lending advice
The New Paradigm
by Mark Levine
Back in July, I stated that the only certainty regarding our financial markets was that the near future would be volatile. Boy, was I ever wrong. Volatility would be a quiet walk in the park compared to what we have been experiencing lately. Mayhem or pandemonium would be a better way to describe the state of the markets recently. If we are lucky, we will return to a state that is calm enough to be described as volatile.
How will we know when we reach this state of relative calm? And what conditions, as they relate to real-estate finance, will characterize this new state of the markets? These are the questions that real-estate owners and managers are asking these days. If we are being honest with ourselves, we will admit that we don’t know the answers to these questions. But we can make some very good assumptions based on what we have seen so far.
First of all, there’s a very good reason that nobody knows the answer to the question of how the markets will look on the other side of this major bump in the road: we are facing absolutely unprecedented conditions in the history of our financial markets. I am not referring to the drop in home values, or the declines in the stock market, or even the failures of some of our largest banks. I am referring primarily to the fact that there are major forces outside of the markets that will shape the future of our business going forward.
If the markets drove everything, it would be relatively easy to guess what will happen over the next several years. Opportunistic money would slowly start coming back to the market. Then some added competition from large, private institutions would increase their participation in the money flows. Then, after some semblance of normality returns, the major banks and funds would once again embed themselves in the business and an efficient market would ensue. When this large volume of players returned to the market and competitive forces ruled again, you would know that we were well along on the path to stability.
But, free markets are not driving this train any longer. The government, in the form of politicians and regulators, has essentially taken over. Whether you think that’s a good thing or a bad thing, it became necessary. Because of that, changes and developments in the markets are subject to political pressures and governmental powers, more so than market mechanisms. Therefore, instead of the aforementioned progression toward a more stable marketplace, we should expect governmental debates and legislation to eventually steer us toward some form of stability.
So, how will we know when we get there? For starters, I do not expect much progress before the November elections. With politics so suddenly imbedded in our financial markets, this election season has gained increased relevance to our finance industry. Political candidates are likely hearing more than ever from their constituents, and those constituents will undoubtedly hold the candidates accountable for votes cast on economic legislation. There will be much posturing, and much debate, but there will not be much progress made until we have a clear indication of who will be running this country.
Another very obvious point at which markets might stabilize will be when we stop experiencing failures of our most major financial institutions. Even if the failures stop today, the carnage is staggering. The list is now too long to name names, but these are monumental times when some of our largest and most well-respected banks have been forced to close their doors. It seems that the worst of these failures are now behind us, but the markets will not return to any sort of sustained normalcy until investors, depositors and traders can be confident in their chosen institutions.
This brings us to the second question: how will the financing markets look when the dust settles? Based on the prior paragraph, the most obvious answer is that the markets will be much less competitive. At least in the near term, only a small group of banks and other lenders will be active in the real-estate markets. After all, troubles in the world of real estate are what precipitated the current conditions, and therefore it makes sense that those lenders who were heavily embedded in the real-estate industry are the ones who no longer exist.
However, this is only partially true.
Some of the banks that remain, and appear to be on very solid footing, were also very active in the world of real estate. The difference, however, is that the existing firms were generally much more weighted in the worlds of commercial real estate and institutional clientele. It is perhaps not rocket science to state that the firms who will have failed will be those who were weighted in riskier residential and lower quality commercial real estate. Other firms, such as Goldman Sachs, JP Morgan and Morgan Stanley, had billions of dollars of exposure to real estate and they are still standing. It is no coincidence that their investments involved arguably more conservative opportunities and stronger clients.
If we learn from the past, which I think we will, future lending will mirror the business models of the firms that survived. This will likely mean that there will be strong demand to lend money on assets perceived to be stronger and safer. Geographic markets will once again be important to credit decisions. A loan for a property in rural North Dakota will no longer fetch the same competitive rate and terms as a similar loan for a property in the Bay Area. Believe it or not, these two loans looked the same to a mortgage investor 12 months ago, and that’s obviously an indication of why we find ourselves in these troubled times.
To be sure, this does not mean that lending will only come back in the strongest markets with the best properties and largest borrowers. Mortgages will continue to be readily available in all markets and to various levels of borrowers, but there will be much more pronounced differences in what exactly is available. As previously mentioned, the details are somewhat unpredictable because of the yet-to-be-determined role played by the government. Based on recent actions, it will certainly have significant influence on the business, at least through Fannie Mae and Freddie Mac. These are two of the few companies that are continuing to actively make loans on residential and multifamily real estate, thanks in large part to governmental support. We can be nearly certain that the government will also encourage other institutions to actively make real-estate loans, in the interest of competition and to the ultimate benefit of the borrower.
For better or for worse, we are still in a very uncertain environment. As discussed in previous columns, the investors who can see through the smoke and focus on the fundamentals of his or her real-estate investments will see great opportunities. This is the time to find ways to operate more efficiently, and to take advantage of the many new opportunities hitting the market every day. Those are the only things that you can personally control, and in hindsight, they will prove to be the smartest investments that you will have made with your time and money.
The opinions expressed in this article are those of the author, and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2008 by Black Point Press. All rights reserved.