As our economic woes continue, many are making the mistake of seeing the restriction of credit as an anomaly… as a symptom of the credit crisis… as something that if markets were functioning normally would not happen. Perhaps, however, it is the loose credit standards of recent years that should be viewed as an anomaly. What now seems horribly strict is really just a return to prudent lending standards.
In fact what is really happening is that the distinction between equity and debt is being reestablished.
An article entitled Riverfront Tower in Jeopardy in Crain’s Chicago Business details how the developers of a proposed tower are having trouble getting as much bank financing to build it as they would prefer:
Hines Interests L.P. is struggling to finance a $536-million skyscraper proposed for a site along the Chicago River, as the credit crisis delays one of the city’s biggest developments and saps potential profits on the 52-story tower.
Houston-based Hines’ troubles show the depths of the financial crisis, which is threatening a project that until recent months would have been seen as a safe bet by lenders. Hines is one of the largest real estate firms in the nation, and its office tower would be anchored by two trophy tenants: investment bank William Blair & Co. LLC and law firm Baker & McKenzie LLP. …
Hines soon may face a painful choice: The developer could move forward, investing more of its own money in a project that ultimately may not be worth the massive risk. Or it could kill the project, writing off millions of dollars in costs and paying an equally high price in damage to its reputation.
So is this all about collapsing credit markets being unable to supply needed funds? The article explains that the banks want more equity put in the project:
A Hines joint venture needs a $328-million construction loan, but a group of four banks has committed only $200 million so far, sources say. The banks won’t lend any more without another $30 million in equity, contributed either by outside investors or Hines, which controls a nearly $23-billion real estate portfolio. But the Hines venture already has pledged $128 million in equity, along with an $80-million mezzanine loan from an affiliate, Hines Real Estate Investment Trust Inc. Pumping in more equity would saddle Hines with a greater share of the risk at a time when commercial real estate prices are falling.
Now we don’t have access to all the details, particularly of the lease terms that the anchor tenants have signed, but it looks like the bank’s expectation of more equity is prudent. Although Hines has secured two marquee tenants, they are taking, combined, between 590,000 and 640,000 square feet of a 1.1 million square foot building.
Typically these launch tenants may receive concessions as, to some extent, the building is being built on the strength of their credit. So we don’t know how valuable the building actually would be if it opened and was unable to lease the vacant space.
In other words, if Hines had leases on 100% of the space with a diverse group of AAA-rated tenants who had all signed 30-year leases and the leases were all triple-net leases (meaning the tenants cover taxes, insurance and maintenance), with the rent adequate to cover the self-liquidating 30-year commercial mortgage, we suspect the banks would be happy to fund the building, probably with much less equity than is being put in now. This is because there would be almost no risk and the risk that exists — the default of one or more of the tenants, overruns on construction costs, etc. — could be insured against.
Traditional banking is, at its core, a low-profit business. People who worked in banks were not traditionally paid very much. Banks were not in the business of taking any risk — they couldn’t be because their margins were so small — they had to live on the spread between what they would pay depositors for funds and what the bank could charge borrowers.
There is no question that the financial markets have changed, as the article goes on to point out:
The financial markets have changed radically since June 2007, when construction started on the last downtown office tower, a 1.1-million-square-foot building at 155 N. Wacker Drive by developer John Buck Co. Chicago-based Buck borrowed nearly 79% of the project’s estimated cost and had less than 24% of the building leased. Hines may be able to borrow only 56% even though Blair, Baker and a third tenant have agreed to lease 60% of the proposed building.
It is, however, lending such as that which should be seen as an aberration, not today’s more conservative standards. Jesse Eisinger, writing in Condé Nast Portfolio explains what happened to credit standards in commercial real estate:
Here’s what we know about what happened in commercial real estate: Lending standards fell, starkly. Or as I prefer to see it, they were thrown out of the 60th-floor window of that gleaming office tower in downtown Atlanta/Phoenix/New York/San Francisco/insert your city here. The gap between the cost of debt servicing and the cash actually being generated by the buildings narrowed.
What’s more, it used to be that banks made loans for no more than 80 percent of the value of a property to ensure a healthy cushion of protection, but by the early part of 2007, loans were sometimes made for 120 percent of a property’s value. Who would be so crazy as to lend more than a property is worth? Anyone who believes in perpetual-motion machines — that is, that rents and underlying property values must always go up.
Now, of course, Hines is not asking for 80% of the cost of a commercial building. However the value of a building is determined not by its cost but by its rent roll. Because Hines has failed to fill up the building with long term leases by credit worthy tenants the value of the building is uncertain, there is enormous risk.
So what is the alternative? Does the economy just stop? Do we stop building things? Not at all. The alternative is to stop hiding risk or pretending it doesn’t exist. There is real risk but also tremendous upside potential. Gerald D. Hines, the founder and chairman of Hines L.P., was a well-known Houston developer but became famous for his innovative approach to sharing risk:
Gerald Hines learned caution in the boom-bust real estate market of Houston, where he landed in 1950 after graduating from Purdue University with an engineering degree. A U.S. Steel worker’s son, born in Gary, Indiana, he later worked in the mills.
He began dabbling in real estate in Houston in the 1950s and by the late 1960s was one of the city’s biggest developers. Back then it was considered foolish, if not wimpish, to share a project with investors; like other developers, Hines borrowed to build and kept any profits for himself. He began to reconsider after risking his entire net worth, about $5 million, to build the Houston Galleria mall and a 50-story office tower at the same time. “That was crazy,” Hines says. “I said I’d never do that again.”
Rather than borrow, Hines recruited equity investors such as European pension funds and the investment office of Kuwait. He usually invests enough to own 10% to 30% of the property, plus, as manager, the firm gets an additional 20% of any sale profit. But he largely eliminates the risk that a project’s failure will jeopardize his other assets.
In other words, banks are not there to take risk. Banks do not get the upside of a deal; they work on a fixed interest rate, so they can’t pay for the downside of a deal. That is the place of equity that gets both the win and the loss.
Whether it is a big commercial skyscraper, as in the Hines project, or a single family home whose buyer would like a mortgage, it is the distinction between debt and equity — between those who get the upside and those that do not — that needs to be re-established if we are to come out of current economic doldrums having built a sound base for future economic expansion.
