Having a finite resource as your business’s main asset has proved challenging for real estate companies, but it has necessitated some creative problem solving.
For years, the real estate industry reaped the benefits of constant appreciation. Unfortunately, no one is manufacturing more land, and most real estate isn’t worth what it used to be.
“Although we’ve gone through recessions, you would probably have to go back to The Great Depression to find a period of time when real estate has suffered such a sustained depreciation in value,” says Robert A. Ranallo, CPA/ABV, JD, CVA, CFF, a partner with Skoda Minotti.
“Now, real estate companies can only generate profits from operations. Before they generated profits from operations and the appreciation of the land they were holding or selling.”
Smart Business spoke with Ranallo about what businesses can learn from the real estate industry’s recent hurdles.
What challenges does the real estate industry face today?
There are two main sectors of the industry: commercial and residential. Commercial can be anything from large multi-family developments to commercial retail centers to industrial buildings to office buildings. Residential is typically characterized as developers who buy and develop land and resell lots for the construction of single-family homes or housing developments.
Each of those two areas has its own unique challenges. However, there are two primary challenges that have adversely affected both sectors over the past year and a half: the absence of credit and the economic loss in value of the underlying real properties in question.
How have these issues affected those in the industry?
The reality is that real property is not as valuable as it was a few years ago. The decrease in property values just exacerbates the credit problem, because what once were acceptable loan-to-value ratios no longer exist after a readjustment in value. It’s not uncommon for loan values to now be greater than the underlying value of the real property itself.
What causes this to come to the forefront is that many banks are having trouble maintaining required capital levels. Developers often are not able to meet debt service requirements. Properties are being re-underwritten, but the underwriting standards that are being applied leave the developers in a position where they oftentimes do not have the cash or financial wherewithal to comply.
For many years, the real estate industry benefited from the fact that real property continually appreciated in value. So when a loan was made on a project, the underlying values of the property would typically appreciate and the loan-to-value ratio would get smaller, which is good for the bank because there is more equity in the project. Over the last two years, however, that trend has reversed dramatically. When you couple that phenomenon with the squeeze the banks find themselves in on their capital requirements and the absence of credit, you have a toxic mix.