During the past couple weeks, I’ve spoken with senior executives at most of the major lending companies. I’ve also spoken with several clients who want to acquire distressed debt and have the cash and professional ability to do so.
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Joel Ross |
Lenders are in no hurry to foreclose and sell loans at reasonable prices, there’s little activity, and most market participants believe it’ll be October or later before the market loosens up. By then, banks will have to foreclose more often, and owners won’t be able to keep feeding the beast. There are several reasons. Lenders haven’t wanted to take a write down if they could avoid it because it hits capital, which is in short supply. The few remaining staff looked around at the empty desks and concluded they need to make themselves needed, and for a long time. This runs to upper levels of the real-estate departments. So, as long as there are loans to monitor and work out, there’s a job.
In addition, nobody knows what the new public-private investment program is going to look like. Almost no final details have been released, and it seems the final program is being revising before it’s released. As a result, lenders don’t know if the program will work or if it will allow another and better exit. Several lenders also believe if the loan buyers are targeting 30 percent plus internal rate of return, the bank should keep the loan, rework it and book the profit.
There’s a sense the crisis has passed, and if lenders can extend or delay and hold, values might increase next year, and they’ll be able to sell loans at better prices. If lenders sell a marked loan for a higher price, they book a profit, and the work-out department then looks like a hero. There were several bankers during the early ’90s who played this game, which paid off in big bonuses.
Extend, extend, extend
The strategy this time seems to be to extend. Get the borrower to infuse 10 percent to 15 percent of the loan amount in new equity and extend for one year. This is great for the lender but terrible for the borrower. He’s now in a lot deeper and didn’t receive a real reduction in debt other than to the extent of his own equity.
At the end of the one-year extension, he’s still stuck with a loan that likely exceeds the asset value, and now he has another maturity. Along the way, he was paying debt service on too high a loan amount, even after the 10-percent to 15-percent cash reduction. Lately, I’ve been retained by several borrowers to buy back the loan at a discount, which is a much better result because it realigns the debt with the value.
The result of these extensions and holding on by lenders is that little loan sale activity, or real estate owned (REO), is happening on any product type. However, the day of reckoning is coming. Values aren’t going to rise for a long time, and not to 2007 values for another seven to 10 years, especially for hotels and retail. Even if hotel revenue per available room starts to plateau, it’s doing so at a historically depressed level, down 20 percent to 22 percent. That’s a disaster for the industry.
Summer upturn? Not so fast
Reports of an upturn in travel this summer are a hope and a prayer by people who seem to think saying so will make it so. True unemployment is about 13 percent, and every economist agrees it’ll rise into next year. There are 165,000 new rooms coming on line, further crushing occupancy in many markets. Every major company seems to have cut travel budgets severely, although there are small signs some business travel will pick up, but not enough to make a material difference; and it will be staying at lower-priced segments and still demanding deep discounts. Baby boomers no longer have the extra discretionary savings they counted on in their IRA or 401(k). There are few home equity loans to pay for vacations.
Maybe the economy will bottom out later this year, but the way back up is going to be long and difficult. That high-leverage loan is going to keep eating your money. It was based on continually rising RevPAR, but RevPAR is down 20 percent and isn’t getting back to 2007 levels for seven to 10 years, while costs will inflate materially during that period thanks to massive government deficits. Interest rates will rise during the next several years, so even if you received the extension to delay refinancing, rates will be much higher, net operating income will be squeezed and loan-to-value much lower. All you’ll have done is delay the day of reckoning.
Office rents are dropping fast. That’ll continue into next year as employment cutbacks continue. Office cap rates have risen substantially. Vacancy, even in Manhattan, is rising rapidly, and especially in suburban locations. Office values will be down 40 percent, according to most professional experts. Retail still is under severe pressure. Tenants are going bankrupt or renegotiating lower rents. Multifamily is suffering rising vacancy and declining rents. Even in Manhattan, new-builds are charging effective rents that are 20 percent less than they had been last year, and that’s before all the unsold condos hit the rental market.
By fall, the major banks will be in far better capital condition. However, hundreds of small to mid-size banks will be in serious trouble with capital as the real-estate loans go bad, further constraining lending at the local bank level, according to the Wall Street Journal. It’s likely major banks will feel more able to sell loans at a reasonable discount and take hits to capital they’ll then be able to afford. Small banks might be forced to sell loans just to monetize their assets.
Patience is a virtue
For all you champing at the bit to buy distressed debt or REO, be patient. It’ll likely be many months before the opportunities are forthcoming. You’re not missing out right now. Hotel values will continue to decline, and loans won’t all get rolled at maturity.
A couple major lenders are working on new securitized loan programs. Before you extrapolate to think this has anything to do with hotels, forget it. They’re going to make loans to major office or retail real estate investment trusts and big borrowers. The loans will be 40 percent loan to value on written-down LTV, two points in two out, and high spreads. Then the lender securitizes the loan by selling the AAA-rated paper to an investor who uses term asset-backed securities loan facility to borrow six to one against the AAA paper at swaps or London interbank-offered rate plus 100, depending if it’s fixed or floating.
This creates good returns to the investor who buys the AAA paper. The lender can make large loans, and the government is financing these loans through the Term Asset-Backed Securities Loan Facility . The lender makes a nice spread on securitization. Were it not for the TALF leverage, the investor wouldn’t be in a position to buy the securitized loan. The borrower is willing to do this because it provides less costly capital than equity at the current low stock prices. This is the only way banks will be able to originate large loans. The distance from these deals to ordinary hotel lending is farther than anyone can see.
The good news is the capital markets have calmed enormously. Spreads are coming back in closer to historic levels, although they have a way to go. Banks and corporations are issuing new debt without government guarantees. This is critical for the economy to settle and begin to rise. It’s all about lending and smoothly functioning capital markets, not housing. Housing will bottom out soon now that prices are down and rates are way down.
In October, the world came within days of ending. Despite what you might think based on the media and politicians, Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Henry Paulson saved the world, and Troubled Asset Relief Program was the key. The big meeting at the White House in March, following the egregious TV circus staged by Barney Frank over AIG was critical. That was when bankers told Obama to stop trashing Wall Street and big banks, or he’d kill any hope of economic recovery. It was the inflection point. That meeting shut down the trash talk from the White House and Congress and was the turning point in the economy. The stock market turned up and people started to feel better. Someday, that meeting will be recognized as the most important moment in this economic calamity.
Joel Ross is principal of Citadel Realty Advisors, successor to Ross Properties, the investment banking and real estate financing firm he launched in 1981. A Wharton School graduate, Ross began his career on Wall Street as an investment banker in 1965. A pioneer in commercial mortgage-backed securities (CMBS), Ross, along with Lexington Mortgage, and in conjunction with Nomura, created the first hotel CMBS program, which effectively reopened Wall Street to the hotel industry. A member of Urban Land Institute, Ross conceived and co-authored with PricewaterhouseCoopers The Hotel Mortgage Performance Report. Ross served two tours in Vietnam with the U.S. Navy.