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| Capital Market Update: Have we Hit Bottom? |
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The lingering question surrounding the credit crisis continues to be: have we hit bottom?
In the early summer months, the answer to this question appeared to be a tentative “yes.” The fallout surrounding Bear Stearns and speculation about other investment banks had begun to subside, spreads were narrowing and a tiny ray of optimism had begun to shine on the beleaguered capital markets.
Unfortunately, the proverbial light at the end of the tunnel turned out to be the headlights of not one, but two, oncoming trains. In this case, the bankruptcy of Lehman Brothers and the bailout of AIG created a train wreck for the world financial system. A wave of “who will be the next to go?” hit the markets and was only exacerbated by the failures of Wachovia and WaMu. Bank-to-bank lending, which allows capital to flow from investors to borrowers, froze up completely. Entities as vast as the State of California and as small as the local supermarket were unable to get working capital loans to finance inventories or payrolls. Finally, the U. S. Treasury was forced to act and the great Bailout of 2008 began.
The U.S. Treasury has announced that the first $250 billion of bailout funds will go to shore up the equity of U.S. banks – a good start that also offers potential upside for U.S. taxpayers when the bank market stabilizes. The initial thrust of the bailout is to thaw the frozen credit markets by increasing banks’ capital bases so they can resume lending. But where will this new capital go and specifically, what does it mean for commercial real estate?
Unfortunately, commercial real estate, particularly new development, is unlikely to be a near term beneficiary of the bailout. As anyone who has developed property knows, the economics always work backwards from the finished product and the permanent financing. Therein lies the rub. Pension funds and life insurance companies have traditionally been major providers of permanent financing. In the current state of the economy, these institutions will have fewer dollars to invest. Witness the current proposals to allow taxpayers to make penalty free withdrawals from their 401(k) or reduce capital gains taxes. These are measures designed to take capital out of the market. Although totally understandable (it’s hard to worry about your retirement or life insurance when you’re about to lose your home), it doesn’t bode well for the availability of permanent financing for real estate projects.
This is causing a ripple effect as construction lenders now question their exit strategies from development projects. Takeout commitments are becoming scarce and even when they exist, who’s to say if the permanent lender will still be around when it’s time to perform?
Developers should recognize that construction lenders are now placing an even larger emphasis on exit strategies. Forward lease commitments and pre-sales to creditworthy tenants or purchasers, once eschewed by developers who wanted to preserve maximum upside, are becoming vital.
Our advice to developers is to focus on minimizing risk, even when that means sacrificing returns. The financial crisis is far from over and capital will continue to be scarce (and pricey) for the foreseeable future. Try to preserve as much liquidity as possible and watch your commitments carefully. When the wreckage from Wall Street’s train wreck is finally cleared, the markets will recover. Just don’t expect to see capital coming down the tracks anytime soon.
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