Borrowers feel the pain as markets reassess risk

There is a scene in "Monty Python's Meaning of Life" where a rotund man eats the entire menu at a restaurant and, predictably, can't keep it down.


"Bring me a bucket," he says, then proceeds to purge. As if that weren't enough, the waiter offers him a wafer; he indulges a little more and then literally explodes.


Monty Python probably didn't have the current debt markets in mind when they created the scene, but the story line is remarkably similar to what is happening today.


Consumers, corporations, private equity funds and commercial real estate investors alike have been indulging at the table of cheap debt for a long time.


There have been warning signs, purges and loud cracks along the way, but investors continued to feast. Over the past few weeks, the market finally exploded and the carnage is working its way through the system.


The subprime mess is what we read most about and even blame for other problems in the debt markets. In the final analysis, however, the subprime meltdown is simply a symptom of the root problem that afflicts other markets.


Cheap debt, like virtually everything else, is good in small portions. As borrowers and investors relied too heavily on cheap debt, they forgot about a little thing called risk. Now, the markets are reassessing risk and borrowers of capital are feeling the pain.


While commercial mortgages have been getting gradually pricier over the past six months, the movements between February and late July were nothing compared with the past few weeks.


Depending on which lender you talk to, pricing widened over the course of about two days anywhere from .20 percent to .50 percent on commercial mortgages and now ranges from 6.25 percent to 6.55 percent for 5and 10-year fixed rate mortgages, according to the John B. Levy & Co. National Mortgage Survey.


Many real estate investors realize that there is a problem, but they are trying to figure out how it affects them in a tangible way. Those feeling the pinch immediately are the ones currently trying to close a loan. Most lenders are not going to fund an unprofitable loan, so borrowers can expect to be repriced if they have not already locked in a rate.


Investors who are currently acquiring property with a high degree of leverage will also immediately feel the shock of the market repricing risk. Equity returns will erode as debt gets more expensive, making purchasers less interested in proceeding to closing.


Perhaps the most wide-sweeping consequence is that property values will come under pressure as purchasers require a higher return on their investment to account for how the markets are pricing risk.


Although institutional quality assets such as Riverfront Towers and the James Center will continue to be sought after, the investors who buy these types of assets will either not pay as much or look to other asset groups to gain better risk-adjusted returns.


The good news in Richmond is that transaction volume will not come to a halt. Prices may not be as heady as they were in the past few years, but trades will still take place. As evidence, several very large transactions took place in the past month and closed, unaffected by the market gyrations.


Boulders Office Park, representing more than 500,000 square feet of suburban office buildings, was sold to Brandywine Realty Trust a few weeks ago.


Closely thereafter, 11 properties representing approximately 600,000 square feet of suburban office space in the Glen Forest office park were sold to Forest City Enterprises. Each purchase was made by a large, mostly cash buyer, making the closing more immune to repriced debt.


Andrew Little is an investment banker with John B. Levy & Co. He can be reached at alittle@jblevyco.com