Lessons Learned From The Past Recession For Trends In

Philadelphia PA Commercial & Residential Real Estate Attorneys

The New Real Estate Market

real estateTo an extent, the most recent recession is reshaping the resurgence of the commercial and residential real estate market with fresh eyes, new trends, new legislation and other banking and business changes to help avoid a similar real estate market crash in the future. The most recent real estate market crash left many developers and speculators filing for bankruptcy, many banks empty handed, many foreclosed properties, and many business districts experiencing the blight of vacant storefronts.

This resulted from an irrational exuberance that the real estate market was too big to fail, a lack of basic, business fundamentals and ignoring risks. Banks provided easy financing lending up to 100% (and in sometimes more) of inflated property values or gave many developers essentially a blank check for projects. After the internet bubble popped the 1990s stock market growth, much of the market looked to real estate as an alternative investment. Many unsophisticated investors were reading the “real estate riches” type books that encouraged people to ladder and overleverage aggressive growth without teaching or stressing certain important business fundamentals including risk management. The high loan to value ratios exasperated this further as many people took on more debt than they could sustain during a downturn. Others were merely coming to the game late to ride the bubble hoping to jump off before it popped while others kept refinancing to take out equity to feed their excessive consumer spending and to keep up with the Joneses.

In the aftermath of foreclosures, belly-up loans, and fortunes lost, buyers, sellers, lenders, and the government have fundamentally changed the real estate market where people are more cautious. The following is a list of new trends, legislation and banking changes affecting the 21st century real estate market:

  1. Government regulation – Dodd-Frank Act: As usual, the government stepped in to provide protections for consumer borrowers by creating the Dodd-Frank Act. This Act is designated to protect consumers from financial institutions offering them financing they can handle in an up market, but cannot afford through a full income and value cycle. This Act requires lenders to more fully evaluate a consumer’s “ability to pay” and to make sure the loan falls under the “qualified mortgage” standard, otherwise, the bank can be subject to legal liability. In realistic terms this Act makes it harder for buyers to obtain loans which have indirect effects on developers and the rental market.
  2. Lenders and buyers are more cautious on what deals they take: Both lenders and buyers have taken a step back in the aftermath of the last recession. Despite making greater profits with looser loan standards, many lenders became insolvent and failed after factoring the loan defaults and foreclosure costs. Buyers have heard or seen real estate speculators and developers lose their life’s accumulation of wealth on a bad project. This is fresh in the back of both lenders’ and buyers’ minds.
    1. Simpler/traditional deals: Lenders and buyers are looking for simpler deals. Lenders are looking for a simple plain vanilla type of mortgages for rental projects or construction loans rolling into long term mortgages. They do not want to give an interest only line of credit or negative amortizing loans (where principal is growing as the payments are less than interest) to a real estate investor for a “fix and flip” or a “flipper” sale. They want a borrower that fits their internal rubric with income plus assets outside of real estate and/or substantial real estate income projections with a clean track record.Home buyers are looking for a cookie cutter turnkey home to avoid the complications and unpredictable costs of construction. Commercial investors are looking for properties that meet their cookie cutter/formulaic investment strategy to avoid risks. For instance, in the current sellers’ market, a number of buyers are simply taking a back seat until the market cools down rather than potentially riding a bubble. The simpler it is, the easier the risks are to understand. Following Warren Buffet, they are only investing in what they know.
    2. Due Diligence: Both lenders and buyers are performing greater due diligence. Lenders are not simply rubberstamping loans or offering wide open, unregulated line of credits for even their best clients. Banks are doing an independent review for each new loan and project requiring clients to cross all their “T”s and dot all their “I”s. For each new loan or even a renewal of a loan, banks are requiring new loan documents, a cash flow analysis, an appraisal, outside independent counsel draft and review the loan documents, environmental studies, tenant estoppels and leases. Buyers, on the other hand, are doing their part with thorough home inspections, requiring tenant estoppels, examining and requiring lease documents for all tenants, evaluating the profitability and risk profile of the project, as well as the aforementioned due diligence requirements of the banks. Both the lenders and buyers are making sure the loan or property, respectively, fits their strategy believing a conservative gain is preferable to risking their entire wealth.
    3. Trend to owning for the long haul vs. merely speculating: In the 1990s and 2000s it was all about condo conversions and flipping. Many buyers got in trouble because when the market took a dip, the magic projected condo sale numbers did not come to fruition. Many developers were forced to rent the apartments out and sustained severe monetary losses by being forced to hold onto loans they intended to be short term and once the leases ended, the places were no longer commanding top dollar with rental wear. Accordingly, at present, there is a trend towards “holding” for the long haul where investors are less concerned with the cyclical ups and downs of the market. Many developers are now buying/building apartments instead of buying/building to flip.On the other side, there is a counter trend of flipping where developers are looking for projects that have greater margins and are using cheaper materials and labor to achieve margins higher. This provides them with a larger cushion if prices drop and/or for a plan B to rent the property if prices drop below their magic number by providing lower end rental quality materials versus top notch residential home quality materials (generally rental quality is lower knowing the wear and tear to the apartments by renters especially with the frequent turnover of renters).Lenders, on the other hand, are generally looking to lend to buyers with long term holdings. Therefore, many short term developers may have to look to private equity markets for financing, may need a very reputable name, and/or may need deep pockets with a plan B to obtain the necessary financing. As previously stated, borrowers are not receiving the same substantial open, unregulated lines of credit that developers received in the 1990s and 2000s to develop and flip real estate.
  3. Fixed vs. variable interest and term: Especially in this market, borrowers are looking for long term fixed interest rate loans. They are looking to lock in the current low interest rates for 10-15-20 years and do not want to chance increasing interest rates. Prior to the crash, most developers were taking variable rate mortgages to take advantage of the “low” interest rates while they were around, but suddenly found themselves in the red when interest rates increased.On the other hand, lenders are looking for short term variable rate loans. They do not want to be locked into the historically low interest rates and want the option to reevaluate the loan every few years. While it may be possible to obtain 10, 20 or 30 year principal amortization, lenders usually limit the term to five years one way or another whether by limiting the term or giving themselves an option to call the loan. Further, lenders build in a de-facto soft termination clause by permitting themselves to declare a default and call the loan whenever the lender does not feel reasonably secure with the loan.
  4. Change in bank protections: Lenders are taking extra precautions to protect themselves. Lenders are requiring a strict due diligence, are requiring fairly stringent representations and warranties sections, are requiring cross default where a default in one loan document defaults all other loans, and are requiring the soft default clause if the lender does not feel reasonably financially secure. They are also placing what are called “bad boy” provisions where if there is a default additional requirements may be demanded including a monetary payment, higher interest rates, an additional guarantor and/or additional security. These additional terms increases the loan costs by changing the lending arrangement. On the other hand, it allows the borrower more leeway to receive more favorable terms up front and may provide for a better alternative to a foreclosure in the event of default.
  5. Requiring more skin in the game: Both lenders and private equity investors are requiring borrowers/buyers to have more “skin” in the game. Whereas previously a borrower could have easily obtained a loan with minimal equity, now many lenders will not provide debt above a 70% loan to value ratio. This requires the borrower/buyer to have more at stake with the implied understanding that the borrower will take on better projects and manage the project better.
  6. Trend of multifamily rentals: As a result of the longer holdings, many buyers are now looking to convert lots, condos and homes into new mini rental apartment complexes that span multiple plots. This allows the developers not only to receive the appreciation and future growth from the improvements, but allows them to stave off some of the risk if the property values drop. The developer will still receive market value rents with the expectation that the market will eventually rebound. This creates a stable cash flow to provide the financing for future projects or to obtain permanent bank funding.
  7. Creation of multi-purpose real estate hubs to help drive demand: In addition to creating more multifamily rentals there has been a trend towards multi-purpose developments. Instead of being subject to the whim of the neighborhood, developers are now proponents of neighborhoods building ecosystems for their tenants creating thriving pockets with almost a New York borough feel. This drives new demand to the area where each property is not an independent venture, but a part of a plan to revitalize and revamp a blighted neighborhood. These areas become highly sought after neighborhoods as they are known for their cutting edge style, restaurants, and stores. Areas like Fishtown, Pennsport, Point Breeze, Brewerytown, North Broad Street, West Rittenhouse, West Philadelphia/University City are now developing at a lightening pace as developers are creating office buildings, apartment complexes, townhouses, locations for bars and restaurants, locations for shops, gyms, markets, drugstores, parks etc. Developers are thus creating inherent, intrinsic value instead of merely following trends. In other words, each new development helps minimize their risk by increasing property values in the entire area.

These new trends are reactions to the shell shock that many lenders, homeowners and developers experienced during the real estate crash. To an extent there may be over-constraints creating friction in the market and between the players involved, but whether this is here to stay or people will quickly forget the blight of the past is to be seen in the future. With funding tight and investors cautious, this is a difficult market to develop and speculate in the absence of large assets, large income and a successful real estate history. As a result, to succeed in this market, it is necessary to be very thorough, aggressive and diligent in your property searches, investigations and acquisitions or it may be better for the casual investor to sit back and let the market loosen up.

The Philadelphia PA Commercial & Residential Real Estate Attorneys at Pozzuolo Rodden, P.C. can help you plan for the future by learning from past recessions.