There’s a little storm cloud on the commercial horizon in New York. While the recent lending crisis hasn’t hit the commercial market, many observers think a Day of Reckoning might be coming.
“Lending standards over the past few years were speculation-based, not performance-based,” says Adrian Zuckerman, the head of the New York real estate practice for the law firm of Epstein Becker & Green, P.C., and co-head of the firm’s national Real Estate Steering Committee. “There’s not a great wave of commercial foreclosures, but I think Manhattan has always been on a different time path. Manhattan has the same issues as any other market — we’re just healthy for now… it’s coming, though.”
Flexible financing is going to catch up with borrowers, he said. While rents have remained high, Zuckerman said his industry colleagues in Manhattan have the same concerns as their counterparts in other major U.S. cities: “There’s still a relatively strong leasing market in New York, but if the leasing market drops, or even remains stable, the projected rents won’t be there — estimated performance projections won’t be met,” he said.
That begs the question of how deep a dip would be. “Does it go to foreclosure, or to workout, or to some other financing scenario?” Zuckerman asked. “We’re still at the beginning of the cycle, and I see a correction coming. Wall Street, the subprime lending mess, transactions that were financed by overly optimistic lending standards — we probably will see a substantial correction before it’s over.”
The past may be a good teacher, but it’s tough to know which past to look at. “It’s unclear whether the credit crisis is a ’97 situation or a ’91 scenario,” said Tim Little, a partner in the firm of Katten Muchin Rosenman LLP. “In the former, we experienced Russian debt defaults, which produced a three- to six-month chilling effect. In the latter, we had a significant real estate downturn.”
David Schechtman of Eastern Consolidated, who last month in The Real Deal mentioned an “increase in technical defaults,” wants to clarify that he is seeing a jump in commercial foreclosures in the boroughs; in Manhattan, he notes, there are merely indicators of concern — “not what you saw in the ’80s.”
“What we are seeing now,” added Schechtman, the director of his firm’s Turnaround and Distressed Group, “is technical defaults and signs of stress, but not tremendous pain. Banks are not taking back buildings.”
The semantics
In a technical default, the buyer’s cash reserves and other indicators of financial strength don’t measure up to the contractual requirements of the loan. In the go-go past few years, banks may not have scrutinized deals carefully, but now many of them are conducting their due diligence and discovering technical defaults.
Banks are “dusting off” their books from a decade or two ago, said Schechtman, who’s been a commercial broker for two years and previously was a practicing attorney at DLA Piper Rudnick Gray Cary, representing clients — including major corporations and individual property owners — in commercial and property litigation and bankruptcy.
Schechtman said technical defaults occurring now are the result of buyers using their cash reserves for other deals — in part because the market has been so robust and opportunities were plentiful. It’s not because there is no cash, he emphasized. “Banks are reviewing existing transactions, trading some loans with other banks, sending nasty-grams — lawyer letters — to their buyers,” he said.
“In most instances, the buyers are replenishing their resources, maybe bringing in partners, but they are not losing their buildings.”
And even in the boroughs, Schechtman clarified, foreclosures and bankruptcies are occurring among the “one-off buyers or groups of friends — not the professionals.”
So far, OK
Indeed, figures from Fitch Ratings show delinquency rates on U.S. commercial real estate loan CDOs, including repurchased loans, are at historical lows — 0.36 percent for October 2007 — as are U.S. CMBS delinquency rates (0.29 percent for September 2007). These figures reflect the real estate boom — both residential and commercial — of the past three years and confirm that the credit crunch triggered by the residential housing crisis in recent months hasn’t yet touched off a parallel foreclosure wave in the commercial market.
“What we’re seeing right now is a statistically insignificant amount of foreclosure,” said Dan Fasulo, managing director of market analysis at Real Capital Analytics. That’s a contrast from the last downturn. “Historical graphs show that in the late ’80s and early ’90s, there was dramatic commercial foreclosure activity. Then it leveled off, and over the past several years there was an actual downtick in foreclosures.”
Now, said Fasulo, lending industry participants hope to keep the possibility of foreclosure quiet. “No one really wants to foreclose — they just want to get the risky stuff off their books,” he said. Higher-debt institutions are putting on pressure, he said, noting that some investors are going to be in trouble, with all that short-term, interest-only debt from the aggressive underwriting of the past 12 months coming due quickly.
For their part, law firms are reporting a certain amount of “proactive restructuring activity” among their investment clients. At Katten, partner Little noted that commercial borrowers in their client base have been re-organizing their portfolios, and in some cases there have been extension requests. “A lot more of that will come up as loans start to mature and need refinancing,” said Little, who has practiced real estate law for 20 years and whose focus is on real estate finance and capital markets-related real estate transactions.
Little doesn’t point to much in the way of technical defaulting; what he has noticed, however, is buyers cleaning up the underpinnings of their loans: “a lot of sales of subordinate interests, mezzanine loans, or B debt pieces being sold at discount.” Existing loans are being securitized and transferred into trusts and LLCs, independent of the credit of anyone else, to spread out any risk and pull it away from the banks that made the loans.
“It’s a credit issue, and a longevity issue,” Little said, “not any real damage to the underpinnings.”
At Epstein Green, Zuckerman reported there have been concerns and issues with his firm’s clients relating to highly leveraged property scenarios in which the owners are looking to divest. “But our clients,” he added, “are savvy investors in the market, so they reposition their portfolios and reduce their leverage before they’d have to turn to an attorney.” And if it comes to it, he said, “out-of-court workouts can include compromise, refinancing, restructuring debt, and selling off some properties to save others.”
The banking industry, said Little, isn’t currently taking on additional staff to handle any perceived pickup in foreclosure activity, generally using existing staff to secure their existing loans, motivated by the reality that they’re in the first interest position, and also as an investment in their ability to issue future loans.
And don’t worry, sports fans, there will be future loans. Real Capital Analytics’ Fasulo believes the New York economy is too strong to be seriously impacted by the current credit vagaries. “As much as there will be some investors getting into trouble,” he said, “it will be nowhere as extreme as it is in other markets. No widespread eruption in defaults, because of the strength of the New York market.”
The investors who will be hurt first, said Zuckerman, are those who are highly leveraged: that is, if the financing on a building was created by investing in future valuations beyond 100 percent of the building’s real valuation.
Lending scenarios that could lead to trouble, he said, include variable interest rates that may increase, short-term loans that will need to be renewed, and lack of cash flow to cover the debt service.
“If the coming correction doesn’t go deep or go on long, we may not see any real repercussions at all,” said Zuckerman. “But the situation with Citibank and Bear Sterns, Wall Street limiting bonuses — that’s all creating potential negative impact on real estate.”