Developers, Investors Say There’s a Credit Squeeze

Call it overstatement--or even whining--but real estate developers and investors, spoiled by low interest rates and years of eager lending, insist they now suffer from a liquidity crunch of immense proportions.

And although they may exaggerating, the impact of a leaner lending environment is reverberating through the nation’s real estate markets, including booming Southern California.

Many building purchases have fallen through. Development plans have been halted or scaled back. And trophy buildings that were once the subject of intense bidding are now lucky to get a second look from buyers.

“Whereas before we might have eight to 10 bidders for a property, now there are only two to four,” says Stuart Rubin of Los Angeles-based Rubin Pachulski Dew Properties, an owner of hotels, office buildings and shopping centers, who sold several of his properties to REITs for hefty profits in the last two years.

The credit squeeze is a warning, analysts say, that people in the real estate business should not get carried away like they did in the last boom.

“This is sort of a wake-up call,” says David Dale-Johnson, director of the real estate program at the Marshall School of Business at USC. “The markets are more in tune now, so I don’t think we’re going to get as overbuilt” as in the last cycle.

Real estate money started becoming more scarce at the beginning of the year, when the specter of overbuilding and declining profits pushed down shares of most real estate investment trusts precipitously, blocking their access to Wall Street capital. Since January, REIT shares, as measured by Bloomberg’s REIT index, have plunged 21.5%. That blow was followed by an uppercut in recent months, when a flood of mortgage-backed securities hit the market just as U.S. investors were getting jittery and demand from mortgage REITs was cooling.

The oversupply forced so-called conduit lenders, or lenders who pool loans and issue securities against them, to promise huge spreads against yardstick 10-year Treasury notes. The price undercutting put many of these firms into the red, and forced some out of the business entirely, leaving investors and developers with far fewer choices for funding.

Total real estate lending by commercial banks fell to $9.2 billion from May through August, from $38.7 billion in the previous four months, according to PaineWebber Inc.

Those that are still loaning money demand that developers shoulder more liability. Instead of financing 80 to 95% of a building’s cost, lenders now require borrowers to put in about 30% of their own money.

And loan rates, which had been priced just over 10-year Treasuries, are now priced a point to a point and a half higher--sometimes at 8% or more, says Richmond, Va.-based mortgage banker John B. Levy.

“They want to make sure this time they don’t get hurt, and they want to make up for some of the losses they have been taking,” Levy says.

This tightening of capital also has put the brakes on development. If it’s not under construction now, analysts say, don’t hold your breath.

“We are getting more conservative in our stance,” says John Davenport, senior vice president of Menlo Park, Calif.-based Spieker Properties. The company has already started a few speculative office projects in Southern California, but it has scaled back plans for other development.

“The easy money has gone away. If developers are going to build, they are going to have to [sign tenants] first,” Davenport says.

Real estate lenders say talk of capital drying up is gross exaggeration. Only the conduits are getting out of the business, they say. Portfolio lenders, or banks that hold on to their loans rather than securitize them, are still using the same underwriting guidelines. And their rates are still relatively low, from a historical perspective.

“Candidly, rates are as low as they have been in--how many years,” says Molly McCabe, principal in Mill Valley, Calif.-based Bridger Commercial Funding. “Generally speaking, to get a loan under 9% is pretty good.”

But for investors, who have little to put down or just a small initial margin of return, the collapse of the commercial mortgage-backed securities market has meant the collapse of deals.

A Wall Street bank walked out in the eleventh hour on Santa Monica-based Kennedy-Wilson Inc.’s purchase of a Los Angeles office building, according to Nick Kanieff, president of the firm’s commercial property division. The lender ultimately returned, offering funding if the company would put in more equity--$7 million instead of $1 million--and pay a higher interest rate. That put the high-rise out of reach, Kanieff says.

“It destroyed my return, so the deal was no longer attractive and I bowed out,” Kanieff said.

Nationwide, purchases have been falling apart, brokers say, as lenders refuse loans or renegotiate them. And sellers, hoping to cash in at what they thought was the peak of the market, have been left holding the bag--and in some cases the buyers’ deposits or so-called earnest money.

“I’ve lost a few deals and right now I’m trying to get one or two back together, says Richard Plummer of brokerage Cushman & Wakefield. “These are very challenging times.”

Some real estate investors, unwilling to play by the new stringent rules, are simply calling it quits for the year, waiting to see if such big investment banks as Nomura Holdings America, Lehman Bros. and Credit Suisse First Boston begin making more commercial mortgage loans next year.

According to Eric Hamermesh, a vice president with Credit Suisse First Boston, most conduit lenders are still trying to figure out how they can make these loans profitable again.

The only people still actively buying commercial real estate, analysts say, are firms with private capital like Rubin’s group of wealthy bankruptcy attorneys and cardiologists, and insurance companies and pension funds that have a steady supply of money coming in from individuals’ monthly payments.

“Cash is king,” Rubin says. “We are using that as an opportunity to buy properties [left by] people that did get caught and couldn’t close.”

Increasingly, he says, there are more bargains to be had, as buyers have been cut off from the cheaper money. Across the country, buildings are selling for anywhere from 5% to 15% less than sellers were originally asking. And here in Southern California, prices are just starting to inch down. They should fall further in the next couple of months, brokers say, as more expensive lending takes its toll.

Rubin says his company has taken a few buildings off the market, because he feels prices already have hit their peak. Unlike many other landlords, his group can afford to hold on to these properties long-term, because the rents more than pay the mortgage.

He thinks the so-called liquidity crisis may once again force investors to consider buildings for their cash flow rather than their potential.

Indeed, most people--even those buying and building real estate--think the current lending crackdown will be healthy for the market, discouraging foolish investment and unnecessary development, which in turn keeps occupancy and rents higher for landlords of existing properties.

“It’s the markets at their best, correcting themselves when there is an overabundance of capital in the marketplace,’ Kanieff says.