Capital Markets…Capital Markups?
Throughout the industry, the slowdown in the capital markets has had ripple effects.
Steve Lipscomb

Lipscomb

While the U.S. economy and the capital markets have thus far proven to be generally resilient, the ongoing national real estate slowdown has had a noticeable impact. While the challenging conditions have exerted somewhat of a limiting influence on the overall economic portrait, the repercussions for the mixed-use and commercial development landscape have been much more profound.

Throughout the industry, the ripple effects of the slowdown have been felt in ways both large and small. From proposed initial concepts through financing, municipal approvals groundbreaking and ribbon-cutting, the residential slowdown and the scarcity of capital is not only changing the ways in which the industry does business, but ultimately determining the nature of the projects that are successfully developed.

For developers, investors and financial institutions alike, the short-term and long-term fallout has been and will continue to be significant. But how far does that influence extend? How deep does it go, how long will it last, and what kind of specific changes have been brought about as a result?

Generally speaking, it is probably more accurate to refer to the recent real estate slowdown a return to normalcy, rather than a deviation from the norm. After years of stratospheric successes and a seemingly unending industry-wide optimism that was too exuberant, risk is being priced back into the market. And that is a good thing! That is actually a healthy development.

This turn of events is not so much a reaction to bad projects that were being built or ill-conceived developments that were going up, but is more a reflection of the fact that the underlying economics have changed. The industry is recalibrating, retuning back to a more realistic perspective.

As much as these events most likely illustrate a natural and ultimately healthy cyclical evolution in the marketplace, the impact on the industry is no less significant. Like a python that has eaten a pig, the financial markets have swallowed some big obligations in a relatively short period of time, but the long-term effects will take some time to digest. There is still a glut of commercial real estate securities and other related debt that has yet to be absorbed and accounted for, and the overall picture does not seem likely to improve dramatically for some time yet. That said, ultimately this is not so much a liquidity crunch as a re-pricing exercise, and a confirmation that “risk” is now a word that is back in the financial markets’ vocabulary.

One of the ironies of a transition phase like the one the industry is experiencing right now is that when it comes to buying and selling, there is a definite double standard in place. Many sellers still think it’s a year ago and are holding out for big returns. However, with some buyers smelling blood in the water and expecting bargains, the stagnation is liable to worsen before it gets better. This counterproductive dynamic only exacerbates an already difficult situation.

In tenuous times, land owners tend to want a greater certainty of closing, so the ability to close efficiently and reliably has become a much more important factor in selecting a development partner. As a result, smaller, less established outfits are suffering disproportionately, while institutionally backed players are positioned well to benefit from recent trends.

The Places

Is the situation different geographically? Absolutely. While some markets and sectors are performing well, there is no question that equity requirements have increased and interest rate spreads have widened; in some markets, you cannot even get financing quotes on a condo project. There has been a definite retrenchment, and in some parts of the country, it is virtually impossible to get a land development loan to do a single-family development.

As a rule, infill development is still a strong performer, and there is a renewed appreciation for the security provided by desirable, predictable locations. In challenging times, a known quantity is always more attractive. On the edge of growth, however, it is somewhat of a different story; retailers are pricing risk back into the equation as well. While cap rates haven’t appreciably moved for infill, dependable tenants, and well-conceived properties, every step further out from that major-market bull’s eye represents both a rise in the exit cap as well as a fundamental change in what buyers are willing to pay.

The Wallet

The obvious bottom line is that it is harder getting projects done. Whereas 6 to 8 months ago, 80 percent financing was commonplace, and there was not much of a difference between the rates on different debt components, the current trend is to accept closer to 65-70 percent leverage at best, and the rate spread has almost doubled.

Deals are less likely to be approved and go live until a solid, ironclad financing commitment is in place. Tenant interest was once enough to get the go-ahead, but with lenders much more likely to renegotiate or change terms, currently it is generally necessary to have a lot more capital and certainty in place and up front. Those firms who are fortunate enough to have a solid, reliable financing structure in place and can point to sound financial backing are ideally positioned to capitalize on these developments and thrive in this environment.

If you are a developer and have real equity (say, between 25 to 30 percent) available to you, there is generally not going to be a problem, and in many cases it will be business as usual. But for entities with higher leverage and low equity, the odds for successful deals have certainly diminished and the development landscape has become more of a challenge.

While changes can always be disconcerting, it is helpful — not to mention much more accurate — to remember that the industry is currently going through a transition. As developers adjust to a marketplace that is shifting from a period of sustained over-exuberance to a more risk-averse posture, changes will have to be made to accommodate new realities and account for factors that may have been less of a concern not too long ago. While it may take some time for many of these fundamental corrections to process and for changes in the development community to shake out, the readjustment period is a natural and healthy part of the process. For years no risk priced in the market, and that is never a good thing. Now, with risk priced back into the market, the industry will steadily adjust to a newer, healthier reality.

Steve Lipscomb is national director, retail investments, for Dallas-based Archon Group, L.P.