Wednesday, March 25, 2009

CRE Loans and the Death Spiral of Doom

When CRE markets start to decline, they can spiral downward dramatically over time. Let’s start out by looking at the underwriting for loans on two identical adjacent apartment projects in Los Angeles in 1989:


The two projects are identical, but the lenders underwrote differently – the Bad Lender used a 3% vacancy factor, but more importantly leveraged the deal to the breakeven point. This was very typical of the market then, and was usually accomplished either by underwriting on the pro forma appraisal income instead of the actual operations and/or by underwriting to a 1.25 DSC on a teaser start rate on a variable rate loan and a 1.00 DSC on the fully indexed rate. The theory was the borrower would refinance when the reset occurred (does this all sound familiar)? The consequence of this approach is the bad lender loan about 80% of the asset value, while the Good Lender loaned 64% LTV.

Let’s go forward to 1991. There have been huge employment losses in the market, and rents have decreased while vacancy has increased. Perceived risk has also increased so cap rates are up too. Here are the numbers (the 1989 Bad Lender underwriting is included for comparison purposes):


Rents are down 5% and the vacancy rate has increased to 15%, creating substantial negative cash flow for the Bad Lender borrower. He defaults, and the combination of lower net operating income and higher cap rate results in the Bad Lender takes a 24% loss. The cash flow for the Good Lender borrower has also taken a hit, but because her deal was not leveraged as highly to begin with, she does not default.

Things start to get interesting when the Bad Lender sells the REO property:


The REO buyer bases their purchase on a higher cap (it’s REO, after all) and suffers an additional loss bringing the overall loss to 33%. The Bad Lender finances the sale at 80% LTV. Note that since cap rates have risen relative to interest rates this level of leverage now has substantial debt service coverage.

By 1992 the REO buyer has dropped his rents 10% in order to capture the best quality tenants and reduce his vacancy factor – the result is his cash flow remains about the same and he has a better quality tenant base. The effect on the neighboring building is profound – this borrower already had negative cash flow and can’t match the rent decrease, so her vacancy goes up. The negative cash flow is too great, she defaults, and the Good Lender takes a 33% loss based on the market cap rate established by the first REO sale. When the Good Lender sells (at a higher cap rate, because it’s REO), their total loss is 40%.

REO Buyer 2 now has a much lower cost structure than REO Buyer 1, and can afford to drop rents below REO Buyer 1’s levels to recapture tenants. Do you see how this cycle reinforces itself? I foreclosed on some buildings 3 times over a five year period as the market spiraled down.

The market will eventually reach an equilibrium again – in LA this occurred when job growth finally returned and virtually all the highly leveraged buildings had been foreclosed upon. But, until an equilibrium is reached it’s impossible for anyone to predict the stabilization level. Those who talk about setting a new price level in CRE don’t seem to grasp that it’s a dynamic, multi-step process and not a one-time mark.

Also, note that the conservative lender actually took a larger loss in the example above, because their default occurred at a point further down the spiral. This is why many lenders consider their first loss to be their best loss, and are reluctant to modify loans.