The impact of the capital crisis of the fall of 1998 on construction lending

Abstract

Over the last three years, the public debt markets in the real estate sector have a grown at a rapid rate. As of June 1998, the Commercial Mortgage Backed Securities (CMBS) market was providing the majority of take-out financing for construction loans for commercial real estate. This dramatically changed in July 1998, when Russia defaulted on it's government debt and investors withdrew their money from high-yield, high-risk investments in favor of safer investments. This "flight to quality" caused lending within the public real estate capital markets to come to a virtual standstill. While macro-economic turmoil was the catalyst of the capital crisis, it brought fears regarding underwriting practices to the surface. The purpose of this paper is to briefly discuss the causes of the capital crisis of 1998 and to analyze its impact on underwriting standards for construction loans. The primary method of research for this paper, a survey of national construction lenders, was designed to provide a snapshot of underwriting standards prior to the capital crisis, at the height of the crisis, and today. These underwriting standards are contrasted against both property market fundamentals and development activity at these various times. The results of the survey confirm that there was a dislocation between the public capital markets and property market fundamentals. While public capital markets are perceived to increase real estate market efficiency in the long term, there is a cost associated with the presence of the capital markets, namely increased volatility in the short term. As macroeconomic shocks occur to the capital markets, property markets will be similarly affected. As evidenced by the capital crunch of August 1998, the role of construction lenders has become more dynamic. Henceforth, construction lenders will have to quickly adjust underwriting standards to reflect the ever-changing risk characteristics present in the capital markets. The question remains: Will the long-term efficiencies gained by the presence of the public markets outweigh the short-term cost of increase volatility? The answer will largely depend on the ability of construction lenders to monitor the capital markets and price loans accordingly.