Archive for September, 2009

Its not a Real Estate Crisis, its a Debt Crisis

The title of this post says it all. Real estate is rarely in a state of crisis unless an earthquake or other natural disaster disturbs the structual integrity of the building. Real estate becomes distressed when too much leverage is used and the net income from the property is insufficient to meet debt service payments.

Even in today’s stressed marketplace, owners who are very conservatively leveraged are doing just fine. For those who were seduced by tons of plentiful, cheap debt which was available in the market in 2005, 2006 and 2007, things don’t look so good.

It is clear that the market must go through a massive deleveraging process. Properties simply cannot support the debt loads that currently exist and we have started to see this deleveraging process start. It is interesting to try to calculate the extent to which leverage must be taken out of the system. Let’s see what the New York City market shows us and try to determine what it means for the rest of the market.

In 2005 through 2007, there were $109 billion of investment sales activity in New York. Based upon a breakdown of property types and their corresponding current price levels and the LTVs that had been available during the 2005-2007 years , Massey Knakal has estimated that about $80 billion worth of those sales, affecting about 6,000 properties have negative equity in them. If we add to this total those properties refinanced during this period, we add about 10,000 more properties which have negative equity levels. This adds about another $80 billion to the total debt on properties with negative equity. Using today’s metrics, what is the correct amount of debt that should be on these 16,000 properties?

If we use a model which assumes a 20% reduction in rental revenue, a 200 basis point increase in capitalization rate and a loan-to-value ratio decrease from an 85% average to a more conservative 60%, the resulting debt level is 60% lower than the existing level. This implies that, of the $160 billion of debt on these underwater properties, the appropriate level of debt, based on today’s standards, should be only $64 billion!

How did the bubble of 2005-2007 get so out of control? If I had a nickle for every time I heard someone say that we were in a new paradigm……..

We clearly were not operating in a new paradigm. It happened because almost all of us lost sight of the fundamental rules of cyclical real estate markets. Our current economy and capital markets offer a reminder of some historically proven truths:

  1. Debt is wonderful when all goes well, but extremely punishing when things go wrong.
  2. Debt rollover renewal is the real risk of using short term debt, not an increase in the interest rate.
  3. Recessions and capital shortages are never incorporated into financial models, but are often incorporated into reality.
  4. Real estate is a long term asset (even though your planned holding period may be short) and therefore requires substantial amounts of equity in order to provide an appropriate asset-liability match.
  5. When money is available for everything from everyone, soon thereafter there will be no money available from anyone for anything.
  6. When money is easy, the benefits accrue to the sellers, not the buyers.
  7. When fear replaces greed and people seek absolute safety, all asset prices are essentially correlated and diversification does little good.
  8. Any rapid change (e.g., the spike in demand for condos and second homes) attributed to demographics must be wrong, as demographic changes move through the system at glacial speed.
  9. Your model’s worst case scenario is not even remotely the worst that can occur.
  10. When you think things are too good to be true, they probably are.

As these rules were forgotten, aggressive plays were made and we have witnessed a cataclysmic bursting of the bubble.

I have seen estimates ranging from $1 trillion to $2 trillion of commercial real estate debt which is scheduled to mature between now and 2013. If we extrapolate the experience of New York’s market to this national total, it would appear that $600 billion to $1.2 trillion of debt must be withdrawn from the market. Much of this deleveraging will occur in the form of distressed note and property sales. It is apparent that due to the unwillingness of banks to realize the losses imbedded in their balance sheets, changes to FASB mark-to-market accounting rules and modifications to REMIC guidelines this process will play out over a very long period of time.

As things play out, it is becoming more apparent that our distressed asset flow will not be in the form of an early 1990s-like tsunami but rather a series of rolling waves extending as far as the eye can currently see.

Mr. Knakal is the Chairman of  and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.


REMIC Modifications and Their Impact

One year ago, one of the most intriguing questions on the minds of commercial real estate investors was what was going to happen to large, performing CMBS loan that matured and the owner was not able to refinance. Since then, 528 CMBS loans valued at nearly $5 billion matured and were unable to be refinance even though 75% of these loans were throwing off more than enough cash to service their debt. The evaporation of the CMBS market and the entire shadow banking industry has created an extremely challenging financing market for all large loans, even for properties which have the cash flow to cover debt service payments. This lack of liquidity has continued to be a tangible concern for the industry. 

A potential solution to this problem was announced by the IRS last week when they issued guidance (Revenue Procedure 2009-45) that provides significantly greater flexibility to modify the terms of commercial mortgage loans that have been securitized into commercial morgage backed securities. RP 2009-45 makes it clear that negotiations involving modifications to the terms of these loans can occur at any time (the servicer only has to believe there is a “significant risk of default” even if the loan is performing) without triggering tax consequences. It applies to all modifications made after January 1, 2008.

Until now, a borrower with a CMBS loan had no one to speak to at the master servicer. The master servicer serviced the securitized loan and the borrower would have to essentially go into default to have the loan transfered from the master servicer to a special servicer. The borrower could then have a dialogue with the special servicer to discuss reworking the terms of the loan.

Administrative tax rules applicable to Real Estate Mortgage Investment Conduits (REMICs) and investment trusts imposed severe penalties for changes made to commercial morgages or investment interests after the startup date of the securitization vehicle. The trusts could have been forced to pay taxes if the underlying loans were modified before they became delinquent, according to the old CMBS rules. Therefore, borrowers were unable to even begin discussions with their loan servicers until they had already defaulted of default was imminent. Often, however, by the time a loan reaches this status, options are generally limited and it is too late to work anything out. Foreclosure would be a likely result, further depressing valuations.

This new IRS guidance puts CMBS borrowers on almost a level playing field with borrowers who have loans with traditional banks. Those bank borrowers have always been able to call their banker at any time to discuss any potential problems that the loan might face. Now borrowers with CMBS loans can do the same thing thereby enhancing the possiblity that the loan can be salvaged and the property can be maintained.

While this modification is applauded by many in the industry, there are some concerns.

First, this program will really only help those borrowers who are conservatively leveraged and simply cannot refinance because of the extraordinary condition of the credit markets today. Any borrowers who have negative equity and are highly leveraged are out of luck (whether they can arrange a modification or not) and may only be delaying the inevitable if they are able to convince the servicer to modify.

Second, it is feared by many that the guidance could open the floodgates for everyone to try to get some sort of loan modification whether it is justified or not.  Some borrowers may take a shot just for the heck of it. It will be interesting to see what criteria servicers use to determine who gets help and who doesn’t.

Third, servicers will come under tremendous new pressures from several participants with different objectives such as competing classes of investors. Some investors holding CMBS bonds are watching nervously because the modifications might not always be in their best interest. CMBS have senior and junior pieces (known as the “A-note” and the “B-note”). The senior piece is in a better position and has incentive, in most cases, when a borrower defaults, to foreclose and liquidate the property. Junior holders, on the other hand, might benefit from a modification because they may not get any proceeds back in a forced sale.

Fourth, the fiduciary responsibility of the servicer is to all bondholders and they should modify loans only when that can be expected to reduce losses. That puts servicers in the challenging position of trying to figure out which borrowers are essentially sound versus knowing when it makes sense to foreclose quickly. My guess is that, based upon the relentless pile of files mounting on servicer’s desks, modifications will be the path of least resistance.

Fifth, from the brokerage perspective, this modification will only further constipate the pipeline of distressed assets which is already moving like molasses. Many of the properties which would be considered “distressed” are financed with CMBS loans and, to the extent that brokers were looking forward to selling these assets, we will have to wait even longer for these opportunities to present themselves.

Importantly, the guidance only applies to outstanding loans and only to servicers who believe a loan modification is in the best interest of all of the bondholders. The servicers are still bound by the terms of the pooling and servicing agreements and the servicing standards (which are not affected by the guidance) but at least the tax rules will not prevent dialogue among the parties.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

Commercial Real Estate Needs Small Business Job Creation

A few times each week I am asked by clients and colleagues what my biggest concerns are in our current marketplace. One that has really been resonating with those that I speak with is the unprecedented shift in economic power from the private sector to Washington DC and how this fact could impact the commercial real estate market. Our CRE market (and the ecomony for that matter) needs job creation which does not seem to be on the minds of those with the economic power today.

While most Americans and businesses are cutting expenses and being prudent about spending under current economic conditions, the present administration has continued the reckless spending habits of the Bush administration. I am not criticizing Democrats or Republicans but all elected officials who are spending our way into serious trouble. If you read StreetWise regularly you know that I do not discrminate when objecting to policy inplementation.

During W’s 8 years, the supposedly fiscally conservative President, oversaw a GDP increase of 15% while he allowed government spending to increase by 58%! The present administration’s stimulus plan is full of more pork than a butcher shop with only 11% of the $787 billion targeted toward infrastructure which is truly stimulative. A number of those on Capitol Hill had agendas other than stimulus and they were the ones shaping the package. Additionally, there are trillions in various programs which are in various stages of deployment and when there is that much cash being thrown around, you are kidding yourself if you don’t think waste, fraud, abuse, incompetency, inefficiency and corruption will exist. History has shown us that this is normal regardless of the party in control. The risk is, however, much greater under a unified government such as we have now. The midterm elections should be quite interesting.

We must remember that politicians do not grow economies. The truth about growth is that it is the product of millions of decisions made by millions of people about what to produce, buy and sell. Politicians can influence decision making by increasing or decreasing incentives about what we produce, buy and sell ( like offering to paying $4,500 for cars that may have been worth an average of $500). Regardless, they cannot control today’s global economy.

In the most recent cycle, since output peaked, our GDP has contracted by 3.9%, the steepest decline since World War II. Many economists believe that our economy is at an inflection point at which we may need to shift to an export based economy as opposed to continuing to rely on a consumer based economy.  We have had decades of growth led by consumer spending which, along with residential investment, grew from 67% of GDP in 1980 to 75% of GDP in 2007. During the credit crisis, $13 trillion of wealth has evaporated. We have seen an implosion of the shadow banking system and a tangible shift to thrift.

In 1980, the savings rate in the US was 10%. In 2006, the abuse of credit cards and readily available mortgage equity withdrawl catapulted us into a savings rate of -4%. During this period, we saw all borrowing in the form of household debt grow from 67% of disposable income to 132%. Today, the savings rate has risen to 6%. This 10% swing in the savings rate alone has eliminated $1 trillion from our total annual output. The stimulus, along with other government programs, combined with dramatic declines in tax revenues have created record budget deficits, now projected to rise to about 13% of GDP. To put this into perspective, this $1.8 trillion deficit amounts to $3.4 million per minute, $200 million per hour and $5 billion per day. Our federal debt is now 60% of GDP and it is projected to hit 82% by 2019. At some point the spending must stop.

Moreover, the off balance sheet obligations of the US associated with Social Security and Medicare put us in a $56 trillion financial hole. Both of these programs are looming train wrecks if there are not fundamental changes made to the way they are structured. Fannie Mae and Freddie Mac liabilities are also off balance sheet whollops to our financial picture – add $7 trillion more.

We are presently faced with 4 looming deficits: a budget deficit, a savings deficit, a value-of-the-dollar deficit and an economic leadership deficit. Political careerism must give way to the implementation of real solutions.

So why do I care about all of this political mumbo-jumbo? Because our real estate market needs real solutions. We need the government to focus on creating incentives for small business. We have been led out of the last 7 recessions by small businesses which have created two-thirds of all new jobs. Anti-business sentiment on Pennsylvania Avenue is not stimulative. We need small businesses to thrive. That will create jobs and those jobs will allow residential tenants to move from a one-bedroom apartment to a two-bedroom, or from a two-bedroom rental to purchasing an apartment or a single family residence. The additional jobs will create demand for office space and the increased economic activity will increase room rates and occupancy levels in hotels. New jobs will put disposable income into the pockets of Americans who can go to retail stores and purchase goods which will allow retail tenants to pay better rents and open new locations. Small businesses have the power to create these valuable jobs. Where are the incentives for small businesses?

The massive deficits we are experiencing (at all levels – federal, state and city) will certainly create pressure for tax increases but tax increase are not the answer. We are all cutting expenses, why can’t the government – at all levels? If they can’t, we could be in this soup for quite a while.