After 10 Years, Back to the Basics

ORLANDO, FL — I don’t think any of us will forget the summer and fall of 2008. The financial markets were in free fall, Wall Street stalwarts, such as Bear Stearns and Lehman Brothers vanished almost overnight, and the government was intervening in the financial markets more directly and forcefully than it had at any time since 1929.

That wrenching, wholesale restructuring in the financial markets and the Great Recession that followed are without a doubt the most important events in commercial real estate (and the economy as a whole) in the last 10 years. They may be the most important economic events, in fact, since the end of World War II. But to understand the true impact of those events you have to look back a few years earlier and consider the economic factors that produced them.

In the years between 9/11 and the financial market freefall of 2008, the U.S. economy experienced solid growth, with real GDP growing an average of 2.4 percent annually from 2001 to 2007. Prices in both the commercial and residential real estate markets soared, development boomed, interest rates remained low and financing was easy to get. In hindsight, we now know that financing was too easy to get and that prices, especially in the residential markets, soared to irrational levels.

Just as we had a bubble in the tech economy in the late 1990s and into 2000, we experienced a bubble in real estate. But unlike the dot-com bubble, the real estate bubble was a lot bigger, and when it broke in 2007, the aftermath was devastating. Although economists may have declared that the recession officially ended last summer, its effects are still lingering, as millions of Americans remain unemployed or underemployed. It will likely be a few more years before we work ourselves out of this situation.

Understanding that the recession was ultimately the result of money that was just too cheap tells us a lot about what the next 10 years might look like. Here are some of the Great Recession’s likely after effects:

Lower leverage levels persist for the next decade. It’s clear now that too much real estate, both residential and commercial, was simply overleveraged during the early and middle years of the decade. There has been significant deleveraging across the economy in the last three years, but going forward we should expect that leverage levels overall will remain lower than they were, and will likely return to more normal historical levels.

Relationships with lenders are important again. As leverage levels drop, the cost of capital goes up and lenders tighten their lending standards. That means debt financing will no longer be a commodity available to anyone. Relationships with banks and other lenders will become much more important, as lenders will want to truly understand sponsors/borrowers and particularly understand how they responded to lenders during this crisis. Stronger relationships will give strong borrowers access to more, and cheaper, financing than their competitors.

IPOs will become more popular. As lenders strive for more balance sheet liquidity, many real estate companies will consider tapping the public financial markets for capital. Expect to see more initial public offerings once the equity markets become less volatile and prospective growth helps propel stock prices to rise sufficiently enough to make new offerings attractive again.   

Development models will change. With capital more expensive and leverage levels lower, and with lots of vacant property still in the market, most stand-alone development companies that thrived on the cycle of “borrow, build, sell and repeat” will no longer be viable. There will be less development for several years, and new development will likely be done by companies with more diversified business models.

So who will thrive in this more conservative and more traditional financial environment? As it always has been, well-managed companies that keep a close eye on their finances will do better. But more than that, the companies that are diversified and are able to establish and maintain reliable access to capital will do the best. As we learned from Wall Street in 2007, being a big or well-known name is no guarantee that a company will survive. It’s back to the fundamentals. And I think that’s causing many experienced commercial real estate executives to, privately, sigh in relief.

Tom Sittema is CEO of CNL Real Estate Group Inc. Prior to joining CNL in October 2009, Sittema was managing director of real estate, gaming and lodging investment banking for Bank of America Merrill Lynch. During his career at Bank of America, he led more than $60 billion in debt, equity and M&A transactions.