Commercial Real Estate - Chasing the Ball Downhill

The sale of One Worldwide Plaza,at 8th Avenue and 49th street, reportedly fell through for the 3rd time last week. It is perhaps a metaphor for the commercial real estate market as a whole. The building was purchased by Harry Macklowe from Blackstone near the peak of the economic expansion and commercial real estate transaction bubble, when they were flipping Sam Zell's Equity Office Property portfolio. There have been a couple swipes taken at this apple. The latest was a second offer by George Comfort & Sons and real estate private equity firm RCG Longview to buy the building using financing from the original lender, Deutsche Bank, which would have retained a stake in the building.

The reasons for the deal falling apart are only speculation at present; Deutsche Bank was said to be the one who pulled the plug, unhappy with the rumored mid-$300 per square foot valuation. The building is said to be as much as 50% vacant. So while this appears to be a case where a bank is reluctant to take a mark on an individual property, that might also impact the value on its books (and others') of similar properties, it seems to be somewhat feudal when one considers the macro picture in commercial real estate land as illustrated below.

This chart was lifted from Calculated Risk. It shows the Case Shiller residential home price index overlayed by the Moody's/Real Commercial Property Index (CPPI). I think it speaks for itself, but to put it simply, it shows that the commercial market appears to be going the way of the residential market, but with a lag. Importantly, the latest click on the Moody's CPPI showed a decline of 8.6% in April, the largest recorded so far in this down cycle. Commercial Real Estate News quotes Moody's as suggesting that "Large price declines may act as a catalyst to cause the bid-ask gap to narrow, which in turn may lead to an increasing number of transactions."

Okay, so nothing new here so far that hasn't been covered by others. I would aver, though, that the seeming similarity in the glide slopes of the residential and commercial real estate market downturns is unlikely to hold going forward. The commercial market is likely to decline much more rapidly than the residential market, once the barf-out gets under way in earnest. I just have a couple comments about why the commercial market is different than the residential market and why I see a step function change in prices.

The residential financing environment has been bolstered by the government's cushioning of lending through:

1) The takeover of Fan & Fred, making implicit the assumed federal backing of their guarantees.

2) Fed purchases of Fan & Fred paper, which are keeping mortgage spreads from blowing out.

3) The demographics of household formation, which despite the loss of romanticism in making home purchases and the negative impact on household formation of the economic downturn, inevitably increases demand and bolsters residential property sales if the rent vs. buy equation tilts in the right direction. (We have discussed previously on Urban Digs, why we think housing formation is actually linked to the housing market in so far as so many jobs were produced by the housing bubble and so much immigration was induced by these job openings).

In comparison to the above, the commercial real estate market is currently characterized by a complete collapse of financing. The CMBS market, which was responsible for roughly half of the commercial real estate financing market and a larger percentage of the "big deals", is dead. The one corner of the lending world that has not been decimated by residential real estate losses thus far has been the smaller savings banks and savings & loans. These institutions, while technically still very well capitalized, are likely to experience a sudden and extreme pressure on their capital bases due to the ballooning losses in commercial real estate.

Unlike the residential world, where new customers are created constantly, the commercial real estate world has no inherent growth in its investor base. Yes, new funds have been raised to take advantage of distressed real estate sales, but many argue that the equity available is still not large enough to absorb all the bad debt. Think of it this way: if there was 75% LTV debt available in the bad old days to buy a $10 million building, the debt outstanding is $7.5 million. Fast forward to today, where it is very hard to get debt at all with LTVs of only 50 - 65% available from a bank depending on property type. On a straight sale of the property at the value of the debt, a buyer would require $2.6 million to $3.75 million in cash. For note purchases LTVs are down at 50% or less and the debt available is very expensive. Instead of the $2.5 million of equity originally used to buy the building - a buyer today would have to either put up 100% of the equity or go to a private lender and take a 50% LTV loan with a 14 to 16% interest rate. So even if the debt on our theoretical $10MM property sold for 50 cents on the dollar, you would be putting up $3.8MM in cash. Or if the buyer were willing to go with a private lender they could keep their equity outlay down to $1.9MM, not much less than the equity originally put up by the defaulting borrower. The combination of equity losses to be taken by the commercial real estate industry coupled with the un-availability of leverage to make purchases and the large volume of bad debt to be dealt with suggests only one thing.....much lower prices.

Interestingly, I recently took a client to visit the workout department of a NYC-based bank. The bank personnel were very polite, but assured us that they would not be selling debt at big discounts to face value. As we discussed property valuation, they cautioned that if we did lots of cash flow modeling, etc., we would probably never buy one of their discounted notes, because the numbers just wouldn't work. To keep the dialogue open, my very savvy clients replied, "that's okay we are location buyers"....as in we are willing to pay for future upside to the location in land value or rehab results. But of course, those things can be modeled as well. So essentially, what the bank was telling us and themselves is that they were looking for irrational buyers, who would continue to pay irrational prices....and without the enticement of cheap debt. Maybe they consider their core borrowing customers of old to be stalwart in this environment. I personally would not be making that bet.

Bids are due for the re-auction of One Worldwide Plaza July 15. I'm betting the price will not be improved much if at all.....of course, terms and conditions will be opaque, so it is never easy to really understand why the current deal is going south or why a new bid is better or worse. The bottom line is today's buyers are likely to be utilizing significant amounts of cash, and to get the double-digit IRRs they look for and promise their investors, purchase prices will have to be much lower (and going-in cap rates, much higher).

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