With More CRE Defaults on the Way, Would-Be Acquirers Need Policy Help

An article in yesterday's Wall St. Journal discussed Maguire Properties' (MPG) loss of several buildings that it had recently acquired from Equity Office (EOP)/Blackstone (BX). The poor economy and job losses have raised vacancy rates, and backfilling space with costly capex and lower rents left the buildings unable to meet their debt service requirements.

We have only just begun to see stories such as this, and in order to address the next crisis we will need to acknowledge some painful truths.

During the commercial real estate crisis in the late 80s and early 90s, thousands of buildings faced the same problem, but with a critical distinction. The real estate crisis was not coupled with a banking crisis. The two industries are, for better or worse, married to one another.

During the last crisis, programs like the Resolution Trust Corp. (RTC) did what a good oncologist would do--they removed the tumorous cells (loans). In some cases, banks failed, but depositors did not lose money and life went on. Further, pools of capital that had not overextended during the boom were able to step in and acquire properties and mortgages at sensible valuations. Indeed, some firms like JE Roberts built their fortunes during this time.

At the moment, replicating the sucess of that outcome is not possible. Unless there is a credit market available, there is simply not enough cash available to acquire what is coming back to the market, even at deep discounts.

While TALF can, if extended and properly managed, help restart the CMBS market for new loans, there is no realistic program in place to deal with the onslaught of "legacy" properties we can expect to see.

Ostensibly, the PPIP regime was created for this purpose, but because the banks cannot sell at discounts without taking further hits to capital, there are two problems. First, there are ready buyers, but few ready sellers. Second, TALF is only applicable to investment grade loans, so again, there is no credit market for the acquisition of the kinds of properties we expect to see.

So how can we resolve this conundrum? Perhaps it is worth considering allowing banks to provide seller financing for REO properties. In exchange, any bank that did would be permitted to continue to carry the property at the book value it held at the time of sale. That would encourage the banks to move the bad assets off of their balance sheets (albeit more slowly), and provide a form of credit for those acquirers who kept their noses clean during the bubble.

Disclosure: No positions.

Comments

[CBTeas]

You are missing the biggest difference between today's real estate crisis and the one that created the RTC: in the prior crisis, real estate prices were allowed to fall to their logical bottom without any artificial government interference to prop up pricing.

Right now, TALF, PPIP, etc... is actually making the problem worse by avoiding getting assets marked to TRUE market. The mistake you and every government official are making is to say there is no market or financing for assets. Nothing could be further from the truth! At cheap prices there are both plenty of buyers and willing lenders.

But the problem: the equity in most of the top tier banks would be wiped out. So we have a banking system in denial. Don't believe it when you read that "there is no market for toxic assets." The problem is the banks just don't like the prices they are offered. There is a market for every real estate asset out there--just as there was in the RTC days.

Even what you are proposing is to prop up artificial prices. Let's do what was done in RTC days: get to the bottom, and encourage buyers into the market, not discourage buyers from stepping up.

2009 Aug 13 08:33 AM

[Kevin Hollins]

CBTeas:

I agree that at cheap prices there are plenty of buyers. Where I respectfully disagree is with the notion that there are willing lenders ready to make loans at terms that make economic sense. That is why we continue to see REITs tap the bond market rather than using the private loan market, which is where over 80% of the (still overwhelmingly private) CRE market sources debt.

Perhaps I was unclear. I don't believe there is no market for toxic assets; quite the contrary. We have better opportunities than we have seen in years, but a lack of financing means that we have fewer *actionable* opportunities in the absence of even very conservative underwriting and leverage. When acquisitions must be financed with 100% equity, simply fewer are possible.

I would rather not prop up artificial prices either; I'm just trying to be realistic about the politics involved. At the moment, banks are disincentivized to move assets. To face the ugly truth and arrive at true market values requires, in the absence of some other form of regulatory relief, allowing a string of bank failures that exceeds the political will available today.

So, in the absence of political will, it seems worthwhile to at least explore a means by which banks can move the assets and lend by another means without, as you duly note, having their equity wiped out. It does not solve the problem fictitious accounting, as you note. Maybe if more politicians and regulators were investors...

Thanks for reading!


On Aug 13 08:33 AM CBTeas wrote:

> You are missing the biggest difference between today's real estate
> crisis and the one that created the RTC: in the prior crisis, real
> estate prices were allowed to fall to their logical bottom without
> any artificial government interference to prop up pricing.
>
> Right now, TALF, PPIP, etc... is actually making the problem worse
> by avoiding getting assets marked to TRUE market. The mistake you
> and every government official are making is to say there is no market
> or financing for assets. Nothing could be further from the truth!
> At cheap prices there are both plenty of buyers and willing lenders.
>
>
> But the problem: the equity in most of the top tier banks would be
> wiped out. So we have a banking system in denial. Don't believe
> it when you read that "there is no market for toxic assets." The
> problem is the banks just don't like the prices they are offered.
> There is a market for every real estate asset out there--just as
> there was in the RTC days.
>
> Even what you are proposing is to prop up artificial prices. Let's
> do what was done in RTC days: get to the bottom, and encourage buyers
> into the market, not discourage buyers from stepping up.

2009 Aug 14 11:39 AM

[CBTeas]

Kevin:

The public markets are getting flooded with IPOs for CRE/mortgage REITs that will not be burdened with legacy assets. This will not take care of all of the demand out there, but my point is, there will be lenders willing to make loans at REAL market prices and REAL market rents. These IPOS are proving that no one trusts the pricing of the legacy assets. Everyone wants to start with a clean slate and clean underwriting. There will be debt and equity for actionable assets. We do both agree that there are less "actionable transactions" due to the interference of "non-market" forces in this cycle.

The banks (with government help) remain in denial.

On Aug 14 11:39 AM Kevin Hollins wrote:

> CBTeas:
>
> I agree that at cheap prices there are plenty of buyers. Where I
> respectfully disagree is with the notion that there are willing lenders
> ready to make loans at terms that make economic sense. That is why
> we continue to see REITs tap the bond market rather than using the
> private loan market, which is where over 80% of the (still overwhelmingly
> private) CRE market sources debt.
>
> Perhaps I was unclear. I don't believe there is no market for toxic
> assets; quite the contrary. We have better opportunities than we
> have seen in years, but a lack of financing means that we have fewer
> *actionable* opportunities in the absence of even very conservative
> underwriting and leverage. When acquisitions must be financed with
> 100% equity, simply fewer are possible.
>
> I would rather not prop up artificial prices either; I'm just trying
> to be realistic about the politics involved. At the moment, banks
> are disincentivized to move assets. To face the ugly truth and arrive
> at true market values requires, in the absence of some other form
> of regulatory relief, allowing a string of bank failures that exceeds
> the political will available today.
>
> So, in the absence of political will, it seems worthwhile to at least
> explore a means by which banks can move the assets and lend by another
> means without, as you duly note, having their equity wiped out.
> It does not solve the problem fictitious accounting, as you note.
> Maybe if more politicians and regulators were investors...
>
> Thanks for reading!

2009 Aug 14 06:38 PM