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  The Debt That Ate Manhattan
The Debt That Ate Manhattan

By Lon S. Cohen

At the time, The New York Times reported that “for all of the deal’s accolades, it also illuminated the financial leaps of faith that real estate buyers are increasingly taking.”
In the intervening years the deal has become a grim lesson in how not to leverage high-valued property at the zenith of a real-estate bell curve. By September 2009, the estimated value of the 80 acre community in New York City had declined to $1.9 billion, and rental income had dropped by 25 percent.
That month, the Times reported analysts’ predictions that the owners were at a “high risk” of default on over $4 billion on loans. Rob Speyer, co-chief executive of Tishman Speyer Properties was quoted as saying, “The asset is going to require restructuring.”
Piling on the bad news, a subsequent ruling by New York’s highest court found that the owners illegally deregulated rents while enjoying the New York City J-51 tax abatement that grants partial tax exemption and abatement benefits on certain properties.
Nearly 4,400 Stuyvesant Town and Peter Cooper Village apartments were deregulated “while receiving more than $24 million in tax abatements under J-51,” stated a post on the blog of the tenants’ association.  In December, the property owners agreed to roll back rents for the first six months of 2010.
The fallout from this will affect properties that are taking advantage of the same tax abatement, as they may face similar rulings, resulting in billions of dollars in losses for owners and commercial-mortgage backed securities (CMBS) holders, said a November 2009 report issued by Deutsche Bank about the court case and reported in The Wall Street Journal.
These problems highlight the direction the market is heading and the dilemma for banks holding commercial real estate paper.
“In general, banks have not written down commercial real estate debt to a level which is consistent with the market,” said Jeffrey Rogers, COO and president of Integra Realty Resources, a New York City-based valuation firm. He said that just about any bank that made a loan within the last three to five years is extending if debtors are still covering interest payments.
Banks are trying to hold off losses in the commercial real estate market as mortgages are coming due, forgoing the need to raise even more capital to cover bad loans until later, and are praying the market will come back before the next round of financing.

A state of mind
The commercial real estate market was on the upswing until 2007, and there seemed to be no need for banks to put aside extra reserves to cover any future losses. Optimism masked reality, and now banks are stuck holding the bag in a rapidly declining marketplace.
In a report released recently by PricewaterhouseCoopers LLP and the Urban Land Institute, survey responses predicted increasing vacancies and decreasing rents throughout all types of commercial real estate. Decreasing values will continue until the market bottoms out sometime in 2010, according to the survey, and the projected value decline is upward of 50 percent of 2007 market peaks.
“Right now commercial real estate has decreased in value about 40 percent since its peak, and banks do not want to foreclose on a property and try to sell it in a bad market,” Rogers said.
So instead of foreclosing, banks are punting the loans to address them in a year or even longer. The practice is dubbed “extend and pretend” by many in the industry – extend the loan and pretend the problem doesn’t exist.
“In this type of environment, banks must keep all options open,” Rogers said.
Even with the assistance of government bailouts and the TARP funds, many banks are still undercapitalized. Writing down every loan to market value will create huge liquidity problems, forcing banks to increase reserves to offset potential losses.
“If a bank has to increase reserves, it will leave fewer dollars available to loan out and earn interest income,” he explained. “It wouldn’t be prudent for any bank to rule out extending loans in this market.”
The commercial real estate crisis is putting added pressure on the country’s tenuous economy. In its Quarterly Banking Profile for Q3 2009, the FDIC noted that despite the fact that banks put aside 4.4 percent more in reserves for loan-loss provisions in the quarter, the growth lagged behind a rise in noncurrent loans.
“The industry’s ratio of reserves to noncurrent loans declined for a 14th consecutive quarter, from 63.6 percent to 60.1 percent,” the FDIC report stated.

How pervasive is the problem?

The extent of the problems in the New York’s commercial real estate market are typical of those facing many banks around the country. Vacancies, falling incomes and plummeting appraisals have all contributed to the problem.
“Everyone has legacy problems; it’s just a matter of degrees how bad or deep the problems are,” said Mike Kelly, president and co-founder of Atlanta-based Caldera Asset Management.
According to a survey released in October 2009 by the National Association of Realtors, financing continues to top the list of the most pressing current challenges. Respondents implored banks to help out by increasing lending on good deals and helping out current property owners to modify deals to avoid foreclosure. One respondent was quoted as saying: “Lenders also need to start working with owners of otherwise good properties going into default because they were overleveraged. When a lender forecloses on a property when they could have done a loan mod quite easily, everyone loses, including the lender.”
But banks are modifying loans. Commercial property loans are being extended all over New York, and Daniel H. Lisser, managing director of a New York-based real estate investment bank, said he thinks “to some extent all of them are” practicing extend and pretend.
“I would say it is quite pervasive,” he said. “From the bank’s point of view it puts off recognizing any credit issues for a period of time.”
Extend and pretend, it turns out, may be helping both the property owners and the bankers. By hanging onto loans that are performing at a minimal level they can ignore valuation and extend terms until the economy recovers. At least that’s the hope.
“There is not one sane reason why a bank would voluntarily write down a loan,” added Rogers. “For smaller banks, it could mean insolvency.”
Of course that depends on the mix of assets in the commercial real estate pool for each individual bank. At First Niagara, a bank based in upstate New York, there has been an uptick in distressed properties, though not nearly on the same scale as elsewhere, partly because they didn’t see the same bubble in real estate as other parts of New York, such as in Manhattan. “First Niagara’s portfolio doesn’t have the same concentrations in the riskier property types like acquisition and development loans or big box retail,” said Oliver Hays, a communications representative from the bank. “Our underlying upstate market pricing has not experienced any dramatic swings through the years.”
Most bankers are saying that they will look to see if the borrower is covering debt service out of cash flow when considering an extension, overlooking the current valuation of a property. First Niagara looks at the underlying strength of the sponsor when making a decision.
“In other words, is there the necessary staying power to weather the problem through other available and predictable sources?” said Hays.
It’s well known what the residential real estate market crash has wrought for banks and the economy in general. The reverberations of that crisis are being felt everywhere from Main Street to Congress and the courts.
“By now, most banks have adjusted to the impact of the correction that has taken place in residential real estate,” said Joseph Harpster, COO of New York City-based Herald National Bank. “But those with large commercial mortgage exposures are most likely to extend and pretend. Generally speaking, large investor properties in major cities are most threatening to a bank’s balance sheet at present.”
In a survey of 50 bankers from all over the country at the American Bankers Association’s Annual Convention in Chicago this fall, about 55 percent of the respondents said they’re offering borrowers one to six-month extensions on their maturing commercial real estate loans with 28 percent offering up to 12 months.
“If they did not get the tenants signed before [2008], then they’re fighting declining competitive rents and lack of demand,” said Caldera Asset Management’s  Kelly. “For many deals on office and retail [space], extensions only delay the inevitable as current market rents do not support the existing loan values.”
Most banks aren’t exactly advertising their loan extension strategy – but they aren’t denying it, either. “I have not heard of any banks claiming not to be doing this,” said Daniel  Lisser. “But from their point of view, it might make underwriting sense to extend if there is cash flow or other issues that they can point to support the extension.”

The Feds ease up
What do the rule makers have to say about this practice?
“Lawmakers are encouraging it,” said Noble Carpenter, managing director at Jones Lang LaSalle. “Anything to avoid writedowns and or foreclosures on borrowers seems to be supported by lawmakers.”
Just like with banks, regulators aren’t exactly making extend and pretend policy, but they aren’t making it hard on banks, either. In fact, new federal rules issued in October (see sidebar, this page) are making it much easier. “I’m sure regulators don’t condone the practice,” said Joseph Harpster. “However, they recently issued regulatory guidelines for restructuring commercial real estate loans.”

Will it work?
First Niagara’s Oliver Hays credits the low rate environment as a positive factor helping debt service requirements on many distressed loans.
“As a result, borrowers are able to squeak by,” he said, but a higher rate environment might further expose weaknesses.
So this may be a good short-term solution while conditions are optimal, but Mike Kelly thinks banks should consider the long-term effects. He thinks banks should take the hit now and get it over with – but that’s not what’s happening.
“Bank management is playing for today and hoping to avoid any material write-downs,” he said.

Lon Cohen is a freelance journalist based in New York.


Posted on Wednesday, December 30, 2009 (Archive on Tuesday, March 30, 2010)
Posted by Scott  Contributed by Scott
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