Zain Jaffer is the founder and president of Zain Ventures, a family office that invests in real estate and proptech.
If you look hard enough, you may see some similarities in the conditions leading up to the 2008 subprime mortgage crisis and the current 2023 real estate crisis. OK, I’ll admit that the two are not exactly the same, but there are some parallels that I think are worth looking into.
The Current State
First, let me help paint a picture of where we are now. As of the fourth quarter, many areas in the real estate market are frozen, due in large part to the high costs of debt financing. Commercial properties, in particular office space, are in an oversupply situation because of the work-from-home trend. However, I’ve found that Class A office spaces that are compliant with environmental, social and governance (ESG) frameworks and well designed can help attract employees back to the office. It is the second tier, several decades-old office buildings that tend to give landlords and property owners problems.
Once the current developer debts are up for renegotiation, many of them will not be able to afford the higher debt financing payments, especially with their lack of paying office space tenants. Most likely if they cannot renegotiate, they will just turn in the keys to the banks. It is similar to the housing market, where higher mortgages tend to dissuade buyers from signing up, which also convinces sellers not to sell as they themselves will have to sign up for higher-rate mortgages.
The situation with other types of commercial real estate, such as warehouses and multifamily apartment units, is relatively better but they are not totally unscathed.
Creative Financing Strategies
Just to produce sales in this tough environment, many real estate developers are using creative financing strategies. In the housing sector for example, companies like Zillow now offer 1% down payments on mortgages, where they will pitch in an additional 2% to move your down payment up to 3%, or if you have 3% equity saved, move it up to 5%. That’s one way.
Another way is to offer buyers a long-term interest rate that is lower than the average 7.5%, which means that the developer takes the loss from the difference. This is called a mortgage rate buydown. The closer you can shrink the loan amount with a large cash down payment with an interest rate that is favorable to you, the better.
Yet another way is a balloon mortgage, which means that the buyer only pays a really low or even zero monthly amortizations on the debt for a few years, then pays a lump sum after the end of that grace period. The problem is if the buyer doesn’t really have the discipline to save that lump sum, which means that the house will get foreclosed.
Developers claim that since tightened government regulations in 2008, there were no more NINJA (no income, no job or assets) loans. They also do credit score and income verification now. But sometimes those can be gamed. Right now Zillow requires a 620 credit score while FHA requires a 580 credit score.
Applications For Business Leaders
If you’re a business owner who is not buying a house, this may not mean much to you. But considering how the 2008 subprime mortgage crisis affected everyone, it should. The same goes if you are holding a real estate investment trust (REIT).
For project finance, the escalating yields on longer-duration U.S. Treasurys, such as the nearly 5% return on ten-year bonds, pose a growing challenge in meeting hurdle rates. Meanwhile, banks are grappling with a burdensome inventory of foreclosed real estate assets and older bonds with reduced marked-to-market valuations, which yield lower returns.
If your project has future revenues and cash flows that look risky, the banks won’t even bother since the risk-free short-term bills and longer ten-year bonds offer them some peace of mind. Sure you could go to the shadow banking system to get a loan, but at what cost?
Unfortunately, until the Fed eases up on rate hikes, I see the situation simply getting worse. Given Jerome Powell’s recent statement about how inflation is high and that they still need to take measures to fix it, it doesn’t look like that will get resolved soon. Debt becomes harder to get and more expensive. Using creative financing just to get more people to buy property can add fuel to an already raging fire that I see harkening back to 2008.
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