On a daily basis, banks are dealing with the reality of today’s world versus what things were like before this financial crisis. It’s radically different, and it impacts everyone from lenders to developers to building tenants, whether they are renting a retail facility, a commercial office building or flex space, or even an apartment.
Michael Dostal, the commercial real estate banking team leader for FirstMerit Bank, says the meltdown of the financial sector has created a paralyzing effect.
“Nobody knows what the next event is going to be,” says Dostal. “You can look at a whole litany of things that have happened in the last six to nine months that weren’t there even a few years ago.”
Smart Business spoke with Dostal about the root of the problem and some possible solutions.
How did the financial trouble start?
The meltdown in the residential market has already been well documented. These comments here will be restricted to investment real estate. Many commercial banks have commercial real estate departments where much of the financing for residential builders took place. In addition to large write-offs in residential mortgages, many of these same banks were holding loans to builders and developers that were now non-performing and were either charged off or placed in the work-out departments of these banks.
A second problem was the aggressive and highly competitive bidding on the few investment real estate projects that the banking community had the opportunity to fund. Up until early 2008, many of the larger and stronger transactions were placed with insurance companies and pension funds. This was because banks, as a rule, could not offer the same rates, amortizations and non-recourse features that were commonplace with insurance companies and pension funds.
With fewer deals available, many banks would try to gain an advantage by lowering rates, reducing the required equity and extending beyond the normal amortization terms. All of these activities contributed to banks taking on additional risk. When the market got soft and values dropped, many banks found themselves with non-performing projects, based on a current appraisal, that were underwater.
Will banks and lenders go back to performing due diligence like they used to?
Absolutely. Sound underwriting has not changed that much in the past 40-plus years. What does change over time is the degree to which a bank wants to adhere to those principles. We are now seeing a very quick return by many banks who veered from these principles to what has historically worked in this industry.
Given the heightened degree to which the regulators and investors are questioning banking policies and procedures, the industry must change if it wants to survive. Now more than ever, training and continuing education in the industry is critical. Those few individuals that have 20-plus years experience in commercial real estate lending have the added benefit of going through the ups and downs of an economic cycle before.
What is the real estate atmosphere like right now?
Banks have tremendous pressure on them to try to lend, but at the same time, regulating bodies tell them they can’t afford to take any more losses, and the easiest way to avoid losses is not to make the next loan. You’ve got people out there who desperately need capital to keep their businesses afloat, and those few people who want to start a business are finding they can’t get financing.
Here’s the real head-scratcher: There are billions of dollars sitting on the sidelines from the private investors who are afraid to redeploy their money. I’m not saying they’re keeping it in tin cans in their backyards, but they might as well. They have taken that money out of the money supply; it’s not out there working. Banks aren’t solely responsible for the tightening of credit.
But you can’t eliminate risk. Banks are in a risk business, they just need to do a good job of identifying the risk. With a real understanding of what the risks are within a particular transaction and how you are going to monitor that risk over time is the key to successful portfolio management. As the financial partner you need to be one of the first ones to react to a negative event, not the last one.
How can it be fixed?
The question becomes: Can an environment of hope and potential be created that could provide incentive for the private investment dollars sitting on the sidelines to come back into the field of play? When that happens, then things will start to move.
We need to get to a point that the rules for both the banks and the clients are at least consistent over time. Much of the fear and reservation many banks and clients have today is their concern that the rules and regulations for lending will be at least the same tomorrow as they are today. The fact that the rates may be higher is a much easier concept to deal with compared to issues regarding changes in what types of projects maybe acceptable, changes in loan covenants, lower advance rates on certain types of real estate, and shorter maturities.
Michael Dostal is the commercial real estate banking team leader for FirstMerit Bank. Reach him at firstname.lastname@example.org or (216) 694-5654.