Fixing the Problems Will Take a Long Time

A number of my friends have assignments to advise lenders on what they have on their book and what to do to fix the problem loans. They are finding an amazing lack of knowledge at the lenders, and bad files even on large loans. The special servicers are overwhelmed and have staffed up in some cases with young people who are not really capable of understanding the real estate. In addition, special servicers are under no pressure to take action. Their fees stop if they foreclose and sell, and the bondholders are still hoping that time will heal all wounds. Because they are overwhelmed, it takes them months to get to try to understand any one asset, while the borrower is in a hurry to fix his problem or give back the keys and get out from under.

Some of the big problems in trying to fix the loan book are docs are often missing, they are poorly drafted, some key items of collateral were not secured, intercreditor agreements do not really work well in some cases, and often the bank loan officers or people at special servicers do not know or understand the asset. In a number of cases they do not even understand what they need to know. While we all know a lot of loans were made with no real underwriting, the problem now is the people who are supposed to deal with the problems do not know how to underwrite either. In short, the lack of knowledge at lenders of all types which caused the mess, is not changed, and many lenders do not really want to have a consultant tell them they should write down their book which will mean capital deficiencies.

Further complicating the fix is the number of small banks who made local loans, and now the bank is out of business or will be within a year. These banks cannot make new loans and likely do not have any staff capable of intelligent restructuring. There have already been 240 banks closed by the FDIC over the last 18 months or so, and there are likely another 200-400 to go. If the economy continues to be slow to improve, which is likely, and with the confusion sewn by FinReg, the number of closed banks will probably be closer to the high end. In the meantime getting new loans for small and mid size assets is difficult, and finding lenders for secondary cities is very hard. There may be a lot of capital around, but it is not for the vast number of smaller assets that are way over levered.

Rents in secondary cities and states like New Jersey are not rising, and in fact are falling, while costs continue to rise, especially for taxes. Larger investors are shunning the secondary cities, and so sufficient capital is simply not flowing to many locations to provide the equity gap necessary to resolve the lack of new debt to repay the existing debt. This is unlikely to change. Extend and pretend may have bought time, but it did not solve the problems. They continue to fester. The economy is not going to grow us out of this as many had hoped. Just as modification programs and time is not solving the residential foreclosure mess, it is not going to get us out of the commercial real estate mess. As a sign of how bad it is, many major tenants now require proof that the landlord will survive, the building will be maintained, and the TI work will be done. Some tenants are even requiring a letter of credit from the landlord to cover TI on new leases. Existing tenants are still asking for rent relief in many cases.

Now we have FinReg severely constraining future CMBS issuance and a vastly smaller investment banking infrastructure to provide origination capacity. Combine this with banks who are either going out of business, or who cannot lend due to capital constraints, or who do not have staff who have time to make loans because they are trying to figure out what do with the old loans.

There is no quick fix for any of these issues, and with Congress and Obama wanting to demonize major banks and Wall St, with the rating agencies afraid to issue any ratings except on the best assets in the best locations, the banks and bondholders not wanting to take write-offs, the capital constraints on real estate are going to be with us for many years. It is very unclear how the busted deals in locations outside of the 6 major cities are going to get resolved until reality sets in and a massive value reset takes place sufficient to attract the capital needed to clear the books. What is happening in New York and Washington DC with sales and refinancing, has nothing to do with the rest of the country, so don’t get misled as to what the real market is.

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Joel Ross began his career in Wall St as an investment banker in 1965, handling corporate advisory matters for a variety of clients. During the seventies he was CEO of North American operations for a UK based conglomerate, and sat on the parent company board. In 1981, he began his own firm handling leveraged buyouts, investment banking and real estate financing. In 1984 Ross began providing investment banking services and arranging financing for real estate transactions with his own firm, Ross Properties, Inc. In 1993 Ross and a partner, Lexington Mortgage, created the first Wall St hotel CMBS program in conjunction with Nomura. They went on to develop a similar CMBS program for another major Wall St investment bank and for five leading hotel companies. Lexington, in partnership with Mr. Ross established a hotel mortgage bank table funded by an investment bank, and making all CMBS hotel loans on their behalf. In 1999 he formed Citadel Realty Advisors as a successor to Ross Properties Corp., focusing on real estate investment banking in the US, UK and Paris. He has closed over $3.0 billion of financings for office, hotel, retail, land and multifamily projects. Ross is also a founder of Market Street Investors, a brownfield land development company, and has been involved in the acquisition of notes on defaulted loans and various REO assets in conjunction with several major investors. Ross was an adjunct professor in the graduate program at the NYU Hotel School. He is a member of Urban Land Institute and was a member of the leadership of his ULI council. In 1999, he conceived and co-authored with PricewaterhouseCoopers, the Hotel Mortgage Performance Report, a major study of hotel mortgage default rates.