Commercial Developers: Not a Credible Threat

Ok, I’ve been tardy in posting. I’m very sorry about that, lot’s of things are going on. This post is, obviously, a bit delayed, but I think it’s important that people realize why this is amongst the dumbest ideas ever and will demonstrate how one can try to pull the wool over the eyes of the public.

On December 22nd I was startled to see a WSJ news alert title “Developers Ask U.S. for Bailout as Massive Debt Looms” in my email. This is potentially the most ridiculous thing I’ve ever heard of.  There are a few reasons I believe this. First, though we’ll need to know a few things about commercial properties and how they are financed…

1. Unlike residential mortgages, there are multiple metrics for value and credit worthiness of a commercial property. Residential properties can be looked at with a few paramters in mind, but there is a certain amount of behavioral science that undergirds mortgage models. For residential mortgages, one mainly considers FICO score and LTV (ratio of loan amount to value). However, these are not created equal: FICO is used to ascertain probability of default and LTV is used to figure out loss severity with a binary “under water or not” input into default probability as well. The intuition here is that how much one expects to lose is the probability you lose anything at all times the severity (percentage of loan value) of that loss. We can debate if the world is this simple (it isn’t, I’ll win that one), but that’s how one analyzes individual mortgages in the context of a pool. Note what is NOT in there, the actual rate of interest or income of the borrower (theoretically contributes to FICO, but FICO is largely a black box).

Commercial mortgages, on the other hand, are sized to two parameters: LTV and DSCR. DSCR is the Debt Service Coverage Ratio and is net cash flow (NCF) from the property divided by the monthly interest payment, and has traditionally been constrained to 1.20x as the minimum acceptable ratio. Further, the cashflow is the result of a detailed underwriting process where every line item (most important being rent, obviously) is analyzed and researched to find the correct assumptions. Values, unlike residential properties which are dollars per square foot, are determined by capitalization rates or cap rates for commercial properties. The cap rate is the NCF divided by the value of the property. So, if a property that generates $10 million “trades” at a 10% cap rate (which is ridiculously high, bubble cap rates were around 4% and normal cap rates are around5-7% for regular properties), it would “trade” at $100 million (trades being used to denote the theoretic level it could be bought or sold).

What we see here is that there are three elements of analyzing a loan here: the actual cashflow the property generates is scrutinized, the ability to service debt from that cash flow constrains the size of the loan, and the valuation of properties constrains the size of the loan along a different, but not unrelated, dimension.

2. The riskiest properties in the commercial mortgage market are structured as much shorter-term loans. If you are a developer and you aren’t refinancing a mortgage on a cashflowing property, you don’t get a 10-year fixed-rate loan. You get a two-year loan whose interest rate floats (although there is a cap purchased, so the property or developer has a maximum payment) and is extendable if you meet certain conditions and pay certain fees. These sorts of loans are made on newly-constructed complexes with no current cashflow, properties undergoing a severe renovation or being repositioned in such a way as to introduce a lot of uncertainty (adding floors, changing building type, etc.), and other risky properties.

Less risky properties get 10-year fixed rate loans, but they aren’t 10-year amortizing loans, they are 30-year amortizing loans that come due in 10 years. This is called a 10-year balloon payment. This means that in ten years the average commercial property will only have paid back 20% of their loan when the remaining 80% comes due. Clearly this is a regime meant to discourage unlevered ownership.

3. For very large loans, in addition to floating rate loans, commercial properties have low leverage mortgages and the additional debt comes in the form of mezzanine debt. Why is this important? Well, mezzanine debt, for those who aren’t familiar with the term, is debt against equity–the owner puts up his/her ownership stake as the collateral of the debt. So, if one fails to make a payment on the mezzanine debt, the mezzanine debt holder can take the property. Note, however, this is unlike a bank foreclosing on your house–the mortgage in this scenario is above the mezzanine debt and is undisturbed by the default of the mezzanine debt. The mortgage holder is still owed money, but from whom the checks are coming is irrelevant to the mortgage holder. This structure exists for a number of reasons, including tax and accounting reasons, but one reason it is to often used is that mezzanine debt makes it much easier to transfer the property’s ownership versus having one large mortgage.

It shouldn’t surprise anyone, though, that this complexity allows investment banks to get deep into the process of lending and distributing debt. The buyers of the lowest pieces of mezzanine debt are completely different than the buyers of the AAA bonds backed by the senior mortgages (yes, the mortgages are securitized, but mezzanine debt cannot be–for boring details on this to look into REMIC rules and other minutia).  The natural buyers of the lowest pieces of mezzanine debt are firms that, in the event of default, can own the property and operate it well. This is an important fact. Some buyers of commercial mortgage debt will refuse to purchase debt on a property, especially large or complex properties, if a smart firm with a good track record of operating properties isn’t in the first in line to take over the property in the event of a default (called the first-loss debt position).

Now, let’s explore what actually happened over the past few years. 2006 was the year underwriting standards totally died. Highly levered transactions became the norm, case-in-point is the EOP transaction. This was financed with floating rate debt and was very highly levered–EOP’s portfolio was yielding about 4% to 5% on the purchase price (although, this was on the final purchase price which was settled on in 2007, but the underwriting and debt commitments were all negotiated in 2006). Here’s another dirty secret about Blackstone’s buyout of EOP: the rating agencies, to rate debt, have to do their own underwriting of the properties and come up with their own, conservative, cashflow. Most, if not all, of the underwriting the rating agencies used was directly from Blackstone. This was not uncommon when the rating agencies were involved in a transaction with a large client who had a good brand name. EOP is merely illustrative of a top-of-the-market deal. Although, there are other huge examples.

Benchmark underwriting standards went from a 1.20x DSCR to 1.15x or 1.10x, although LTV’s stayed at 80% (although valuations were sky-rocketing).  A huge percentage of loans were interest-only, so the balloon payment went from 80% of the loan to 100% of the loan. Think about that… A borrower is constrained by their ability to make payments on the debt, but they are only constrained to 1.10x their debt payments, which don’t include amortization payments, and the constraint is based on your expected future cashflows (which, obviously, assume rent growth!), not your current cashflows. Starting to get the picture? Properties became over-levered in the instance where any problems developed.Who pushed for this? Developers and property owners. As a matter of fact, the push to grow market share and revenue meant that banks needed to lend more so they could sell more debt and securitize more. 2006, for these reasons was the peak of lending on commercial properties. Between 2005 and 2006, I would estimate, 40-50% of all the currently outstanding commercial mortgage debt was originated (the chart in the WSJ article bears this out).

2007 was the year that problems began to occur. Spreads blew out to record levels (at the time, those records are being smashed all the time). Within six months of relaxed standards being instituted, they were rolled back. It was also during this year that supply of debt, including the unsold inventory referred to as hung debt, far outstripped demand. Because of the large percentage of “fast money,” or hedge funds, in the real estate debt markets (see #7 in that post), when spreads moved against them the largest players took huge losses and shut down (“blew up”). Also, CDO’s were a huge consumer of this sort of debt, and the non-corporate CDO market stopped completely in 2007. Seeing the headwinds for reduced demand? So, in essence, the marginal buyers of debt who could live with relaxed underwriting standards, because they needed to get enough debt to issue a CDO or invest their new $1,000,000,000 they raised, disappeared.

2008 was, in essence, more of the same. The same pressures and lack of demand persisted and debt prices continued to sink. Also, more buyers of debt left the market or shutdown, compounding the problems.

So, now, we can examine the request for bailout funds by developers. In the next three years, there is, according to the article, citing some firm I never heard of, $530 billion coming due ($160 billion in the next year). Well, I can count, so let’s count backwards. The vast, vast majority of mortgages are 10 year mortgages with a balloon payment, so those loans made in 1998 with this structure will be coming due. Rents are up significantly since then (page 23), perhaps 40%. Cap rates have also compressed significantly. Taken together, these two facts mean that someone with a stable property, who got a mortgage in 1998, is coming due  this year and has 40% more cash coming in from the property and can lever that cashflow much more now. I think those people will be fine refinancing. Ditto for all normal loans coming due in the two years after that.

What’s left? Well, all the risky, shorter term loans. These are 2 year loans that can be extended by one year up to a total term of five years, traditionally. In my estimation 95% of the floating rate loans I’ve seen conform to this structure.  Well, two years ago means originated in late 2006 or early 2007. Three years ago is 2006 or 2005 (very top of the market). You see the pattern. These loans are the riskiest projects, undertaken at the top of the market. These loans were made with aggressive assumptions underlying their underwritten cashflows, top-tick valuations, and higher levels of allowable leverage than at any other time in recent memory (certainly in the time this market has been considered mature). Seems like I just made the case for the developers, no? Absolutely not. Common sense tells us that these risky loans aren’t the normal apartment buildings, malls, retail space, and industrial space–those are the 10-year loans we talked about. These risky loans are for acquisition and re-positioning of hotels, construction projects resulting in marginal increases in commercial space, and highly levered purchases of portfolios of properties. Not exactly the sort of properties that are the backbone of our economy.

Even worse for developers is the fact we discussed above: short term loans are designed to transfer owners. Defaulting on a highly levered property usually means the property owner becomes someone as good, if not better, at running that same property type. No one will come to their office to see the front door padlocked and the bank selling the building for the majority of these loans. Oh, and the majority of those 40-50% of loans I estimated were made in 2005 and 2006, based on frothy valuations and underwriting, will be coming due in 2015 and 2016–those numbers, then, can’t be in the numbers presented by developers.

The conclusion? Devleopers are using big numbers to scare people into putting money up to backstop the riskiest of their highly-levered projects. As a matter of fact, there was quote in the WSJ article.

“The credit crisis has got so bad that refinancing of even good loans may be drying up,” says Richard Parkus, head of commercial-mortgage-backed securities research at Deutsche Bank.

(Emphasis mine.)

HA! “Even good loans” … The unread part of that is, “Not just bad loans, but…”

Further, this just can’t be true at all:

There’s widespread agreement that a record volume of commercial real-estate loans made during the boom years are starting to come due. According to Foresight Analytics, the $530 billion of commercial mortgages that will be maturing between now and 2011 includes loans held by banks, thrifts and insurance companies as well as loans packaged and sold as commercial-mortgage-backed securities — or CMBS.

(Emphasis mine.)

Unless we are defining “boom years” as 1998 to 2001, this isn’t just suspect it’s patently false. No significant amount of loans turned into CMBS is coming due between now and 2011. At least the WSJ is consistent…

Unlike home loans, which borrowers repay after a set period of time, commercial mortgages usually are underwritten for five, seven or 10 years with big payments due at the end. At that point, they typically need to be refinanced.

[…]

At the heart of the financing scarcity is the virtual shutdown of the market for CMBS, where Wall Street firms sliced and diced commercial mortgages into bonds. During the recent real-estate boom that took off in 2005 and lasted through early 2007, that market fueled the lending to real estate because banks could sell easily the loans they made.

(Emphasis mine.)

Wow! Five, seven, and ten year loans, made between 2005 and early 2007 are coming due between now and 2011! The disproving of these are left as a simple exercise for the reader.

Look, as a reader of Dear John Thain, you know that I’m not always right. I’m probably missing something. Let’s see what else the WSJ has to say:

What’s not clear is how soon the crunch will come. The Real Estate Roundtable, a major industry trade group, predicts that more than $400 billion of commercial mortgages will come due through the end of 2009. Foresight Analytics estimates that $160 billion of commercial mortgages will mature next year.

Jeff DeBoer, president and chief executive officer of the Roundtable, says the group came up with its estimate by looking at the $3.4 trillion of commercial real-estate loans outstanding. It’s not unusual for roughly 10% of the industry’s debt to roll over every year, he says, referring to refinancings.

This year, some $141 billion worth of commercial real-estate debt owed by property owners and developers to lenders came due, according to Foresight Analytics. Most of that was refinanced or extended by existing lenders. The lion’s share of those loans was made between five and 10 years ago. Despite the recent decline in property values, the underlying buildings were still worth well more than their mortgages and were generating sufficient cash to pay debt service.

(Emphasis mine.)

Well, I guess not. So, the larger number is a guess based on the “take a large number and multiply it by 10%” rule. The smaller number is similar to what was experienced in 2008, where most of the debt was refinanced or extended by lenders. Further, those properties that make up the “lion’s share” were worth much more than their mortgages and generating sufficient cash to pay their debt service. Oh, and they were originated between 5 and 10 years ago, as I conjectured above. Seems like there is no justification, whatsoever, for spending a dollar on “bailing out” commercial mortgage developers. (I really want to put a Q.E.D. here…).

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Tags: cap rate, cashflow, commercial, credit, DSCR, erroneous, estimates, FICO, hedge funds, loans, LTV, metrics, mortgage, mortgages, NCF, property, reasoning, WSJ

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