Over 250 small and midsized banks have been closed and it is possible another 300-500 could get closed or merged over the next two years. Some of the big aggressive banks like Wachovia, Countrywide, Colonial, Freemont and Corus are gone. Capmark is gone, I Star is still stabilizing, and CIT and others are essentially gone. CMBS may be slowly returning, but it will be a long time before the old style conduit lending returns for the average small to medium sized project refinancing. It may be one year, but more likely it will be two or more years as the economy falters and the recovery remains muted. The lending infrastructure is obliterated with entire lending groups at major firms having been wiped out. That has to be rebuilt and there will need to be some changes to how it operates under Finreg. The rating agencies are still trying to figure out how they will rate the everyday conduit pool of properties.
Although many talk of all the capital looking for a place to invest, reality is that there is a total of roughly $3.4 trillion of real estate debt outstanding from all sources and which will be maturing over the next 7-10 years. There is supposedly around $800 billion of just CMBS which will be maturing that has to be refinanced. 2010 CMBS issuance will just be $6-$10 billion most likely. Not even a rounding error, and it was almost all to just a few top borrowers. There will not be capital for the average borrower with a property in a secondary city for a long time.
On top of all of this there is all the refinancing and new financing required for companies, municipalities and states. That is another very large sum. Then we have to fund the Obama-Pelosi spending binge and massive federal deficits. I don’t know what the overall demand for capital will be over the next 5 years, but clearly it is massive. While that demand is growing, the Fed is going to be reducing the money supply and raising rates. Consumers are also going to hopefully be increasing borrowing for homes and autos. All of this ignores the demand for capital from foreign governments and businesses.
The providers of capital have been reduced in quantity and in ability to create that capital. It is not just the banks which are reduced in number, but we also do not have Bear, Merrill, Lehman-huge originators of loans and equity investments. The rest of the Street and commercial banking will be tightly restricted for at least a few years and the rating agencies will be much tighter on subordination levels than they had been in 2007.
So the question for the average borrower whose loan may have been extended for 2 years or even 3 years, and whose asset is now worth 40% less than his total capital basis, is, where will the refi dollars come from. Even if values rise by 20% from where they now are, that will mean on average the asset is still only worth 72% of original cost, and that is a very overly aggressive assumption of value increase over the next two years. Even at 72% it means the original loan is likely as much as, or more than, the value will be in two years. Under what will surely be much tighter underwriting, the refi loan is likely to be no more than say 75% of the new 72% of original value so it is 54% of original value in 2007. That is a very large equity gap to fill for most ordinary owners whose net worth and cash reserves have been devastated over the past two years. His original equity is gone now, and probably he infused more to get the extend and pretend. There may be nothing left for him to cover the difference.
It is for these reasons that I predict we are yet to see the real downward revaluation of assets which is coming over the next three years. Unless the fairy godmother of capital sprinkles fairy dust on us all, there is simply a massive capital shortage to sustain the pretend values still carried on the books of CMBS bondholders, mezz investors, banks, private equity firms, pension funds and other investors. The reset has to happen. The refinance requirements are simply not going to get extended long enough for inflation to solve the problem. One of the biggest hotel appraisers is claiming that hotel values in 2015 will be 140% of 2007 froth values. That is utter nonsense. Anyone who thinks that, or similar sorts of projected values for other food groups, is either on drugs or has an agenda. It is not happening. Values have to get back to fundamental real estate underwriting. Be patient- the buying opportunities are coming.
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Joel Ross
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.
