the borrower in the position of having to pay just about anything demanded in order to obtain funds to develop his project. The lender, having control of the most desirable commodity around these days-namely money-finds that if one borrower will not go along with the requirements, others will. In a recent case, a particular insurance company proposed a real estate investment trust and said they would make $36 million available for apartment mortgages at approxi mately 10% yield, plus 2% of the gross income. The insurance company had on file $100 million in loan applications and continued to issue commitments only to those who would accept the "kicker" until such time as this $36 million was exhausted. The problem, obviously, is one of scarcity of funds in the overall market place. Unfortunately, our industry always gets dealt the severest blow in a tight money situation, and this tight money situation today is no different from most previous ones, except in the degree of severity. Some states have laws which prohibit this type of lending, wherein an owner ship participation is demanded or various other types of fringe benefits are demanded. Unfortunately, in the type of market we have, legislation at the local or state level merely makes an insurance company lend in another state. For instance, we have one large investor which will not make apartment loans in Texas today, because that State has a law which prohibits insurance companies buying the land out from under the projects. Therefore, they will make these loans in other states where they can get this type of kicker. That is why national legislation is needed which places everyone on an equal footing. Obviously, if the firm which controls the lendable funds is able to have ownership of the project, it would only seem logical that they would prefer to make loans in the areas where they will eventually obtain ownership and certainly prefer to lend to a developer who will go along with that type of a situation. We also feel that just as lending institutions switched from bonds to stocks gradually after World War II, when this tight money market eases, we will witness a greater trend toward equity participation kickers by lending institu tions, as opposed to straight mortgage loans, simply because they would hope to make greater profits. As we all must remember, though, once one goes to the equity side, the risk is greater and the public funds which are being invested by these institutions are in a greater risk position than they are in a straight loan. It is the opinion of the National Apartment Association that Congress should enact legislation prohibiting lending institutions from using the participation and equity kicker forms of lending, which are having such an injurious effect on our industry today. Unless this is done, we are confident that the combination of the equity kicker and mortgage money scarcity will result in a sharp further decline in multi-family residential construction. We are submitting for insertion in the printed hearings as part of this testimony an article which was published in the July issue of FORTUNE entitled, appropriately, "The Future Largest Landlords in America." It focuses attention on this ominous blurring of the lines between those who lend money and those who need to borrow in order to construct the housing which this country needs. I commend it to the thoughtful reading of the members of the Subcommittee and the subcommittee staff. Thank you. Lender Takes All Most insurance companies are now willing to provide 100 percent finan ing for real-estate ventures B exchange many of them are demand ing what amounts to all of the cure income for at least the first fou five years of the project's ite. The real-estate developer who concehes plans. builds, and manages the ture gets no part of the cash f This illustration shows what happened to the first year's rental income for a 200-unit housing development re cently built in Missouri The act numbers have been changed, but the relationships among the items are curate After the developer paid and expenses, he turned over the re of the rental income to the insurance company that financed the proc Payments were in the form of fiet and variable ground rent, mortgese debt service, and a dividend on the insurance company's equity in In fact, on this particular project the developer had a negative cash that year-e, there was not enough cash to pay the entire dividend. The deficiency was carried forward to be come part of the developers obiga tion in the following year Century-Fox, says wryly: "What we need in L.A. is a Developers' Anonymous. A guy with an idea for a project should be able to call up a half dozen friends in the middle of the night and get talked out of it." Insurance companies, on the other hand, are supposed to be a bit more hardheaded. H. Eugene Ross, vice president for mortgages at Aetna Life & Casualty Co. of Hartford, says: "We turn down 90 percent of the deals that are currently presented. They have potential negative leverage. In other words, the return per dollar invested could work out to be less than the cost of the debt." Some insurance companies, however, seem to be betting that the cost-value equation will be improved by a rise in rental rates or by successful efforts to bring costs under control. As a matter of fact, rates of return in real estate are capable of quick and dramatic escalation. A sudden spurt in the demand for office space in a particular location, for example, can push office rentals from $9 to $11 a square foot within a few months. If taxes, the most volatile of operating costs, are not increased, total expenses might stay at, say, $4 per square foot. As a result, net yield on the property will have risen from $5 to $7 a square foot, or by 40 percent. When such fortuitous economics can be predicted-which is sometimes the casethe project can be capitalized on the basis of the higher, future earnings rather than current earnings, much like a common stock. If the insurance companies cannot find enough new ventures with such prospects, they may be able to fulfill their real-estate objectives by buying existing values rather than trying to create new ones. Connecticut General, for instance, is still financing new ventures, but it is also devoting a good chunk of its real-estate funds to buying older buildings whose potential appreciation in value is not yet fully reflected in market price. Last year the company obtained control of three large skyscrapers-the forty-two-story Mobil Building and the forty-one-story Continental Can Building in New York City and the fortystory Erieview Plaza in Cleveland. The $27,600,000 purchase was the largest deal ever made by Connecticut General and one of the biggest in U.S. real-estate history. A three-course special John Hancock Mutual of Boston, on the other hand, remains almost exclusively committed to financing new ventures. Hancock has the reputation, among people in the real-estate business, of being the most aggressive lender. Although it did not invent equity participation, it has refined the concept to the point of maximum sophistication. In some senses, the company has proved a model for the rest of the insurance industry. Hancock makes two types of real-estate deals-one for the star developers who are able to resist giving up part of their equity, the other for the bit players. The company's favorite proposition for the ordinary developer is a three-part package, consisting of a ground lease, a leasehold mortgage, and an equity participation. The package works something like this: A developer has land worth $5 million on which he wants to build an office building that will be valued at $25 million. If he mortgaged land and structure together, he could raise $22,500,000-i.e., 75 percent of the value. He can borrow more by separating the land from the building. First he arranges with Hancock to buy the land for $5 million and lease it back to him. Then he mortgages his leasehold estate to Hancock for 75 percent of the value of the building, or $18,750,000. In this way the developer gets a total of $23,750,000, or $1,250,000 more than if he had mortgaged land and building together Moreover, he can deduct the ground rent as a business expense, whereas if he had mortgaged the land he could have deducted the interest but not the amortization of principal. Hence the first two parts of the Hancock package are all to the developer's liking. The final part, however, is often extremely unpleasant As a condition for making the deal, Hancock demands the right to buy, through a wholly owned real-estate subsid iary, a 50 percent equity interest in the building Hancock would probably purchase this stake for about $1,875,000 or 10 percent of the size of its mortgage loan. The insur ance company, of course, would put down no cash. As was the case with the land and mortgage money, it would pay for its equity with a commitment to provide funds once the project was completed. The developer must take this three-level commitment to a bank to pick up his construction money. Just as it might have done in the Fifties, Hancock ends up, in effect, meeting 100 percent of the cost of the project. But this it not because it has inflated its appraisal or because value is sufficiently greater than cost to justify 100 percent financing. Hancock has simply elected to supply that tier of junior capital which, in theory at least, the developer formerly had to provide himself Hancock is so devoted to the idea of acquiring equity that if the developer came forward with his own equity money and said, "Lend me 75 percent of the value of the building. I can put up the rest," the insurance company would refuse. So, in fact, would many other companies In the Fifties scrupulous lenders worried that developers had too little of their own equity in projects. Today the developers are not allowed to put any in! Devouring all the cash 9 Although Hancock's package is a three-part affair, the company's short-term reward comes in four stages. Thre payments accrue to it as landlord and mortgage lender. the fourth as equity participant. Hancock usually charges percent interest on the leasehold mortgage, and about 9 to 91 percent of the land's value as ground rent. Then comes the kicker. After deducting mortgage and rent pay. ments, taxes, and a predetermined amount for what it considers reasonable operating expenses, Hancock insists on 25 to 35 percent of the remaining cash flow. Moreover, this bonus interest is attached to the ground lease rather than the leasehold mortgage. (Hancock, in fact, calls it a variable ground rent.) This is because the mortgage is usually fully paid off in twenty-five years while the ground lease runs twice that long. At the end of twenty-five years, therefore, only about 21 percent of Hancock's initial land and mortgage investment remains in the deal-$5 millior out of $23,750,000-but the company continues to earn a bonus interest based on its whole original investment The fourth short-term reward represents a return on equity. Since the ownership of the project is split fiftyfifty, one would expect the remaining cash flow to be divided in that proportion. But such is not the case. Hancock insists on a 12 percent cumulative preferred dividend. In effect, the company treats its equity just like a senior security. On an equity investment of $1,875,000, for example, Hancock takes the first $225,000 before allowing the developer any part of the cash flow. If the project throws off less than $225,000, Hancock takes all there is, then adds the difference between that amount and $225,000 to its second year's return, and so on. In practice, after |