Why Bailouts Suck…the NYC Real Estate Edition…

This REALLY got under my skin:

A bill winding its way through Congress proposes to prop up deteriorating apartment complexes by injecting $2 billion from the Troubled Asset Relief Program into an effort to stabilize multifamily properties in default or foreclosure.

The bill, which is called the TARP for Main Street Act and was sponsored by House Financial Services Committee Chairman Barney Frank (D-Mass.) and Rep. Nydia Velazquez (D-Brooklyn and Manhattan), would use TARP funds that have been returned by banks and plow it into programs that, according to the bill, would create “sustainable financing” for the complexes as well as provide funding for property rehabilitation.

The House is considering the measure, which focuses on apartment buildings with units that are either rent stabilized or receive government subsidies.

Many developers during the housing boom bought rent-regulated apartments by borrowing against the properties themselves and betting they could make hefty returns by converting them into market-rate buildings.

However, thanks to the recession and the collapse of the real estate market, many developers are now struggling to make mortgage payments, let alone finance repairs and upkeep of the properties they own…

…

Nevertheless, Gluck, who stressed he maintains his properties, said the bill sounded like a good idea, and that real estate developers might as well collect from the government since everyone else was already getting handouts.

“As long as there is a long list of people out there with their caps in hand, why should everyone else be getting a free run?” Gluck said. “If it staves off some bank foreclosures, it is good for real estate and good for tenants.”

Set aside the moral hazard issues and Gluck’s entitlement mentality for now.  This proposal sucks.  It’s not about the tenants.  It’s a lifeline to equity investors and gives lenders more reassurance about recovering their loans.  It is important to understand how messed up this proposal is.   To get us to that point, I have a story to tell.

Approximately three years ago, in my previous job, I was part of a team that worked on a real estate transaction where we represented an owner of rent-stabilized multifamily properties in Manhattan.  Because we were amidst a bit of a housing bubble and an extremely overheated condominium conversion market, we observed that where potential investors thought that they could convert properties to condiminiums, or in the case of maintaining rentals, converting rentals to “market rate” units from rent stabilized units (serious dollars were involved here), real estate developers, generally backed by capital from private equity, Wall Street or other institutions, were bid aggressively.  Lenders, especially the CMBS lenders on Wall Street, bid aggressively and underwrote their loans off of the aggressive assumptions made by developers.  There were two ways to play this game:

1) Convert the property to condominiums, sell them out and make a load of money in the process (subject to certain rules and regulations unique to NYC which we’ll exclude for the time being).  If you can buy a 100,000 square foot  property at $500 per sq ft, spend another $200 per sq ft and sell the property for $1,000 per sq foot in a very short period of time, that’s a very nice return, especially with high leverage.

2) Convert the property to market rate apartments.  In some markets, especially certain areas of Manhattan, there were apartments that could get thousands of dollars per month more of rental income than what was currently allowed due to the rent stabilization guidelines.  While the law prohibited increasing rents to market rates levels for existing tenants, the opportunity was there to do this when tenants vacated.  Landlords would make improvements substantial enough so that the units would qualify as market (it’s a bit more technical but this ought to do).  Of course, in doing upgrades like putting in brand new kitchens with spiffy stainless steel appliances were only done to those apartments that were going to get those nice rent increases.  The existing tenants got nothing, and that always breeds discontent.

This was not the norm (nothing about the last bubble was normal) and the rules of the game were changing because traditionally, local NYC families (predominantly Jewish) bought the properties as long-term investments, financed them conservatively and kept them in the family so-to-speak.  These bidders were basically run out of the process because they 1) they typically weren’t used to dealing with processes which didn’t allow them to negotiate with the owners directly and 2) they were simply outbid.  If anything, these families would have made lots of money by selling their properties and quite a few did.

Because of what happened in the capital markets and in the economy as a whole, both of these bets, especially for those who did not get out early enough, went sideways.  Condominium values dropped like a stone and busted condo deals are all over the city.  The market rents that landlords can get today are far below than what landlords were assuming during the height of the market (I believe a court ruling which prohibited owners receiving NYC tax benefits from deregulating apartments played a role as well).  Nevertheless, owners who paid extraordinarily high prices during the boom are now sitting on properties worth less than the debt that’s currently on them.  To the extent they have interest reserves paying the underlying debt service because the existing cash flow is unable to cover the amount, these reserves are running dry.  These loans will go into default and lenders and/or bondholders can lose big time.

The irony of all of this is Gluck’s statement stating that this is good for the tenants.  The incentive to make money was based on trying everything possible to get tenants out of those spaces and owners pushed the envelope of the law to do this.  Why care about a tenant renting your unit for $1,000 a month when you can get $3,000 when he leaves?  Why care about the tenant in 3B when 3B is a $700,000 condominium occupied by a tenant paying $850 that you wish would keel over so you can get the unit back?  I don’t mean to single out Gluck because these opportunities were everywhere and anyone and his mother who could partake in trying to make money in this business did just this.  Those who were successful got out before the market crashed.  Those who didn’t have problems.

The only part of the TARP for Main Street Act that does not necessarily offend me is government funds being used to fund rehabilitation and certain capital expenditure projects, especially with respect to buildings that require it (IMO, it’s a public safety issue – it needs to be addressed).  That said, the main push of this plan offends me because I see this whole concept of creating sustainable financing as nothing more than a bailout for the equity investors who bid too much for the properties in the first place and who now have loans that they can not only not service but loans with principal values that are far in excess of the market value of the properties themselves.  The only way they can make money on these assets, given that their equity has been all but wiped out, is to reduce the basis in their investment.  The only way to do that is to renegotiate and restructure the loan so that the investor owes a lower balance than the original mortgage.  With us taxpayers subsidizing the losses of these loans, both the borrower and the lender win, at least for now.

There is no need to bail these people out.  Even in a worst case scenario where the federal government would have to step in and fund some capital expenditures for certain properties, what people ought to realize is that the government does not have to create “sustainable financing” for NYC multifamily properties.  The fundamentals of this property type have always been strong and occupancy levels have been in the high 90% range since the entire rent regulation regime began decades ago.  These properties are cash cows, but they are also operationally intensive, require a thorough understanding of the business and the laws that apply to them.  As such, the potential ownership pool is limited but not non-existent.  If you want to see sustainable financing, then the banks should foreclose on these loans and potential investors should bid for them at market clearing prices.  Given the cash flow characteristics and the expertise amongst local banks, financing will be available to buyers.

My experiences in dealing with the property type didn’t teach me everything about this business, but I do know that at the right price, the well-capitalized local players will come back.  If it’s “about the tenants”, the tenants are no worse off  because the new landlords will be required by law to make necessary capital improvements.  Local developers are not too big to fail, not systemically important and also tend to have overinflated senses of self worth, especially those who think of bailouts as a “free run”.  No such thing.