by Brad Donnell, Senior Director
At some point in the not too distant future, development projects will start again as the economy recovers and the CRE market moves into the next development cycle. The question is who will those developers be? The past three years of carnage have purged the system of many experienced developers. Most developers who were active in the past 5 years are likely to have some degree of legacy issues, if not legacy disasters.
The market was filled with small to mid-sized developers who built 3 to 10 deals per year. Over a long period of time, they built solid relationships with national and local retailers, office tenants and users of industrial space that newcomers to the market will have to spend time re-creating. They took risk and while many were rewarded, many took it on the chops and those that escaped with their hide are rather gun-shy about sticking their toes back in the perilous commercial real estate waters right now.
Unlike the late 1980s, there is not an overwhelming supply of excess space in the market. There is a lot of space that is obsolete or unusable, but nothing like what was seen around here 25 years ago. The past lending cycle saw most deals underwritten with a fair amount of pre-leasing and even at the peak of the market, few 100% spec deals were approved. As a result, there are not a lot of new, unused, class A office buildings or apartment complexes just laying around waiting for tenants. The exit of many of existing tenants for financial reasons has left a fair amount of vacancy behind, but nothing a good stretch of economic recovery will not cure.
What lies beyond is more important to those with existing properties or for those buying distressed deals with vacancy. Currently, many lenders are just now transitioning from the denial phase of recovery to the acceptance phase. That is still a long way from being able to get behind a concerted effort to start lending for new construction again. A few have managed to right the ship and are back lending, but for those that are, they will not touch a developer who had any type of legacy issues. That is a rather small cadre of potential borrowers as almost anyone who came in contact with commercial real estate over the past 5 years has some blood still on their shirt.
Further thinning the herd of potential borrowers is the unwillingness of those unblemished to come anywhere near a recourse loan. Those remaining clean were likely at the opposite end of the risk taking scale during the past several years and the words risk-averse and recourse are generally not found in the same sentence with them. Many lenders who gleefully took back land loans will have difficulty finding developers to help them find the exit. We have encountered several potential transactions where a lender has asked us to help find a developer to build their way out of land deal. Even the prospect of contributing the land and effectively joint venturing it with a developer is not enough incentive to pull those sparkly clean, liquid, risk-averse developers off the sidelines and those with the experience and stomach for it are persona non grata with lenders.
For non-REO deals that do attract the stray, typical developer, the requirement of a substantial amount of equity by lenders has driven the capitalization cost of a transaction so high that the economics wind up scuttling the deal. While some non-recourse financing for construction exists, it is solely geared towards large, low leveraged transactions with institutional borrowers with relatively low return expectations.
While lenders will eventually soften their aversion to borrowers with less than clean records, there will be an extended period of time during a recovery where little development will take place for reasons other than economic. There may simply not be enough warm bodies around who are able or willing to place their head on the chopping block. For existing property owners and those buying distressed assets with vacancy, there will come a day where you might wish you had more of it.
Want to learn more about this? Feel free to contact Brad Donnell, Senior Director.