lending advice
A Clean Sweep
by Mark Levine
For the past several months, I have been helping with some spring cleaning. It goes without saying that many people involved in the world of commercial and multifamily real estate have some sort of mess that they’re trying to sort out. It didn’t just accumulate over the winter, and it’s not something that will be cleaned up over the weekend. In fact, many real-estate professionals are not even sure how to clean up the mess in which they find themselves these days. But we’re trying to sort it out and figure out where to put all the pieces.
Each person’s mess is a bit different. Since the beginning of the year, I have been consulting for various professionals in different areas of the industry. Suffice it to say that I have seen a wide range of issues in that short period of time. Most of my work has focused on evaluating commercial mortgages to help determine current leverage levels and values, and to predict the lifeline of various loans. Many are not in good shape, and the outlook is for things to get worse. It is not a pretty picture out there.
This shouldn’t be news to anyone, though. Ever since the Obama administration came into office, there has been much talk about government-assisted economic recovery programs. While the overall focus is on the larger economy and job growth, nearly every aspect of the government’s plans has involved the support and strengthening of the nation’s larger banks. More specifically, the plans all incorporate some type of strategy for helping these banks lessen the weight of “toxic assets” (primarily mortgage loans) on their balance sheets. If nothing else, this sends us one very clear message: banks still have an enormous amount of bad debt on their books. In the opinion of the government—and most other observant parties—this weight of bad debt is what’s keeping the flow of capital from moving through the system again.
At this point, the situation is fairly clear, the broader goals are set, and all involved participants are starting to take action. But, of course, that’s easier said than done. When you organize your basement, you don’t just bring in a dump truck and blindly throw everything away. Hopefully, you have some items down there that still have value to them, so throwing everything away might mean wasting a lot of money. Instead, you want to identify what you have in the piles so that you can make some decisions about what to clear out and what to keep. In doing so, you also learn about how to change your future habits, so that you will hopefully create less junk for next spring’s cleanup.
That’s what I’ve been doing—sorting through the piles and trying to separate the good from the bad from the ugly. In doing so, I’ve learned a lot of lessons about some of the junk that has been created. Some lessons that were learned during previous real-estate cycles were ignored due to short memories or perhaps because things were supposed to be different this time. Other lessons are brand new and stem from the increasingly complex workings of today’s financial markets. And yet other lessons just can’t be explained in any rational manner. Regardless of the types of lessons we’re learning, hopefully some of them will help us avoid many of the mistakes that have led to today’s distressed markets.
The easiest and perhaps most obvious lesson to be learned is that leverage can be a very dangerous tool. Among nearly all of the distressed debt that is plaguing bank balance sheets these days, leverage is the primary issue. Perhaps that’s simply the case by definition, since a loan isn’t usually considered distressed if the leverage is not too high. But it’s not necessarily that simple. The issue of leverage is not explicitly a problem unto itself. Even though so many commercial real-estate loans today have outstanding balances in excess of the underlying asset’s perceived value, many of those loans still have debt-service coverage ratios above 1 to 1. In other words, the properties might have lost significant value, but the cash flows generated by the properties are still sufficient to fund monthly mortgage payments.
So what’s the problem with leverage? The problem is circular, in that high amounts of leverage rely on a future with high amounts of leverage. In the commercial mortgage world of the twenty-first century, mortgages did not amortize much, if at all. Therefore, when a loan matured, the full original principal balance was due. In order to pay off or refinance this balance, the borrower had to find another loan that would provide at least as much debt as the original loan. Of course, there are some exceptions where borrowers are willing to “come out of pocket” with additional equity to lessen the debt load, but that’s a rare case these days.
So the lesson to be learned here, and it’s quite obvious in hindsight, is to avoid assuming that debt terms will be the same in 10 years as they are when the loan is originated. Nearly every distressed loan that I review relied on the assumption that highly leveraged loans would be available forever and would always be a viable exit strategy. Of course, markets are fluid as we go through various stages of real-estate cycles, so everyone knows that things will constantly change. But the point is that you should not rely on just one strategy to get you out of your loan when it matures. Instead, borrow what you’ll be able to pay off even if debt markets are essentially nonexistent when it’s time to refinance.
Another common theme that I see among so many troubled loans is the underwriting of cash flows that were nearly impossible to achieve. At some point, lenders became so competitive that they stopped questioning borrowers’ budgets and just underwrote whatever numbers were provided. Actually, it was even crazier than that. Many lenders were finding ways to actually boost cash flows beyond borrowers’ wildest dreams, based on revamped underwriting methodologies and the ability to look at future (often way into the future) cash flows. Lenders, of course, encouraged this because it helped properties qualify for higher loan amounts, or alternatively for lower loan spreads based on lower underwritten leverage.
To be fair, borrowers were not innocent bystanders in all of this. It’s easier said than done to tell a lender that you don’t want as much money as a lender is willing to lend, but that’s exactly what should have happened. Instead, borrowers helped lenders conceive of ways in which their underwritten cash flows could be inflated. They told lenders about major plans to upgrade units and common areas, changes that would, without question, raise rents by a certain large percentage. Borrowers were also persistent about being able to lower expenses, based on newly found efficiencies or downsizing of overhead. They were willing participants in having and creating very optimistic views of the world. Because of insatiable demand for mortgage securities, investors barely questioned the underwriting and the flow of money kept going around and around.
One more major issue that seems to plague most of the distressed debt I have evaluated is the lack of cash equity in a deal. For years and years as a lender in a large bank, all I heard from credit officers is that there needs to be borrower equity in a deal. Without it, and because most commercial loans are nonrecourse these days, borrowers have little incentive to stick with a property when things go bad. But somewhere along the way, those credit officers began believing the different excuses for why the equity story should be overlooked.
Maybe it was because a borrower had owned a property for a long time and his cost basis was so low. Or maybe it didn’t matter because there was a very experienced mezzanine lender who filled the spot where the equity would normally exist. Or, more likely, it was because the focus was just on producing as many loans as possible, and therefore nobody had the time or interest to consider if there was a good equity story behind a deal. Whatever the case, it was a fatal flaw in the credit methodology over the past 10 years. Considering the importance of cash equity as it relates to a borrower’s interest to work out and repay a loan could have prevented much of the damage that we are experiencing today.
If you are involved with commercial real estate, you have undoubtedly heard stories about the late 1980s and the bad loans, workouts and eventual implementation of the Resolution Trust Corporation at the time. All too often these days, veterans of the industry talk about so many things in this current cycle that are repeats of the mistakes made nearly 20 years ago. For everyone’s sake, I hope that we’ve learned our lessons and that we don’t find ourselves repeating some of today’s mistakes over the next 20 years.
The opinions expressed in this article are those of the author, and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Mark Levine is an independent consultant with over 12 years of experience in commercial real-estate finance and investment banking. He can be contacted at marklevine05@gmail.com. Copyright © 2009 by Black Point Press. All rights reserved.