Friday, March 6, 2009

The CRE Downward Spiral: Fire!

Real Property Alpha has a good post on deteriorating CRE fundamentals, but the conclusion points in a dangerous direction. Two excerpts:

This analysis, however, is not focused on providing a historical explanation for the office market weakness. Rather, I note the weakness of the fundamentals in order to provide counsel to lender clients with commercial properties on their books. Unfortunately, the downward trajectory of the graph on page 1 shows a market with a steep downward trend. Bank sellers failing to timely dispose of non-performing assets in this environment risk further deterioration in fundamentals and the resulting price decline. Simply based on fundamentals, office pro forma values are off 38% since Q108. The 38% decline is significant as it likely destroys any equity to debt coverage which was assumed during the initial underwriting, assuming that the deal was financed in the last few years…

Despite the tremendous liquidity problem in the financial industry today, I believe that making proactive moves to dispose of non-performing assets will provide reward for banks with the will to do so. Banks that can expedite the process of disposing of non-performing assets will be the first to clean up their balance sheet and begin lending again. The reward for these banks will be a risk environment in the new lending which will be significantly improved from the landscape we see today.

I agree, and disagree. When the banks dispose of their nonperforming assets, those assets become the comparables for and the new basis the remaining portfolio competes against, so those assets are now overleveraged and are disposed, and so it goes. An aggressive disposition strategy reinforces the downward spiral, so unless you get out of the asset class completely, you continue to suffer losses. A disposition strategy that looks smart for an individual asset can magnify your losses in the remaining portfolio. And remember, it’s not just you – the market won’t stabilize as long as other banks are making significant dispositions.

Also, an aggressive disposition strategy is smart, until it isn’t. If you sell an asset and the market continues to fall, you were smart, but if this downturn is like all the rest at some point the market will stabilize and values will start to rise. There is always someone selling at the bottom.

In a perfect world the most highly leveraged assets and the assets controlled by weak operators would be liquidated, and lenders would restructure the debt on marginally overleveraged deals with good operators to allow them a reasonable return and some upside in exchange for maximizing the asset value during the downturn. It’s like a fire in a theater; more people will get out in an orderly exit than if everyone tries to get through the door at once. Of course, we live in a far from perfect world, and at this time it’s hard to argue with Real Property Alpha’s conclusion that lenders should be running for the door.