The real estate market has always been cyclical, and the current situation is no exception.
As lending institutions became more aggressive during the majority of the first decade of this new century, they started to relax requirements. As requirements relaxed, the amount of equity needed to put into a project went down. That made it easier for developers to do more projects than they normally would have. If the bank was asking for 15 percent equity, rather than 25 percent, the developer was obviously going to do more projects.
The problem came when the market slowed down, and there was a far greater amount of projects than people who wanted them.
“Basically, we’ve returned to the lending posture of the mid-’80s,” says Tom Cargo, senior vice president of commercial real estate at FirstMerit Bank. “In the early part of that decade, we had double-digit unemployment, double-digit inflation and the prime rate at 21.5 percent. There were all kinds of ugly issues going on and it caused a downturn, just like today.”
One possible silver lining to today’s downturn is that we’re (hopefully) finally learning the lessons we should have years ago.
Smart Business spoke with Cargo about how investment real estate has changed in the new economy and how the industry has adapted.
What is the new reality of real estate?
For projects to be successful and for banks to be willing to take the risk, the client has to put more equity into the game. The bank may be a willing financial partner but they don’t wish to be the sole source of funding. Another reality is the change in value of appraisals. If an appraisal is a snapshot of estimated value at a specific place in time, those values are neither static nor guaranteed to escalate year over year.
Developers want a higher rate of return today than they would have five years ago. That shows there is a greater perception of risk associated with investment real estate. Where there is high risk, there should be high reward. Values have retrenched from where they were. Projects need more equity to work.
How has the market changed?
Right now, it is more of a tenant market than it is a developer market; there is more space to lease than there are people wanting that space. Also, industry consolidation is impacting the volume of space that might be needed in this marketplace. We are dealing with a shrinking population, but when you look at the volume of building that took place over the last 10 years, there is more square footage today than there was 10 years ago.