Archive for September 27th, 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.