This time is no different. We are headed into the same mistakes as last round. In the oft repeated scenario, lending is back for both real estate and for commercial deals. Just as we did in 1993 when I created the first hotel CMBS programs, we began with a tough set of underwriting criteria, we ignored appraisals as being unrealistic, and we focused on who was the sponsor and what was the real historic cash flow. No projections, no special adjustments, no nothing other than getting to true cash flow and debt cover of 1.5 on trailing 12. Maximum loan was 60% initially of our valuation. It rose to 65% by 1994.As we all know, and as we predicted at the time in late 1993, competition heats up, lenders want to fill the bucket, and the bonus pool awaits closings. In 1993 the tighter underwriting lasted several years and only slowly mitigated until by 2006 there was none at all, negative debt cover was allowed and people actually believed appraisals even though they were even more phony than in 1993 and during the S&L bonanza. Corporate lending was equally ramped up over the same period. Then we went to CDO's, CLO's, and finally to virtual loans in pools. Many of us warned repeatedly in 2005 and on that covenant light was creating a very bad situation, and when things crashed the lenders would be very sorry.
So here we are just seven years after the market began its slide in late July 2007, and crash in 2008, and what do we find. Covenant light, CDO refreshed, CLO refreshed, What began this time as 11%-12% debt yield, has slipped to below 9 already in some cases. Leverage levels can sometimes reach 70% again. Appraisals are back as phony as before. While sponsorship remains a key metric, this will eventually slip. There are probably few people remaining doing underwriting who were around in 1993-94, and while some of those veterans may be in very senior positions now, they are not doing the detail work.
Over time the pressure builds for volume-fill the pool, create a bigger pool. Covenants light is already pervasive in real estate and corporate deals. The regulators can think they regulate, but I have watched over the years how over time, the rating agencies in search of fees, become more flexible, the regulators have no clue what is going on so just issue dumb rules, and the beat goes on.
The one thing that never changes is the basic story is never different. There is simply a new crop of young MBA's who think they are smarter, they have a better computer program for analysis, they know better, and in reality they just make the same stupid mistakes as generations before them who all thought they knew better and this time was different. The Rogoff book of a few years ago, “This Time Is Different”, traced 800 years of financial collapse around the world, and they proved over and over it never really changes. The kings reduced the amount of gold in a sovereign to help pay for their wars, and it went from there, right to 2008.
So here is the clarion call. It is already happening, Covenant light is already way too lenient, debt yield needs to be raised a bit to account for the refi problem in 5 years when the 10 year will be 5% or 6%. Nobody is taking account in underwriting hotels of the material changes happening to ADR through all of the new portals which are slowly making it harder to raise rates. Airbnb is siphoning off guests. Other internet based services will appear and further squeeze hotel ADR. All this while Obamacare, higher energy, much more regulation and food inflation start to eat into NOI margins. Soon a lot of new hotels will get funded and built and the same old cycle of too much supply will eventually impact rates and occupancy. It is just a matter of time. Once again the risk is mispriced, just like last time. I have been at this for 50 years and I can absolutely assure you it will happen again. When and how bad the crash of loans is the only issue. Groundhog day is coming. In 1993 the bankers at Nomura said, “who cares, we sell the risk so what does it matter, we get our bonus”. Until you don't.
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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.
