Real estate borrowers bearing more risk

LANSING – Michigan may be the "Water Wonderland," as the state's license plates used to say, but one liquid asset – money for commercial real estate projects – is in short supply.

The massive credit crisis has left many developers and investors thirsty – not to say parched – for the money they need to undertake new developments, according to panelists at a recent Michigan Commercial Board of Realtors (CBOR) discussion in Lansing. And the drought is extending into northern Michigan.

Not only are national lenders treating Michigan companies as pariahs due to the state's troubled auto industry, but two key sources of funding – life insurance companies and conduits loans from commercial mortgage brokers – are mere shadows of their former selves.

Given their retreat from Michigan (and some other parts of the country), Dennis Bernard, moderator of the CBOR panel discussion, felt obliged to leave an empty chair on the stage at the Lansing Center, the venue for CBOR's spring convention.

"The empty chair represents the life (insurance) companies and the conduits – all of whom are nonexistent or refuse to come to Michigan to be on our panel," said Bernard, president of Bernard Financial Group in Southfield.

Conduit mortgages have become infamous, and not just in the world of commercial real estate. Like home mortgages, these loans were typically "bundled" into securities, given overly optimistic ratings as investments, and then sold to investors.

With the near-freefall of the nation's financial system, conduit funding has dried up – at least for now. In addition, scared off by auto industry woes, life insurance companies have beaten a hasty retreat from Michigan. They had been major providers of long-term loans for commercial projects.

Their absence definitely affects the region's developments, according to local developers. For one thing, a few major developments, such as Grand Traverse Mall, have historically relied on conduit or life insurance financing. Similar options might not be available for the next big projects in the pipeline.

In addition, projects of all sizes will now be competing for a shrinking pool of funds. New local developments "will be directly and indirectly affected," said Gerald Snowden, president of the Snowden Companies, who attended the CBOR session.

"There is no question that there is a tremendous imbalance between supply and demand," said Jeffrey Schuman, a senior vice president at Bank of America and a panelist at the conference.

Furthermore, the auto industry's woes have rubbed off on many Michigan companies, even if they have little or nothing to do with the sector.

"I think a lot of banks are saying, 'We will not do anything in Michigan right now,'" said Rick Deneweth, managing member of ThreeWest LLC, in an interview. "To be honest with you, I don't know what the national banks with a presence here are going to do."

He said they might cut back on the number of loan officers they have in the state.

In this new environment, borrowers will face a new set of ground rules: Success will depend more on proposing the right project and providing the right amount of capital and collateral. And developers probably won't be able to get around putting up personal guarantees for repayment.

"The borrower is going to be asked to carry the risk," Schuman said.

Borrowers should expect their prospects to be based more on the relationship they have had with their lending institution than the specific details of the transaction they are proposing. And many banks will tend to favor depositors over non-depositors in their loan decisions.

Bank of America recently did a survey of 25 national, international and community banks nationwide and found that a majority are restricting their lending to existing customers. They only plan to make an "occasional exception for a new upscale relationship," Schuman said.

"The first call on capital really goes to our existing, established clients."

Borrowers can also expect differences between community, regional and national banks, according to the CBOR panel. Compared to local banks, national banks may want to see more owner equity in projects they finance, all other things being equal.

If a community bank offers a company an 80 to 20 percent loan-to-value ratio, Schuman recommends that the borrower take the deal. That would mean the bank is lending 80 percent of the figure projected to be the value of the project.

His employer, Bank of America, might be willing to finance just 55 to 60 percent of that value today, he said.

But banks of all sizes are likely to adhere more strictly than ever to their lending standards, the panelists said. If a developer falls even a single percentage point short on the equity share that the bank has prescribed for the project, he or she will likely have to come up with the difference to get the loan.

It's no secret why national lenders, in particular, are imposing tough criteria right now: They are simply trying to survive, the CBOR panelists said. They are at risk because they hold overvalued securitized loans as assets. They bought high-risk, securitized mortgage packages after ratings agencies gave them their dubious seals of approval, often exaggerating their value in the process.

Schuman believes the purchase of these securities hurt banks more than the risky mortgage loans they made themselves. The income from those assets has generally been less than predicted, reducing their value. And in the banking world, your ability to lend money is less if your assets fall in value.

In those cases, the worth of those shaky securities "has been challenged, questioned and proven wrong," he said

While the banking crisis remains serious, the CBOR panelists agreed that it may have hit bottom. But none saw a quick recovery.

Bank earnings generally came in better than expected in the first quarter, they noted. If banks continue to make improvements, lending may loosen up next year. It could improve still more over the next two to three years, and be back to normal in four to five years.

As the opportunities for profit eclipses the risk of losses, Bernard said, lenders will become less averse to risk, make more loans and lower interests rates.

In the short term, Michigan can even expect to shed some of its pariah status. "I think as the economic crisis spreads, this is going to be less of a problem," Schuman said. With many states in economic trouble, the special disadvantage of Michigan borrowers is already lessening, the panelists said.

Businesses that fall victim to the economic crisis may be able to restart their banking relationships once the dust settles. But that's more likely if they have been with the bank for a long time and have tried their best to minimize its losses during their recent difficulties.

Eventually, the memory of failed banks, auto bankruptcies, and waves of foreclosures will fade, and the wild west of lending and borrowing will be back, the panelists agreed. Then the cycle will begin all over again. BN