A bloody mess…

For reading up on commercial real estate, Robert Knakal’s blog is one of my favorite sites.  His topics are of interest.  He has good commenters that are knowledgable about the commercial real estate business and his writing is accessible to the layperson.  His latest post is the perfect summary of the significant problem facing commercial real estate properties, a problem that will plague commercial real estate for years, as it is estimated that there will be in excess of $1 trillion in real estate mortgages that will be maturing in the next four to five years.  To demonstrate the problem, let’s put numbers to the following passage:

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.

To show the order of magnitude of the problem, I want to assume two scenarios that I will call “Yesterday” and “Today”.

Under the “Yesterday” scenario, assuming a property had $1 million dollars in net income and assuming investors were willing to value that income stream at a 6% yield, the value of this property is calculated at approximately $16.7 million.  Assuming a lender underwrites a loan at 85% of value, the lender will lend $14.2 million loan.  For the purpose of this discussion, we will assume the loan is interest only (not unreasonable given the lending environment prior to the crisis) and that the loan is non-recourse (standard practice in the industry). 

Under the “Today” scenario, we have to refinance our $14.2 million loan.  Unfortuneately, our $1 million net income is now $800,000 and the yield that investors will assign to this income stream is now 8% as opposed to 6%.  As such, a lender will assume a market value of $10 million, a 40% decrease over the “Yesterday” scenario.  Because lending standards have tightened since the time the $14.2 million loan was originated, a lender will only provide a loan based on 60% of the current market value of $10 million, or $6 million (roughly 60% less than the $14.2 million it was originally able to borrow).  

We have a problem.  Under this refinancing scenario, an investor would have to come up with an additional $8.2 million in cash to make whole on its loan.  This is not going to happen.  The original lender will not  get its $14.2 million back through a refinancing scenario.  How does the bank recover its original loan in full?  It doesn’t.  Remember, the current market value of the property is $10 million so if the bank decides to foreclose on the property (and assuming it sells at market), the banks net proceeds would equal $10 million less transaction and foreclosure costs.  The bank could sell the loan to an investor, who would foreclose on the Property and take ownership, but those buyers don’t pay the full market value either given that they themselves incur the costs and risks of the foreclosure process.  In this example, my (very) rough math suggests lenders recovering roughly 60 to 70 percent of what was originally borrowed, but that is higher or lower depending on the situation.  

This sort of situation is pervasive throughout the industry and applies as much to NYC multifamily properties as it does suburban office buildings, especially for those properties that were either purchased and financed or refinanced during the market’s peak (2005-2007 ).  Assuming $1 trillion of loans coming due in the next five years, we could see losses on those loans of $300 to $400 billion (mark-to-market writedowns have already accounted for some of these losses, but the numbers are still staggering). Having banks and CMBS servicers extend the loans and pretend the inevitable doesn’t exist, but at some point they are going to have to realize that market fundamentals are not going to be there for these loans to be repaid in full.   A massive and bloody process of deleveraging commercial real estate assets has to take place and there’s little that can be done about it.