Saturday, April 18, 2009

Value, Cash Investments, Equity, Cash Out Refinances, Anchoring, and Sunk Costs

When I’m talking to a borrower about a loan workout, there is often a major disconnect between the reality they see and the reality I see. One of the disconnects almost always relates to the equity in the property.

Let’s say Bill Ant buys a property in 2005 for $10,000,000, and I make him a 75% LTV loan. Here are the numbers:


Bill’s equity is the difference between the value and the debt, and is equal to his cash investment.

Now, let’s roll forward to 2007. Values have increased 20%:


The cash investment remains the same, but Bill’s equity has increased 80% (the magic of leverage).

Now it’s 2010, and values have decreased 50% (think that can’t happen? Here’s my post, “Commercial Property Values Down 50%?”):


Here is when the disconnect occurs. When you talk to Bill Ant, he will refer to his $4,500,000 or $2,500,000 of equity in the property. Borrowers tend to anchor on their equity at peak value of the property, or on their cash investment in the property, instead of the equity based on the current value. Bill doesn’t have equity in the property any more – all he has is a sad story.

But, he does have $2,500,000 in sunk cost on the deal. Is that worth anything when it comes to his decision to continue to make the payments in a workout context?

Let’s say Tom Grasshopper did the same deal in 2005, and refinanced in 2007, pulling out all his cash investment with a new loan based on 75% of the higher value, and spent the proceeds on a big house and a boat. Here are the numbers:


Now, it’s 2010. I’ve put Ant’s and Grasshopper’s situations side by side for comparison purposes:


Some people think borrowers who have done cash out refinances are less committed to the property and less likely to support the loan than people who never pulled their cash out. After all, Grasshopper no longer has a sunk cost, and he can walk away and keep his house and boat, while Ant has nothing.

This makes sense in theory, but I can tell you with absolute certainty that in practice both of these borrowers are equally focused on their loss from the peak value, and are equally angry, in denial, willing to bargain, and depressed (depending on what stage of the process they’re at). Grasshopper is more likely to default and is likely to default earlier than Ant, but that’s because he owes more relative to the current value of the property, not because he has less commitment to the property.

To recap, borrowers anchor on what they had to start out with or at the peak of the market, measure their losses from those points, and are not much influenced by any gains they made along the way if they end up underwater.