Developers and Lenders at a Standoff as Payments Drag

The real estate sector was a boon for lenders in the tender years of the new millennium. Banks and investors were dumping billions of dollars into large scale projects and enjoying significant returns. Then the real estate market collapsed. The devastation caused a worldwide economic downturn and plunged the United States and Europe into the throes of recession.

The snapback of a rocked financial and real estate sector has been a clamp down on lending and a stall on new development. A more serious problem on the horizon is the maturity of loans doled out during those years when the market was hopping, which, now, as the financial climate in the country has cooled, are expected to lead to a massive series of defaults.

“The construction loan side is one of those things where nobody really has a good handle on the details and the pain and implications of it,” said Mike Kelly, president and co-founder, Caldera Asset Management. “Based upon the values on which the loans were given—where the prices and where the world was two to three years ago— all these loans are coming up on their maturity periods without any home.”

Most construction loans have a 3-year term with two one-year built-in extensions. Loans that originated in 2005 have already expired and the developers are currently staying afloat by the extensions. And with each passing month, the number of those loans extensions increases.

“When most people were building, they were trending rents, which has not occurred. Rents have actually gone down and underwriting standards have gone up,” explained Kelly. Added to the situation is that permanent loan holders, like commercial mortgage-backed securities (CMBS), have been wiped out, leaving few venues for this debt to go or few parties that want to take a risk holding such debt. “You’re going to have a lot of maturity defaults to start coming in the next six months on for the next 2-3 years as all these deals mature,” Kelly said. “They’ve already had their one extension or two. But this time it’s not going to help them.”

According to Caldera, hard hit sectors, like apartment construction lenders, are facing losses of $22 billion as asset values have tumbled downward 25% during the last couple years. That loss amount represents 17% of total loan balances. Because of the real estate market bubble burst, investors who anted up the 10% equity during the 2005 boom have already lost that investment. Apartment construction loans from 2005 to 2008 totaled roughly $137 billion. Equity represented approximately 10% of that sum, around $12.5 billion, while construction debt accounted for another $125 billion outstanding. That original equity has been evaporated as the total value of those projects has fallen to $103 billion this year.

Furthermore, Kelly believes that the days of that 80-90% loan-to-value (LTV) ratio that was available in 2005 are gone for the foreseeable future. Lenders today want to have a lot less exposure, with around 65% LTV. That means if the original developers wanted to refinance those completed apartment assets, they would need to come up with $36 billion in new equity.

The current economic situations forces banks into a difficult position. New loans aren’t problematic—conditions now are very optimal for lending. It’s that the payments on existing loans have slowed considerably and are not being repaid at the rate the banks had originally anticipated. This creates a clog where, even though conditions are ripe for banks to fund new projects, the exposure they already have on their books and the loans they are waiting to receive payment on won’t let them supply more capacity to the marketplace.

“Apartments were the belle of the ball on the investment side,” said Kelly of the boon years between 2005 and 2008. “But those days are gone. If the money is not being recycled through, the bank isn’t going to add to its exposure in an asset class where there is a lot of uncertainty.”

Now, the near-term future for the construction market is going to be smaller deals in “bulletproof” markets like Washington, D.C. The days of a $100 million project backed by a single lender are done. But for developers, another tough obstacle to overcome is that banks that lent heavily to the construction sector, like Washington Mutual, are also gone.

“You had a lot of these guys that were aggressive who aren’t there anymore,” explained Kelly. “Now, banks don’t want to put that much exposure into the sector or with an individual developer or with an individual project. That means you’re going to have a lot more equity and the deals are going to get tighter and tighter and tighter because your equity wants a higher return.”

Even though Kelly believes there is plenty of money on the sidelines waiting to be put into play, he doesn’t think there’s enough upside right now for anybody to leap into the game. “The pain can sort of be mitigated. However, nobody has a lot of real incentive to jump in front of the train. Not from the lenders’ standpoint, from the FDIC’s standpoint, from the borrowers’ standpoint or the buyers’ standpoint,” Kelly stated. “What that is going to do is kill new development going forward because there’s not going to be any capacity. So, the developers are going to start taking hits and laying people off and it’s just going to be a vicious cycle.”

Matthew Carr, NACM staff writer. Follwo us on Twitter @NACM_National