Today’s Lending Environment and the Looming Threat
of Recession and Its Effect on Your Property Values

Recessions are bad. However, if we are lucky enough to miss a recession, that doesn’t mean everything will be “coming up roses.” Technically, economic recession is defined by two consecutive quarters of negative real growth. Our previous WAM article reported the statistics of Santa Monica’s apartment market and by glancing at the last 2 quarters of 2007 and the first quarter of 2008; we are experiencing consistent devaluation in real estate. But, are we in a recession?

Recent figures indicated that the U.S. housing slow down has continued into a third year while construction building permits dropped to a 16-year low. Slowing economic growth will reduce inflationary pressures in the months ahead because debt-laden consumers will be far more wary of spending money and businesses will be more cautious about investing. As a result, lenders will further tighten borrowing parameters. Unfortunately, this phenomenon will directly affect real estate values and dramatically shrink the pool of potential buyers.

The lending environment has become tight with higher yield requirements and banks are requiring more margin spreads to protect themselves in a declining market. They have also stopped allowing second trust deeds behind their first trust deed which again is a protective measure in uncertain times. CMBS and conduit loans, which are sold in secondary markets on Wall Street, have dried up too. When it rains, it pours! The numbers of lenders are decreasing across the board.

A lender uses a Debt-coverage ratio (DCR) to determine maximum amount of loan risk they are willing to take when financing properties. In the summer of 2007, lenders were using a debt-coverage ratio of 1.0; now the minimum DCR is 1.15. This change in the underwriting criteria causes lenders to mitigate their risk on conventional loans and hence, less money for buyers in today’s market. Local lenders are still making aggressive recourse loans with a debt coverage ratio of 0.8; but only for A-location properties and smaller buildings of 5-11 units, and only to very strong buyers. This tighter environment in the lending world has a direct impact on property values as the amount of loan available to buyers are shrinking and in order to buy a property, buyers must make up for the loan differential with a hefty down payment, many times close to 50% of the price of the property! Sellers need to lower their expectations on price in order to sell in today’s market or… wait out this cycle and see what happens.

On the national level, in order to aid an economy in crisis, the Federal Reserve has recently delivered another big interest rate cut of ¾ % of a point. Experts believe the economy is in shambles because of the fallout from the housing and credit debacles. Many businesses are shedding jobs, Wall Street is like a roller coaster on a daily basis, energy prices are skyrocketing and people are reluctant to spend. Yet many economists say that lower interest rates should help cushion the blows of a recession.

The rate-cutting began in September 2007 with the goal of picking up the economy and reviving spending. The Fed’s key rate has fallen from 5.25 percent to 2.25 percent. The Fed slashed rates in January when, during an eight-day period, the Fed lowered the rate by 1.25 percentage points. It was the biggest one-month reduction in a quarter-century.

In response, commercial banks have lowered prime lending rates by corresponding amounts. The prime rate, now at a nearly three-year low applies to certain credit cards, home equity lines of credit and other short-term loans. Another cut would further drop the prime rate.

What scares me is that even with the Fed’s aggressive moves, economic and financial conditions keep deteriorating. The Treasury Department recently proposed even stricter regulation of mortgage lenders as part of a broad effort to prevent a repeat of a credit crisis threatening to drive the country into recession.

Battling an ailing economy is the Fed’s No. 1 focus now. The Fed said it would pour as much as $200 billion into larger Wall Street banks and investment houses and allow them to put up risky home loan packages as collateral. This maneuver is intended to bring relief in the market for mortgage securities. Yet prices for oil and gasoline continue to hit record highs! High energy prices slow economic growth because people have less money to spend elsewhere. No road trips for me anytime soon. All I see coming is more Inflation! Inflation! Inflation!

Also, the Fed’s rate cuts have added to the downward pressure on the value of the dollar, which recently plunged to a record low against the Euro and has fallen sharply against the Yen. The weaker dollar most likely will raise the cost of imported goods entering the U.S. and lead American companies to raise prices as foreign-made products become more expensive. The declining value of the dollar is creating fears that inflation might skyrocket.

Even after more rate cuts in March, economists predict the Fed’s key rate will head even lower, probably to 2 percent or even lower by the spring or early summer. Let’s keep our fingers crossed!

What does this mean to your local Santa Monica real estate? Well as I said, lenders are loaning less money and the Federal Reserve’s aggressive rate-cutting will have little or no effect on apartment loans. In fact, interest rates for apartments have bounced up a bit following some Fed cuts since September 2007. Banks continue to be reticent to lend money and investors are especially leery of mortgage-backed securities, the market for which has been shattered by hundreds of thousands of defaults during the sub prime mortgage collapse. Thus, prices at this point on all real estate, even properties located on Ocean Avenue are softening to accommodate the lack of financing available, especially in a troubled economy. In my opinion, whether we are in a recession or not, we most definitely are in a “psychological recession.”

I am in the market everyday and I think it is an important time to know the current value of your property in order to make intelligent decisions regarding your investment. Whether you sell, exchange, refinance or hold tight, being informed is paramount especially in uncertain times like these.