When Timothy Geithner unveiled last Monday the latest effort to restore normalcy to credit markets, the natural inclination was to believe that maybe the government had gotten it right this time. Certainly the stock market’s response to the Treasury’s new plan was overwhelming. On the surface the plan appears to be a workable solution. One aspect of the P.P.I.P is to facilitate liquidity in the commercial real estate secondary loan and securities markets.
The thrust of Geithner’s plan is three-fold. Banks will auction off their illiquid assets, private investors will set market prices, and Treasury will provide the majority of the financing. Unfortunately, Treasury’s plan doesn’t acknowledge the fundamental valuation problems in commercial real estate, overlooks the excessive leverage in commercial real estate, and ignores strategies banks and financial institutions have already implemented to mitigate the problems of illiquid markets for their assets.
First of all, it is unlikely that banks will embrace an auction process. These firms have generally not sold their assets at discounts to par over the last 15 months specifically to avoid having to sell at auction–type prices. But over that same time, firms have been busily reducing their exposure to commercial real estate by shifting assets to hold-to-maturity accounts, hedging, and of course, taking write downs and impairment charges. In fact, the nine largest firms by commercial real estate holdings have reduced their net exposure from $255 billion to $95 billion, according to the industry trade publication Commercial Mortgage Alert.
Furthermore, Geithner limits the scope of the securities plank of his plan by allowing for the financing of only AAA-rated securities. Commercial Mortgage Backed Securities are comprised of many property types dispersed across different parts of the country. Currently, the indicative pricing level for these securities is 62 cents on the dollar. But it is unlikely that the AAA tranche of these securities have been marked down. Fair market accounting rules allow institutions leeway in determining value in illiquid markets, and AAA securities backed by loans (and not securities) are insulated from all but the most severe losses.
Another shortcoming was Geithner’s failure to understand that banks have no incentive to sell commercial real estate assets and securities that are still performing by and large. Defaults and delinquencies on commercial mortgages and related securities are still at historic low points given the lag time in contracts from which property cash flow is derived. Given the scope of Geithner’s plan and the efforts institutions have been making to come up with solutions to alleviate the pressure on their balance sheets, the incentive to sell assets at a discount is dwindling.
Ironically, this approach by Treasury seems to be working at odds with the pressure on FASB to revise its fair value accounting methodology. Setting the debate about the effectiveness of changes to accounting rules aside, the question remains that if banks no longer have to mark down their assets, why are they now going to sell them at discounts, particularly their highest rates securities?
Secondly, Geithner did not acknowledge at his press conference that commercial real estate is overvalued, and values are still falling. Both empirical and anecdotal signals are overwhelming. As a lender, I witnessed first hand the unreasonable property capitalizations that began fomenting in the earlier part of the decade. As the Federal Reserve started adding reserves to the banking system and the Bush Treasury mocked the importance of a strong dollar, the dollar weakened and investment capital was directed to commercial real estate at an astonishing rate.
It was astonishing to observe cap rates (earnings yield) compress from the eight percent and higher range to five, four, and even three percent levels. Many times, depending on the volatility in the yield curve, these rates were lower than U.S. Treasuries – the benchmark of all investment! There are really two reasons someone would be compelled to do this: an investor believes that rent growth (and thus income) will bail you out over time, or for some magical reason prices will keep going up. Certainly it became standard that cap rates were lower than the weighted average cost of capital, implying investors were relying on continued appreciation.
As an example of just how far the fundamentals have had to adjust, The New York Times recently sold its own building to raise cash. The property ‘traded’ at an eleven percent cap rate. At the peak, there was no hotter commercial real estate market than midtown Manhattan. Given that properties in this high rent district generally commanded five percent cap rates, one need only do the basic math to get a sense for current property values and how far prices have come down from their peak.
Especially dangerous was the leverage that grew disproportionately to escalating capitalizations. Loan to value ratios soared from a high end of eighty percent for the most qualified credits to leverage that oftentimes exceeded ninety percent of value. One particular apartment builder I know that competes with the large apartment REITs was getting one hundred percent leverage for his projects. This developer is now a shell of its former self. Such high leverage levels are outright suicidal in the commercial market. When the marketplace began to recognize that real estate was overvalued, the de-leveraging process got underway. This is the reason real estate credit markets remain jammed.
And in yet another twist of irony, the Secretary admonished excessive leverage in the financial system. One has to wonder if he sees the contradiction in providing up to ninety five percent of acquisition financing for these assets.
The Treasury’s plan is destined to fail because it attempts to prop up asset prices in the face of deteriorating fundamentals and is contradictory to the Treasury’s own market-clearing price mechanism – the FDIC. The Treasury’s approach is especially confusing given that the FDIC is in the process of seizing failed banks and liquidating secured real estate loans. The sale of these secured real estate loans to private investors is setting the market clearing prices. This is exactly what the RTC did in the early 1990s. This is how the process is supposed to work.
Even if an investor has only five percent at risk, this is real money in the face of deteriorating fundamentals due to the overhang hangover of the commercial real estate investment binge. The Treasury’s plan is a waste of time and will not resolve the underlying valuation problems in the commercial real estate markets and the risk inherent in the financial system due to excessive leverage.