Capitalism doesn’t work without capital

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Capitalism, whether you love it or not, requires capital, which comes in two forms: equity, at-risk money, without a promise of repayment, invested to own companies and assets; or debt, loans with a promise of repayment, secured by companies and assets as collateral.

Commercial real estate lending is like a fire hydrant. It is either gushing or it’s off. Today it is off, and large commercial real estate loans are nearly impossible to come by. The absence of debt has not been so pronounced since the Great Depression.

Conversely, equity abounds. There are many individuals and companies with cash to spend. But equity, without debt, is like one hand clapping.

Historically, when equity and debt dance in commercial real estate, equity provides about 25 to 30 percent of the funding and debt provides about 70 to 75 percent. When debt accounts for zero percent, everything halts.

Federal policies, though well-intentioned, are part of the problem. While the government infuses stimulus funds into the economy for expansion with its left hand, it has the lenders by the neck in a tight grip with its right. By increasing capital reserve requirements, tightening the underwriting criteria to evaluate and make loans, and instilling fear into the heart of every bank, federal banking policy is the opposite of expansionary; it is constrictive. And so the pain of this “Great Recession” increases and continues.

Lenders have swung from irrational exuberance, when a pulse qualified one for a loan, to irrational petulance, with fretful, overwrought, angry loan officers not only refusing to make loans, but haranguing their best-paying borrowers over things like covenant defaults, lease approvals and non-disturbance agreements. Also, lenders are waiting to see if more federal bailout money, like TARP or TALF, will materialize.

Of course, if it’s any comfort, lenders are cutting their own throats. The refusal to make even sound commercial real estate loans dramatically reduces demand for large commercial projects. Thus the price of these projects is in free fall, up to 60 percent off-peak. The bank’s collateral becomes worth less and less. The bank’s losses grow and grow.

The simple fact is that capitalism needs debt to survive. Lenders must step up to the plate and use all the wiggle room the Fed provides to make good loans to good borrowers for good transactions. They must stop following each other, like lemmings running off a cliff.

But the federal government needs to align its banking policies with its stimulus policies because all the stimulus in the world will not end this recession if business can’t grow by borrowing money. The Fed should tell lenders in no uncertain terms that there is not another bailout in sight: They will have to take their losses. At the same time, the Fed can relax reserve requirements, or provide reserve capital on an interim basis, to lenders that acted with the most prudence during the froth. In other words, success – not failure – should be rewarded.

In the meantime, commercial real estate developers and their lawyers will need to be creative, by forming public-private partnerships to leverage stimulus money, by structuring safe seller financing when private debt is unavailable, and by creative capital stacks that leverage new market, energy, historic and other tax credits. With these techniques, we have been able to structure in the last quarter one of the few sales of hotels with more than 100 rooms, start one of the largest construction projects on the West Coast, and take part in a large senior housing development project.

But these are stop-gap measures. Until private debt returns, the prognosis for recovery is dim.

Stephen LeDoux is a partner in the Portland office of Davis Wright Tremaine LLP, and focuses his practice on commercial real estate and land use. Contact him at [email protected] or 503-241-2300.