The softness of Washington's office-rental market may be only temporary, but developers are beginning to feel pressures that can have serious, long-term consequences for some.
In the interim, there are likely to be wholesale renegotiations of loans by developers with their lenders. Ultimately, however, several lenders could find themselves stuck with non-income-producing property. And marginal investors will likely be forced to leave the market in an inevitable shakeout.
Leasing agents and developers continue to describe the market here in terms such as "soft" or "weak" or "flat" because of the large amount of unleased space that has accumulated. What they have been reluctant to say, however, is that developers are having serious cash-flow problems as a result--a fact that is causing nervousness among some lenders.
In a surprisingly candid admission, the president of a medium-sized District bank recently declared: "Some of the real estate loans are coming back to roost."
While he and other bankers decline to be more specific about nonperforming real estate loans at their banks, they paint a fairly grim picture of mounting cash-flow problems for developers.
The problem is rooted essentially in an oversupply of space in a weakened economy and high interest rates that have driven up construction and operating costs. In many cases, tenants have been reluctant to renew leases in older buildings. Elsewhere, owners are stuck with virtually empty new buildings that have high carrying costs.
"The whole process has been overbuilt by 25 percent," one banker estimates.
"There are 8 million square feet of office space under construction in the region, and the economy is on hold," remarked John O'Neill, executive vice president of the Apartment and Office Building Association of Metropolitan Washington. "Corporate America is on hold. Nobody is making commitments to expand. Nobody is opening new offices. Costs are too high.
"I hope a lot of our friends don't get hurt but there are lots of time bombs ticking," declared O'Neill. "Before this is over we may see some bankruptcies and foreclosures."
Although several lenders agree that the cash-flow problem is serious, they don't expect the situation to be as drastic as the forecast offered by O'Neill. On the other hand, they agree, as O'Neill and others suggest, that lenders could wind up owning several buildings by default.
"There are going to be people stuck with these properties. There's no question, whether they be lenders or not," predicted the head of the loan department at a leading District bank. "What the hell good does it do a lender to take over property?" asked one bank president. "They can't lease it."
Realizing that, lenders are likely to be more willing to renegotiate interest rates and "continue to ride out the market," as one of them remarked. "In terms of mass foreclosures, I don't see that in the cards."
Generally, major office projects are financed so that developers can either walk away from them or carry them out of pocket. It's the latter option that is apparently bedeviling even the strongest of developers.
But it's the relatively new investors who don't have established cash flow from older projects who are already on the razor's edge.
A scenario sketched by several lenders epitomizes the dilemma of some developers. The construction loan on a project is roughly 17 percent and the mortgage loan is 14 percent over 25 years, provided the developer has lease commitments for 70 to 80 percent of the space in the building. The crunch develops when the construction loan comes due and the developer can't deliver on the 70 to 80 percent lease commitment.
"Where does an owner get 17 percent if he doesn't have cash flow?" asked a lender. "He has to dig in his pocket or if its a partnership, each partner has to kick in," he said. One development team, for example, is said to be paying prime plus 1.5 percent, or about $7 million a year in interest on a loan. "I don't care who you are, if you've got a $40 million building that's not leased, you've got a problem," said one lender.
The problem is compounded for some developers because, as one lender pointed out, "A lot of people are leveraged on borrowed money."
"Hard times are upon us, and some of our gamblers are in trouble," observed O'Neill.
A senior official at a local bank envisions a "very squeaky time" during the next two quarters but doesn't anticipate a flood of serious problems. On the other hand, he declared: "We may go through a serious adjustment if the long-term market doesn't come back."