Holes in The Dike

I have noted several times in the past that the commercial real estate market decline is a continuing major challenge to the banking industry (especially regional and local banks) and, as a result, a continuing stumbling block for the economy as a whole. I have laughed along with you at the new industry maxim that "a rolling loan gathers no loss" and averred that pushing the problems out further in time is not a recovery strategy. I just read about a recent big metropolitan area distressed sale that got me thinking about how the constipation of the commercial real estate market may be beginning to ease...I won't take the analogy to it's logical conclusion, but suffice it to say that I think the market clearing adjustment to the downside is under way, and I believe I can put some logic behind my intuition that trying to hold onto properties that are marginally servicing debt and/or have no equity value in a refinancing scenario is a doomed strategy, even if the economy doesn't get a lot worse.

According to Globe Street, Realty Finance Corp. has sold an original $47 million loan on a Class A office building at 250 Montgomery Street in San Francisco for approximately $25MM. The building was reportedly only 55% occupied, so obviously debt service by the borrower, Lincoln Property Co., was an issue. What was really interesting was the reason given for why the lender, Realty Finance Corp. (who received the property back through a deed in lieu of foreclosure) turned around and sold the loan so quickly at a huge haircut. The article reports that according to SEC filings, Realty Finance's $1.2 billion investment portfolio, which has lost 26% of its value since the start of 2008, is encumbered by non-recourse long-term financing through two CDOs. It also noted that in February the company was notified that it failed the overcollateralization test for one of the CDOs and that payments were being diverted from the firm to pay down principal of senior bondholders. The firm also expected a similar result for the second CDO some time in 2009, resulting in minimal incoming cash flows to its primary business. So here we see a distressed property, being handed over by an owner to a leveraged lender, who immediately must sell the asset at a market clearing price. As I heard at the IMN Conference, fund level leverage exists up and down the real estate finance and investment business. This will be a significant catalyst of distressed sales as property owners start to default on their loans.

Okay you say, but this is only an example of a building that is distressed being puked up at a big discount, it's not just a property someone overpaid for.....like so many out there. Why should banks cough up the latter if they are not absolutely forced to? Why is their first sale likely to be their best sale?

What we have to do is look ahead at how the new owner of 250 Montgomery Street is likely to act. The new owner has not been disclosed in this case, but is said to have been another real estate private equity firm. This firm now has a great new basis cost in the building and lots of incentive to be aggressive in getting it leased up. This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

So not only does the "new mark" caused by the transaction, in this case about $200 per square foot, versus a late 2006 purchase price of approximately $405 per square foot, hurt the valuation of banks' interests in loans on similar properties, it will eventually end up hurting cash flows across all their properties as the general rent level declines.

According to another Globe Street article, across the country in Florida, Ashkenazy & Agus Ventures recently foreclosed on a mortgage note they were said to have acquired on Downtown at the Gardens, a high-end mall in Palm Beach Gardens. Institutional Mall Investors, a joint venture between Miller Capital Advisory and Calpers, was said to have defaulted on the mortgage on the property, which they reportedly acquired in 2007 for $200 million. The mortgage note was said to have been acquired for $48 million, or about 35% of the original principal amount from TIAA CREF. It is speculated that Institutional Mall Investors will lose $60 to $90 million on the deal. With the mall, which has suffered the loss of several tenants, eventually landing in new hands at a lower basis cost, my guess is that rents will be lowered to get some tenants into the open space.

This situation certainly underscores the idea that your first sale may be your best sale, since Downtown at the Gardens is the second Palm Beach County mall to be foreclosed on recently after JP MorganChase foreclosed on the 1.2 million square foot Palm Beach Mall, suggesting yet another player in the market with a new lower basis cost and ability to discount to fill space.

The real estate financial market, like other financial markets, is like a permeable membrane: when the concentration of debt on one side gets too high, diffusion restores equilibrium. Fighting the restoration of equilibrium is a losing game, and it looks like the membrane is becoming quite porous in a few places.

Here in Manhattan we are seeing "distressed on distressed competition," but we may soon see (low basis cost) "blessed on distressed competition." In my recent piece I noted that the William Beaver House was doing some creative things to catalyze sales of units to investors. Nearby, 45 John Street, a project that has suffered from significant construction delays, is said to be facing foreclosure by lender BayernLB. According to The Real Deal, because units in the building wouldn't start closing by July 1, 2009, buyers in contract would have rescission rights. I wonder how the already fragile downtown condominium and rental markets will react if any of the troubled projects there eventually fall into the hands of someone with a really low basis cost?

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