How investment real estate has changed in the new economy Featured

8:00pm EDT March 26, 2010

The real estate market has always been cyclical, and the current situation is no exception.

As lending institutions became more aggressive during the majority of the first decade of this new century, they started to relax requirements. As requirements relaxed, the amount of equity needed to put into a project went down. That made it easier for developers to do more projects than they normally would have. If the bank was asking for 15 percent equity, rather than 25 percent, the developer was obviously going to do more projects.

The problem came when the market slowed down, and there was a far greater amount of projects than people who wanted them.

“Basically, we’ve returned to the lending posture of the mid-’80s,” says Tom Cargo, senior vice president of commercial real estate at FirstMerit Bank. “In the early part of that decade, we had double-digit unemployment, double-digit inflation and the prime rate at 21.5 percent. There were all kinds of ugly issues going on and it caused a downturn, just like today.”

One possible silver lining to today’s downturn is that we’re (hopefully) finally learning the lessons we should have years ago.

Smart Business spoke with Cargo about how investment real estate has changed in the new economy and how the industry has adapted.

What is the new reality of real estate?

For projects to be successful and for banks to be willing to take the risk, the client has to put more equity into the game. The bank may be a willing financial partner but they don’t wish to be the sole source of funding. Another reality is the change in value of appraisals. If an appraisal is a snapshot of estimated value at a specific place in time, those values are neither static nor guaranteed to escalate year over year.

Developers want a higher rate of return today than they would have five years ago. That shows there is a greater perception of risk associated with investment real estate. Where there is high risk, there should be high reward. Values have retrenched from where they were. Projects need more equity to work.

How has the market changed?

Right now, it is more of a tenant market than it is a developer market; there is more space to lease than there are people wanting that space. Also, industry consolidation is impacting the volume of space that might be needed in this marketplace. We are dealing with a shrinking population, but when you look at the volume of building that took place over the last 10 years, there is more square footage today than there was 10 years ago.

How are banks handling these new realities?

Another major reality is the pressures that lending institutions are facing to maintain credit quality. Banks are rewarded or punished both from regulators and the investment community based on the quality of their loan portfolios. Institutions that have high-quality loan portfolios — whose stock values have stayed up — are being asked by the FDIC to take over other institutions that are having trouble or in some cases have actually failed.

The attention and focus on loan quality is driving banks all across this sector to make sure that they make good decisions. These decisions go back to requesting client equity in transactions, dealing with quality tenants and borrowers, and getting more information.

The result is not unlike a grocery store suddenly changing its floor plan. You walk in the store and go to aisle six for chips and Coke, but you’re looking at laundry detergent. Now it takes you twice as long to figure out how to shop in your store because you don’t know where anything is.

That is one of the banking industry’s huge responsibilities. People are aware of the fact that the world has been turned upside down. Banks need to communicate the changes to the borrower. If people are looking to finance a project, the bank needs to tell them what is different and why it’s different.

How can you help your banker?

First, meet with your banker frequently. If there is a change out there that is impacting you, your banker needs to understand it, and vice versa.

The more timely information the bank has, the easier it is to make a quality decision. Robert E. Lee lost the battle of Gettysburg in part because he had no advanced knowledge of what was going on. While his chief scout, Jeb Stuart, was off trying to generate headlines for himself, Lee marched into that area not knowing about the amount of Northern armies gathering around him. History might have been radically different if he had that advance knowledge.

How do banks use that information?

Banking is an industry involved in risk. Banks can’t always make the risk disappear, but if they take no risks, they make no loans. So, banks have to take appropriate risks. Their goal is to truly understand what the risks are in your business. What about your business makes you wake up at 3 a.m. in a cold sweat? If it makes you nervous, it should make your bank nervous. Your bank can’t make the risk go away, but if it understands what the risk is and how to measure it, it’s in a better position to react.

Tom Cargo is the senior vice president of commercial real estate at FirstMerit Bank. Reach him at tom.cargo@firstmerit.com or (330) 384-7527.