz lenders were able to exit their loans through commercial real estate collateralized debt obligations: pooling these loans and selling bonds. It’s possible that I might not see another CDO in my lifetime. The demand for yield in a low-interest rate environment and the exit provided by CDOs drove this market to a great degree. But the fear and uncertainty that has shut down the CMBS issuance is amplified in the mezz market.
Paul Adornato chartered financial analyst, BMO Capital Markets
What’s your biggest concern about the lending freeze?
I don’t necessarily think a reduction in construction lending in New York is a bad thing. If we are in for a period of slower demand in residential and commercial space, then delivering new space to the market is not wise. The market is working the way it should by slowing the amount of capital when there is less demand for new construction.
What kinds of projects are still able to get funding in New York?
There could be projects that still make sense. For example, Acadia Realty is looking to redevelop their retail space underneath the Port Authority Bus Terminal at the George Washington Bridge. So even in this environment, there are big-box retailers looking to redevelop retail space. Acadia Realty also has another project on Fulton and Flatbush in Brooklyn, the City Point tower, a mixed-use building anchored by Target [with] office space and residential above. By the time these projects are completed the economic environment will likely have changed. At Atlantic Yards the first portion is the arena, and that is moving forward. The rest will be subject to market conditions.
Will we see projects in the city that are partially complete and left hanging because banks will begin canceling loans?
It is not in anyone’s best interest, including the banks’, to have a half-built project. Usually when you see a half-built project, it’s because the developer is not able to meet its obligation. In that case, a better-capitalized developer can sometimes take over.
What do you expect for the short- and long-term future of mezzanine financing?
That’s an interesting area. A lot of the work-outs we expect to come from the bailout package will come in the form of mezzanine debt. They will look to acquire mezz debt if it provides an attractive risk/reward profile. It could sometimes be restructured into equity ownership, as a creditor sometimes gets ownership of the asset if the borrower is not able to satisfy the terms of the mezzanine loan.
Are you seeing developers shift to smaller projects or halting projects altogether because of the lending environment?
There are projects that were planned that will never get built. That’s the nature of the real estate game. There’s more talk than action. It’s part of the normal real estate cycle. It’s worse than it has been, but not as bad as the worst real estate depression in New York City. Office vacancy right now is 7 percent, which is quite healthy, given the layoffs that have been announced. We think vacancies could climb to 11 or 12 percent — still less than the 16 to 18 percent that the city saw in the mid ’90s.
Paul Fried principal, AFC Realty Capital
What area of New York real estate development do you expect to be most affected by the lending freeze?
Starting with condos, for-sale residential has been hit the hardest and will come back the slowest, depending upon the employment picture. At this point, it’s really a race to see what slows down more. Commercial development is entirely a function of the economy. With the financial question mark hanging over our heads, it’s not an environment supporting residential or commercial development.
What’s your biggest concern about the lending freeze?
The real estate industry sees growth through middle-market entrepreneurs. It’s not dominated by large public companies. Middle-market players need access to leverage lending. As we go into the lending thaw, the middle-market borrower will be the last to get access to credit.
Do you foresee anything positive resulting from the lending freeze?
It’s a little like rebooting a computer [and] starting again with very conservative lending. We are going to go through severe retrenchment. As we come out of recession, lending is going to be done on a conservative basis, which will keep the market at lower, less volatile valuation levels.
What kinds of projects are still able to get lending today in New York?
Basically, all lending now is cash-flow based, for all property classes — retail, residential, rental or office. The notion is that there is still money available to the extent the lender can assess a property’s cash flow and forecast future cash flow. The riskier the property’s cash flow, the less likely it is to get financing.
What sort of impact do you think the government bailout will have on lending in New York?
New York is still home to some of the world’s primary trophy properties, so as credit markets thaw, some of the places the first loans will go to are stable New York assets with Fifth Avenue and Park Avenue addresses.
What is the lending freeze going to mean for the construction loans that banks dole out in phases?
Construction has pretty much ground to a halt. Outside New York, we’ve seen many situations where banks have stopped funding in the middle of construction. In some situations, they don’t have funds or participating banks have gone under. Quite possibly, we could see problems here in New York because the projects tend to be large and involve multiple banks. If one bank has a liquidity crisis, that can bring the entire project to a halt.
Do you expect lenders to start canceling loans to developers?
There are banks that have not been in a position to fund their loans. We are already seeing that. Some lenders are reluctant to confess to their borrowers that they don’t have capital and try to find a technical breach of the loan terms so they can stop funding.
What do you expect for the future of mezzanine financing?
Mezzanine financing as it existed in the prior cycle is gone. The notion of a junior- to high-level senior loan with a little sponsor equity behind it is toast. It will only exist in a model where the sponsors are required to bring significantly more equity to their project. No matter how you look at these questions, it all comes back to the same result — developers and property owners are going to be required to bring far more equity to their projects.
Are you seeing developers shift to smaller projects or just halting projects altogether because of the lending environment?
If they do larger projects, they don’t shift to small projects because it means the same amount of work for smaller economics. It’s more [likely] that they sit on these projects, or mothball them while they wait for a change in this environment. It’s been going on an entire year. There has been talk about projects halting, but they have such long gestation periods before they require financing.
Matt Pestronk managing director, Ackman-Ziff
With lending at a virtual standstill, what area of real estate development do you expect to be most affected in New York?
Condo development is not going to be financed until current projects sell through or are converted to rentals. Condos will be down about 90 percent. For rentals, it depends on the availability of government money — rent-subsidized programs. For the people that build rental housing without government assistance, land cost will have to come down by half. Commercial development is not happening right now.
Will we see projects in New York that are partially complete and left hanging without the funds because banks will start canceling loans?
I don’t see that to be one of the primary problems right now, except with projects funded by Lehman.
What will it take for lending to free up and for banks to start lending to other banks again?
I think banks are already lending to other banks again. It’s just a matter of time as to when they lend to developers and how long it takes for reasonably aggressive debt to show up. I’d say it’ll be over 24 months before we get back to the traditional 75 to 80 percent leverage levels again.
Jarret Tarnol director of commercial real estate finance, GFI Capital Resources Group
Do you foresee anything positive resulting from the lending freeze?
Once the dust settles, there will be tremendous amounts of opportunities for those investors who have liquidity and the ability to develop, own and operate. The next few years will be a time for certain people to make a lot of money in commercial real estate.
What kind of projects are still able to get lending today in New York?
Stabilized assets like apartment and office buildings that have borrowers with good liquidity. Good net worth are still deals that are getting done.
What is the lending freeze going to mean for the construction loans that banks dole out in phases?
I was in Vegas a couple of weeks ago, and I counted the cranes not moving during the four days I was there. New York City seems to be the last market hit, but there are definitely projects that are going to be frozen for a while. Some banks that have closed loans on these deals will stop funding draws if they have no other choice, forcing developers to seek equity investors or to try to find money from sources like mezzanine funds. In some cases they will simply walk away, giving another developer the opportunity to take over. Although I can’t see Manhattan projects being affected like those in Las Vegas or Florida, the city is not completely protected from every bad thing that is going on in the country.
Do you expect lenders to start canceling loans to developers?
Yes. I have seen it begin to happen. Some lenders are looking for clauses in loan documents to avoid future draws.
Steve Kohn president, Cushman & Wakefield Sonnenblick Goldman
With lending at a virtual standstill, what area of real estate development do you expect to be most affected in New York?
Condo development will be most affected because that constituted most of the development occurring in the city over the past few years. Other than in Downtown, there was not much office development to speak of, but if there was it certainly would be impacted as well. Quality rental projects would be the most likely to be financed, but even these are challenging today.
What is your biggest concern about the lending freeze?
The biggest concern is that the lending freeze will affect well-performing, high-quality assets. The only problem is that they have near-term debt maturing at a level that can’t be refinanced today.
What do you expect for the future of mezzanine financing?
There will be increased demand for mezzanine financing given the reduction in senior loan levels. Senior debt used to be in the 75 to 85 percent loan-to-value range, and today it is less than 70 percent. This capital gap needs to be covered by mezzanine financing or additional equity. This is projected to continue for the near term.
James Parrott chief economist, Fiscal Policy Institute
What sort of impact do you think the bailout will have on lending to New York City developers?
There are three main components to the economic situation: the financial market, the housing market and the broader economy. It looks like some stability is returning to the financial market. It’s not clear, but it looks like bank lending is starting to thaw, especially since the Treasury has created an infinite safety net. But we still have the housing market problem and an economy in recession. We won’t be able to tell if [the bailout] is working until the economy gets going again. It was only intended to stabilize the financial market. Until there is action from Washington to stimulate the economy, the overall outlook for New York City development is not going to improve.
Do you expect lenders to start canceling loans to developers, and how will that process play out?
It depends on the project, what resources the developer has, their contingencies, but it is not going to be easier to get construction financing in particular.