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.

37 Responses to “Its not a Real Estate Crisis, its a Debt Crisis”

  1. 1 residential real estate September 27, 2009 at 11:11 pm

    Good post good content I enjoy reading it.

  2. 2 Jeffco September 28, 2009 at 12:45 pm

    I wholeheartedly agree with you. The debt is one of the big problems. It has caused fear amongst retail landlords. Unfortunately landlords are making long term decision based on short term economics. The rent concessions being doled out will come back and haunt many landlords. If the banks would free up capitol, and remove the fear of refinancing, the markets could start to heal. The banks are cutting their nose to spite their face with their current policies. There is little money available for the average deal. 45% down will devalue many properties and remove a vast part of the investor population. Leverage is and will always be an integral part of most real estate transactions. True, the improper lowering of underwriting standards over the last few years is one of ingredients of the current real estate melt down, but if the banks don’t back up their current mortgages, they will be faced with foreclosing on property that in the short term is worth 20 to 40 percent lower than what some time and patients will eventually heal. The banks have to support the property and work through the negative equity levels. It’s all in the long game.

  3. 3 rknakal September 28, 2009 at 1:00 pm

    Hi Jeff, thanks for the post. Leverage, in the right amount, is what makes this industry work. Imagine what value with be if all transactions were completed on an unleveraged basis. It will be interesting to see how deleveraging unfolds over the next couple of years.

  4. 4 UrbanDigs September 28, 2009 at 3:54 pm

    good article. Right now it is clear to me that liquidity in the marketplace is not a problem. Of course this may become a problem, but right now, there is a run for higher yield in riskier assets, of course driving yields lower.

    Whatever problems many see in the CRE sector, whether its debt rollover, distressed sales at 50% off, or future losses on banks balance sheet that are yet to be absorbed, are certainly not showing up in the packaged bonds. CMBS AAA Series 1 has rallied close to par, with bids in the 93/94 range. Series 5, closer to low 80s. I wonder how much room to rally is left? Its clear this improvement in credit was built on a foundation of fed backstops and liquidity facilities, not to mention trillions in debt monetization that now is winding down. This is where assets were inflated, not residential or commercial property.

    I think if there is any overextension of euphoria somewhere, its likely embedded there in the credit markets. The moves were quite amazing. Stocks are a proxy for everything and are reflecting this – and of course many are interpreting moves in equities to mean the world is much better now. This could last way longer than many think as market dynamics kick in and sustainable fundamentals go out the window. I do however believe we still have the positive data yet to come out via inventory restockings and effects of stimulus.

    So while I agree with your concerns and I do worry about the deflationary side effects of distressed property sales that so far have been largely contained by banks, I cant help but see a new program announced that will be targeted directly to this issue. As for the deflationary effects I mentioned, think of what happens when the new owner has a way more efficient operating environment which much less debt to run a business or investment property in? How does that affect distressed properties that have not yet made it to the open market? I think this part of the cycle will play out over years.

    I recall Lutnicks argument with Jim Rogers and Kudlow many months ago that this is likely a 2011 or 2012 problem.

    I think he may be right as by that time I just cant imagine what role or enemy the fed might be fighting – what facilities will be in place? PPIP? Doubtful from what I hear. Perhaps a hawkish fed kick starts the reversal in creditville? Because until that happens, liquidity seems to be overflowing and I wonder how concerns over debt rollover will pan out should this environment continue.

    As for the losses, it seems marks on MBS have been taken way down already. Whole loans have not but then again, they are not required to. I wonder if that is a constant cloud over the banks? I just scratch my head when I see what is going on in some of these credit markets and what seems to be happening in the real world. Something seems dislocated. I guess I shouldnt have underestimated the power of the fed, fdic, treasury and govt stimulus. They will keep this bank recapitalization environment for a looong time, until one sector of the markets don’t believe in them anymore – which will it be?

  5. 5 Marc Lewis September 28, 2009 at 4:38 pm

    Not to mention that the income of all the residential units in Manhattan is worth 20-40% less than the 2007 years when walkup studios were renting for as high as $1900 a month! These same units are struggling to get $1400 now, and the owners are stuck with having to offer incentives of one to three months rent as the supply of new tenants is limited to Manhattanites who are “refinancing their rents” by moving, rather than new tenants relocating to Manhattan for “shiny” new jobs. Besides leverage we nned jobs to support the rents, as the biggest culpret is the lack of jobs coming to Manhattan. Having Banks lending more money and on more favorable terms is essential, but without tenants to support the rents the whole system is under tremendous pressure to support itself. Marc Lewis President Century 21 NY Metro

  6. 6 Chris T September 28, 2009 at 7:14 pm


    Until the financial institutions are forced to remove the so called “toxic assets” from their balance sheets, and are held accountable to realize their very real losses (in many cases balance sheet supported by TALF/or federal loan/purchase dollars), our commercial real estate markets will remain in a state of paralysis.

    We really don’t have a real estate problem. We have a Capital Markets problem. Since 2007 we’ve seen a combination of federal monies between TALF, MBS buys, and outright fed loans in an amount exceeding $11 trillion dollars being placed into the money supply. A large percentage of this money was originally designed to flow back out consumers and businesses. This outflow has not occurred and until it does commercial real estate will continue to struggle.

  7. 7 David Bahr September 29, 2009 at 10:23 am

    Mr. Knakal,

    Love the blog!

    Few quick questions. The 16,000 properties in question, are you considering only Manhattan?, NYC?, or all of New York state. Whatever the area, do you have an estimate of the total number of properties in that area?

    Also, are you including apartments in those 16,000 properties? If so, it is possible to break out their percentage and apply a different model? They clearly don’t fit the model.


  8. 8 Danco September 29, 2009 at 3:08 pm


    I think you mean patience, not patients, will eventually heal. Althougth with all the hits we are suffering, perhaps there are more “patients”.

  9. 9 rknakal September 29, 2009 at 9:59 pm

    Hi Urban Digs, thanks for the post. I’m not sure about an abundance of liquidity but, clearly, different indicators will move the market in different ways. While 2011 and 2012 will be big deleveraging years, there is plenty of stress to go around before that. TALF and PPIP, while largly ineffective on a direct basis, their mere existance have brought credit spreads in significantly which may work its way into the real estate market at some point.

  10. 10 rknakal September 29, 2009 at 10:00 pm

    Hi Marc, thanks for the post. Jobs are, indeed, the key for commercial real estate. See my piece on small business job creation for more on this topic.

  11. 11 rknakal September 29, 2009 at 10:01 pm

    Hi Chris T, thanks for the post. Amen to you!

  12. 12 rknakal September 29, 2009 at 10:04 pm

    Hi David, thanks for the post. The 125,000 properties are walk-up and elevatored apartment buildings and mixed-use properties in Manhattan, Queens, Brooklyn and the Bronx. Only buildings are included, no individual apartment units.

  13. 13 TF September 30, 2009 at 6:57 am

    How did you determine 200 basis points was appropriate adjustment to cap rate?

  14. 14 terrig September 30, 2009 at 7:37 am

    Great job, however interest rate risk is real. It’s just that the Fed has rates near zero. If the Fed had not stepped up and accepted RMBS and CMBS debt, we’d probably looking at another 200, 300, 400 b.p., in interest rates which would not be pretty.

    Over the last 12-18 months commercial institutions would have been insolvent if they valued the debt where it belongs. Until a regulatory authority steps up and forces banks to value at “market”, you probably won’t see the hoped-for deluge.

    Unfortunately we are still in the early innings.

  15. 15 JWB September 30, 2009 at 8:55 am

    In 2005, I was a CMBS underwriter. I find your take on worst case scenario models interesting because at the time it was best case scenarios. I think in the future (agencies are already doing this) lenders are going to be more focused on exit strategies, especially under worst case scenarios. ie. falling rents, occupancies, rising cap rates and a contraction of LTVs in the marketplace for refinance.

    Hopefully, we will reach an equillibrium of “smart real estate” at some point, but bridging the gap in the mean time is going to be challenging with all of the roll in our current situation. There is still not a definitive trend or course of action. Some are waiting to sneak out of this meltdown, while others are waiting for blood in the streets.

    Unfortunately, people’s memories are short and new people will eventually enter the marketplace again. We will probably be repeating the cycle in 10 years or less and the key for the investor, as you stated, is to time the buy sell cycle correctly.

  16. 16 David Bahr September 30, 2009 at 11:05 am

    Mr. Knakal,

    Sorry, I wasn’t clear. I meant of the 16,000 buildings, how many are apartment buildings? They clearly should be under a different model, no?

    20% reduction in revenue in ETPA buildings seems overly conservative. 200 basis point increase in cap rates I can buy because they were so low to begin with. (Office and retail, not so much, especially coupled with a 20% reduction in revenue.) 25% reduction in multi-family LTV is overly harsh, too. This market has liquidity because of Fannie and Freddie.


  17. 17 Chris September 30, 2009 at 3:14 pm

    Great article. I’m going to put it in a scrap book so I can look at it again in ten years so I never forget the lessons of this era. My only disagreement with your formula is that leverage ratios should move from 85% to 60%. During heady times when rents are increasing and cap rates are falling that is when leverage should be 60%. When corrections come and values depress then leverage should move to 85% because there is clearly less risk to falling income and value.

  18. 18 r lobel September 30, 2009 at 5:06 pm

    HI BOB,

  19. 19 rknakal October 1, 2009 at 4:58 am

    Hi TF, thanks for the post. I used a 200 basis point increase in cap rate because that is about the average increase we have seen since the peak (low point) in the marketplace. Clearly this is lower for multifamily and higher for retail and office.

  20. 20 rknakal October 1, 2009 at 5:01 am

    Hi Terrig, thanks for the post. You make good points and I agree with you.

  21. 21 rknakal October 1, 2009 at 5:07 am

    Hi JWB, thanks for the post. You are correct that timing is everything. If you bought in 1987 and had to see in 1992, you lost a lot. If you bought in 1994 and sold in 2006, you were a genius. If you bought in 2007 and have to sell now…… Fortunes were made by those who bought right after the S & L crisis and I think those that purchase in 2009-2012 will see the same results.

  22. 22 rknakal October 1, 2009 at 5:12 am

    Hi David, thanks for the clarification. I do not have the data in front of me at the moment, but I would guess that 30-40% of the properties were multi-family. In this sector we assumed that only about 50% of the 2005-2007 vintage sales were in the negative equity category which was clearly the best performers. Also, the 25% reduction in LTV occurs when you go from senior debt plus mezzanine debt (both at higher percentages) to just senior debt. Mezz money is availble today but it is very expensive.

  23. 23 rknakal October 1, 2009 at 5:15 am

    Hi Chris, thanks for your post. I like your perspective about what “should” be and understand your perspective. Unfortunately, human nature kicks in and the pendulum overswings both ways.

  24. 24 rknakal October 1, 2009 at 5:21 am

    Hi Robert, thanks for the post. You are on point, as usual. I hope all is well with you.

  25. 25 Peter Nikic October 1, 2009 at 2:13 pm


    Well written, you seem to have hit some key points. Over the past few months, I’ve been on the market for multi-family apartment buildings in the Bronx. I find it very frustrating that owners are trying to sell their properties based on 2005-2007 sales and refinancing. I admit, most of these properties have nice financing packages, but what boggles my mind is how in the heck did they get it?

    Most of these existing loans are well above 75% LTV, while some even exceeded 100% LTV.

    I understand that investors were anxious to buy and the sweet financing they were getting from lenders only served as justification for them. What I don’t understand is, what in the world were these lending institutions thinking?

    This is where I agree with you that it’s a debt crisis. I keep wanting to say that it was created by the financial instituitions themselves. I know it’s easy to say now, but what were they thinking?

  26. 26 Simple Minded October 1, 2009 at 6:13 pm

    Call me simple minded, but I think some of Bob’s critics are missing the point.

    1. Lenders were compensated based upon closed business, not on loan performance and profitability. First motivation to write deals that didn’t make sense.

    2. Credit committees rubber stamped deals written up by freshly minted MBAs with no experience with rising interest rates, among other proforma assumptions made to crank the model into submission. The pressure to approve deals was fierce because- well, see point 1 above.

    When lenders abandoned fundamentals that allowed owners to have zero skin in the game under essentially fully non-recourse conditions they get what they get. C’mon, 4 caps for office? Never was, never should be.

  27. 27 rknakal October 2, 2009 at 7:24 am

    Hi Peter, I understand your frustration. The market is slowly adjusting to today’s reality. Many of the sales we are closing today consist of a recasting of the existing assumable debt which requires a paydown of principal to create some equity in the transaction. It is difficult to point the finger at just one segment of the marketplace. Many were guilty of exacerbating the bubble.

  28. 28 rknakal October 2, 2009 at 7:27 am

    Hi not-so-Simple Minded, Thanks for the post. You said it all very succinctly.

  29. 29 David Bahr October 2, 2009 at 11:30 am

    Mr. Knakal,

    Am I right to infer from your last paragraph that you expect a “Japan Lost Decade situation” for the US?


  30. 30 Matt Isken October 2, 2009 at 11:41 am

    I’m not clear about rule number 7. “When fear replaces greed and people seek absolute safety, all asset prices are essentially correlated and diversification does little good.”

    It seems to me that in the multifamily space I operate (granted it is not in NY but rather in CA, TX, CO, TN), while everything has lost value, the C class properties have lost value much quicker than the A class properties. Also, a city like San Antonio over time stays much more stable than cities like Dallas which fluctuate and overbuild themselves.

    Do you have data to back-up that diversification does little good in times of crisis?

  31. 31 Charles Cecil October 5, 2009 at 8:35 am

    Bob: have you tried to model the lost “equity” that is incorporated in the deleveraging of CRE? How concentrated is it-there are no doubt, mezz investors, REITS and other major operators that, like Macklowe, will be seeing staggering losses.

  32. 32 rknakal October 6, 2009 at 1:16 pm

    Hi Charles, thanks for the post. We have not done this modeling yet but will. Based upon average LTVs by product type and value reductions, it would not be difficult to do. I will keep you posted.

  33. 33 PWPOWELL October 15, 2009 at 1:43 pm

    I agree with the overall concept of Debt Crisis. I also blame the Lenders (Banks, CMBS, etc.) for the position we are in. Since the “turn of the century”, the loan to value ratio (LTV) has been 75% (the norm) for investment RE. To over simplify the root of our problem, from 2004 to 2008 Lenders wanted to get more money out in the market, so they changed this ratio to 85% LTV. This was risky because the lending premise was the market was always going to go up and now we are paying the price in this down market!
    On the other hand, I would caution the FEDs from “Whip Sawing” the LTV to a ratio lower than 75% “the norm”. This will have the unwanted consequence of ‘defacto’ causing a huge percentage of Investment RE assets becoming “non-conforming” overnight. This is also “changing the rule” mid-stream for those investors who stayed with “the norm” (75% LTV).
    A 75% LTV will still cause those borrowers who grabbed easy monies and ‘over borrowed’ to come back in line with “the norm”, but would not “swamp” the Investment RE market with excess non-conforming loans because of the FEDs ‘changing the rules’ in the middle of the game.

  34. 34 rknakal October 15, 2009 at 11:07 pm

    Hi PW, thanks for your post. I can understand your frustration with lenders but there is more than enough blame to go around. It is difficult to blame just one group for our economic condition.

  35. 35 Rory Ramirez February 1, 2010 at 11:36 am

    I just came across your article and found it very timely and informative. I happen to own a commercial development in central Ca. that has a construction loan from 2005 ($9,580,000.00 ) that was not allowed to convert to term financing, by the same lender, for lack of meeting covenants. We continued to make interest only payments on time for 27 months while trying to negotiate with the lender some form of workout. We were unsuccessful in getting realistic terms so we stopped making payments and our now in litigation. The bank is a regional bank that holds a considerable amount of non-performing commercial loans in central Ca. Being in the middle of this unwinding (slaughter) will ultimately prove to be both educational and expensive, I am sure. I felt that someone might be interested in the here and now real world of real estate development in central Ca. Stay tuned!

  36. 36 Tsquare March 5, 2010 at 7:34 pm

    Great Blog!……There’s always something here to make me think…Keep doing what ya do 🙂

  37. 37 Catrina March 29, 2010 at 6:51 am


    First of all , I want to thank you for all this informations , and I’d like it so much .
    Thanks for this sharing!

    Good work ! 😉

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