FINANCING INVESTMENT REAL ESTATE
Since the credit crisis of 2008, financing for real estate acquisitions has been squeezed tightly as banks struggle to contain risk amid falling real estate prices. The end is not yet in sight.
Interest rates are very low, as the Fed continues to motivate the loanable funds market. As the price of money, or the interest rate, declines, the demand for money should increase. Taken another way, with the availability of low interest rates, big-ticket purchases, such as real estate, should be attractive. Except that loanable funds are not being made available.
There are a variety of reasons why the nation’s economy took the big hit in 2008. Gary Hindes of Deltec Asset Management suggests that the Securities Exchange Commission is at least partly to blame. Apparently, the SEC in early 2004 allowed the investment banking community, which until then had net capital rules permitting a maximum leverage ratio of 12 to 1, to effectively operate without a maximum leverage ratio. Hindes contends the larger investment banks went to 30 and 40 to 1 leverage.
The concept of leverage is important when borrowing, or lending money. The more leverage a debtor employs, the more risk the creditor assumes. So if a creditor wants to limit risk, the leverage ratio, or loan to value ratio, is reduced. For example, in purchasing a home, mortgage insurance is typically required for loan to value ratios of 80 percent or more. The lenders have determined that borrowers purchasing homes with less than 20 percent equity or downpayment are more likely to default than borrowers with more than 20 percent equity.
To the Hindes’ point, when the SEC allowed investment banks to exceed loan to value ratios of 91.5 percent to leverage ratios of 96 percent to 98 percent, they assumed a lot of risk. Their asset value needed fall only three or four percent, and there was no debt coverage at all.
While it is true that real estate purchasers can purchase properties with three and five percent downpayment under certain conditions, and there is the obvious risk of default associated with the minimal equity invested, the idea was that the property would appreciate, thereby spreading the loan to value ratio out, and reducing that risk.
So people were buying real estate at ever – increasing prices, with minimal downpayment and with exotic loans like interest – only or adjustable – rate, and the investment banks were buying these mortgages and re-selling them to investors at ever – increasing leverage ratios. The fees and commissions and profits were astounding, and the cycle kept spiraling at ever – increasing numbers.
Of course, this market provided loanable funds. Borrowers signed mortgages, underwriters sold the mortgages, investment banks bought the mortgages and then sold securities collateralized by those mortgages, and pension funds and countries and small local banks bought those securities. And the money filtered its way back to the street to be lent again.
The famous bubble burst, however, due to a number of factors. Case studies indicate that household debt to income ratios rose to 135 percent by 2007. Obviously, debt that exceeds income is a problem about to crash. The adjustable rate mortgages, and the interest – only mortgages written in 2005 and 2006, and earlier, came due. With the excessive debt burden, people put their properties on the market for sale in order to escape.
When enough people put their properties on the market, the bubble burst, and everything tumbled thereafter. Unemployment rose, further increasing debt to income ratios. Mortgage defaults in the subprime market rose. The subprime market, or the Alt-A market, are exotic loans mentioned above. But defaults were not concentrated in the subprime market; defaults occurred in the fixed rate and conventional markets, as well.
With the higher default rates, the secondary market because frightened, and the securitization of the mortgage market dried up. And a huge pool of loanable funds dried up with it.
While there are more factors to the credit crisis and current economic conditions than these few discussed, these factors are relevant to the current state of lending in today’s market. Financing real estate today is difficult because of the lack of loanable funds, and because of the total aversion to risk exhibited by lenders. Finally, there is the high unemployment rate.
Lending standards have reverted to the pre-bubble conditions that existed prior to the Clinton Administration, when the borrower’s source of income had to be verified, when actual downpayment monies had to be invested, when higher loan to value ratios resulted in higher interest rates and higher mortgage insurance premiums, and when lenders had less confidence in the price appreciation of the real estate market.
So while financing is available, it is difficult to obtain. Many local lenders are still trying to recover from huge loan defaults in the commercial real estate market. When the residential market crashed, many half – built subdivisions stopped absorbing, and ultimately defaulted, leaving lenders with real estate to dispose of, known as Real Estate Owned, or REO. Loan Loss Reserve accounts increased, further reducing the amount of loanable funds.
The current conditions are simply that local area lenders are not extending loans for speculative developments or investments. Many lenders, while seeking new loan clients, are cautiously measuring their opportunities with wealthier clients, who need lower loan to value ratios, that have sterling asset values.
Many lenders are lending only to owner – occupied investments. Investment real estate is out of the question except for very low loan to value investments. This trend should continue until unemployment drops, vacancy rates decline, and foreclosure rates stabilize.
The world’s largest economy is starting to purr again, as evidenced by increasing stock market returns and higher retail sales, however, the real estate market continues to teeter with the lack of liquidity and credit that a healthy real estate market requires.
McGinnis Commercial Real Estate Company can assist you in your purchase of investment real estate by helping you to find properties that are priced correctly, and by matching you with lenders who are ready, willing, and able to help you with your acquisition. The real estate market has become complicated with the current market conditions, and you need real estate professionals who can help you navigate through these difficult market conditions.