ran across this in one of the real estate newsletters that end up in my box each morning. a fairly concise explanation and i thought it would be fun to share...

by christopher grey -

On any given day, leading financial commentators, government officials, and CEOs claim that this is the worst credit downturn in the past 25 or 50 years or even since the Great Depression in the 1930s. However, in commercial real estate at least, it sure doesn’t seem that way to me.

From 1994 to 2000 it was puzzlingly difficult to get financing for commercial real estate development, especially speculative projects, even though our economy was healthy and growing, interest rates were relatively low and falling, commodity prices were low and falling, inflation was dead, the dollar was strong and rising, and there was plenty of capital available for other industries such as technology that seemed quite a bit riskier. That all changed after the technology bubble and bust and the recession of 2001-2002. But now we have gone through our own bubble and bust in real estate.

Nevertheless, capital, both equity and debt, for commercial real estate still seems far more available in 2008 than it was for most of the 1990s, even though today we have an economy that is at best stagnating and at worst going into a severe recession, interest rates that have nowhere to go but higher due to spiraling inflation, an oil price and commodity price shock, the dollar has crashed and still can’t seem to stabilize, and many other sectors of the economy, such as technology, industrials, mining, and energy have much better growth prospects than real estate. Of the hundreds of real estate projects I have looked at financing since the credit downturn began in August 2007, not a single one of them that I believe deserved to get financing had trouble getting it on reasonable terms compared with what has was available during the past 10 years.

The projects that cannot get financing in the current environment simply do not deserve financing. That is not a credit crunch. That is just a return to somewhat more rational investing by debt and equity capital sources. From 2004 to 2007 borrowers became so addicted to an excess of debt and equity capital on cheap and easy terms that the current environment, even though it is actually pretty good compared with the 1990s and against the horrible economic backdrop, feels like a severe shortage of product.

Now we are going through withdrawal.

Here are just a few very public examples: The Federal Reserve has reportedly agreed to purchase various forms of CMBS, CDOs and even some of the Hilton LBO debt that cannot be sold in the market without exposing the insolvency of the institutions holding these assets. Lehman Brothers, which is widely known to have been on the brink of collapse, was also saved by a lifeline from the Fed even though the legality of that lifeline is in question. Bear Stearns was saved from bankruptcy by the Fed. Sovereign wealth funds and other institutions have continued to pour fresh capital into failing banks even though nearly all of those investments declined almost immediately after they were made. In a real credit crunch - such as that in the early 1990s - troubled institutions fail and are liquidated. Hundreds of banks failed at that time. In a real credit crunch, t a minimum, the equity and in many cases even the debt of insolvent institutions would be wiped out investors would lose a significant amount of their investment. Even Bear Stearns, after admitting that it faced a choice between the Fed bailout and Chapter 11 bankruptcy, still received $10 per share. Lehman raised $8 billion of additional equity and is raising another $6 billion even though it also would have failed without the Fed. Compare those outcomes with what happened to Drexel Burnham Lambert, Columbia Savings, Lincoln Savings, Executive Life, or hundreds of other institutions associated with the excesses of the 1980s.

We do not have a real credit crunch. What we have is a liquidity trap created by the excessively accommodative policies of the Federal Reserve combined with an excess of capital in oil producing countries that have benefited from the spiraling energy inflation created as a result of the Fed’s excessive money printing, which destroyed the value of the dollar. In a liquidity trap, assets remain overvalued on any fundamental basis because there is still too much capital available versus opportunities to invest that capital at a reasonable return. This creates even more stagnation and inflation in the real economy, which cannot generate growth. Capital cannot be allocated efficiently in an environment of high inflation, overvalued assets, and excess liquidity.

We know that new transaction activity has collapsed and is down around 80%. Of $13 billion allocated for distressed investing, less than $2 billion has been invested. If there is so much distress in real estate why isn’t this money being invested more quickly? Why have commercial real estate values barely declined according to recent sales activity despite an economy in recession and historically sky high valuations? Because most sellers won’t sell at prices that make sense to most buyers because sellers still have access to cheap and easy sources of capital helping them to delay the pain and hope for a rebound. So the market remains largely frozen in a stalemate between buyers and sellers and prices do not adjust. It is particularly telling that most of the recent distressed sales were only completed because the seller provided very aggressive financing to the buyer. This is further evidence that those assets were overvalued on a fundamental basis.

Fortunately, certain members of the Fed, such as Governors Lacker and Plosser, have recently spoken out for a more responsible approach that would put an end to bail outs that just encourage more risky behavior and prevent the system from correcting itself through the normal capitalistic process of creative destruction. Ending these bail outs, allowing poorly run and insolvent institutions to fail, and normalizing interest rates in line with the rate of inflation, which would mean 5% to 6%, is the only long term solution. Although there would be some pain – and a real credit crunch – the result would be a higher long term growth rate for the economy, more efficient allocation of capital, lower prices for energy and other commodities, a stronger dollar, lower inflation, and asset prices back in line with fundamental value.

Christopher Grey is a Managing Director of Emigrant Realty Finance, a subsidiary of Emigrant Bank, and a 15-year veteran of the real estate capital markets.