We’re In This Together
No doubt we have all enjoyed the classic holiday film It’s a Wonderful Life, and in my household more than once. To remind everyone, the plot is built around the Bailey Brothers Building & Loan business and George Bailey’s near-death experience only to be saved by an angel who seeks his wings by showing George what the world might be like without him and his community savings bank. Our Chairman Minutes would be remiss if we did not catch-up on the current day banking mess and its impact to the real estate industry and the potential offing of a new credit crisis.
Certainly, we are not wanting of additional media coverage, expert hindsight, or moral hazard debate. We understand that the cause of these bank failures was a perfect storm of a trillion dollars in deposit outflows, poor risk management, massive government spending, a sustained low-interest rate environment and precipitous rate hikes not seen since the 80’s. From the borrower’s sideline, its own worst-case scenario unfolded with changing real estate demand metrics affecting occupancies, the overuse and dependence on floating rate mortgages and ultimately the market’s debt illiquidity.
All real estate, however, has not been equally affected. Much of today’s real estate is still performing quite well, especially those in segments with appropriate supply demand metrics and properly capitalized long-term fixed rate financing or with little or no leverage at all. The vulnerability primarily exists with those in need of refinancing, and specifically, within the office sector. Further, the properties financed with floating rate debt will be particularly hit hard in a vastly changed interest rate environment with the inevitably of more equity required to balance the books.
Fortunately, today’s $20 trillion commercial and multifamily real estate market is modestly financed with $5.6 trillion of debt. Unfortunately, 50% of this debt financing has been supplied by banks outside the top 25 weighted banks in the small and regional bank network whose balance sheets are the most affected by today’s credit crunch. The challenge then is where does the refinance capital come from with 25% of all mortgages expiring by the end of 2025?
During our last financial crisis, Great Financial Crisis (GFC), you’ll recall that all financial institutions were affected, big or small, compared to today’s more measured impact. Contributing explanations include added regulation preventing excessive risk-taking, required stress testing, higher base capital requirements and, rightly or wrongly, the government’s quick response to the crisis. Today is certainly further differentiated by an overall lower levered asset class and a better positioned economic environment with its low unemployment and growing economy.
My business partner, Tim Ballard, and I recently discussed this banking predicament, its impact on real estate lending, the going forward landscape, and its influence on our business, both positive and negative. We noted that lenders are becoming more frugal with their balance sheets, advance rates are going down, spreads are going up and non-relational customers without large deposit relationships are getting locked out of the market. This is resulting in investors/borrowers needing to fund more equity capital and utilize lower levered, more costly bank debt which will ultimately reduce overall valuation and investors levered returns.
Tim reminded me of our previous market cycle experiences, the Resolution Trust Corporation (RTC) days in the early 1990’s and the GFC of 2008-2009 where asset valuations were highly correlated to the availability of debt capital. The illiquidity caused by the market’s massive bank failures severely restricted the availability of real estate financing, ultimately resulting in some of the most attractive buying opportunities during our lifetime.
While Tim and I don’t predict market stress as severe as those times, today’s conditions will translate to a shortage of capital for many real estate borrowers. These experiences taught us to borrow conservatively and to build strong relationships with our lenders. Specifically, today, we have addressed our banking partners’ needs to buoy their balance sheets with increased deposits and gained clarity as to their new lending parameters to assure ourselves of their continued ability to transact in these challenging times.
Importantly, the credit upheaval will provide buying opportunities where we won’t have to compete with highly leveraged buyers that push asset prices to unrealistic levels. In contrast to what the headlines might report, we are becoming much more optimistic and active about new investment opportunities with fewer competitors pursuing assets. Predictably the seller market is now returning due to refinance pressures or exiting requirement mandates forcing more owners to sell. Highlighting this seller’s distress is the growing credit crunch predicated on fewer banking participants, their new debt underwriting and increased equity requirements.
Within our own lending business, the alternative lending market is alive and well serving as a lifeline to the growing exodus of regional banks. This non-bank lending space, sometimes referred to as shadow banking, is predominantly supplied by private equity sources who ironically still need banks to fund portions of their lending business. This sleeve of bank lending allows banks to originate real estate loans more conservatively with increased subordinated equity from both the private equity fund and the borrower. Our lending affiliate, Buchanan Mortgage Holdings, serves this very niche in providing sound borrowers and projects with predictability of capital in a space that was previously served directly by the banking sector.
There is no doubt that today’s credit crunch will have an enduring influence on certain banks’ survivability, going forward business models, and borrowers’ capitalizations of real estate projects. I’m confident that we have all improved our conversancy of banking technicalities and of the symbiotic relationship between deposits and lending. Banks will continue to be influenced by many variables including public policy, market cycles, new business delivery models and evolving capitalization requirements. In the final assessment, foundationally we need our banks to succeed given their integral role in both our business and day-to-day life activities.
Thankfully, at Buchanan Street, our banking relationships have carried the day for each of our real estate investment activities, and while new structures and terms are needed by the banks, we are appreciative of their open desk and willingness to provide continued credit. For those that haven’t watched It’s a Wonderful Life, in the end, Bedford Falls rallies around the bank, the Bailey Brothers Building & Loan survives, George gains a new appreciation for his life, and the angel gets his wings.