Conversely, banks have been enjoying wide spreads for quite a while, and an increase in the funds rate would eat into these comfortable cushions. How much will banks allow their spreads to compress before passing along the increase to borrowers in the form of higher mortgage rates? Many bankers I have spoken to indicate that they may absorb 50 to 75 basis points before opting to pass along the increase to borrowers. This would mean higher mortgage rates for borrowers, and lower commercial real estate asset value.
Another factor that would exert downward pressure on the value of assets is the impact of the massive de-leveraging process that our commercial real estate market must work through. We estimate that based on the sale and refinancing transactions closed in the bubble years of 2005 to 2007, and on pricing trends, approximately 15,000 commercial properties in New York City have negative equity. Based upon today’s value levels and current bank underwriting standards, we estimate that there is $100 billion of excess leverage on city properties.
Clearly, not all of this leverage will be extracted from the market. Some properties will be held for the long term by owners who can afford to feed them out of cash flow from other sources. Some properties will be worked out between the lender and the borrower. We believe, however, that at the end of the day, $30 billion to $40 billion will be extracted in the form of losses based upon the recycling of assets. This dynamic will be especially acute in 2011 and 2012, as 2006 and 2007 vintage loans mature. These are the loans that are the most underwater.
Distressed assets have been slow to come to the market; everything that has occurred legislatively has created a disincentive for lenders to deal with their troubled real estate assets. Fed monetary policy is allowing banks to make tremendous profits that can be used to write down the value of known-to-be-toxic assets. The Making Home Affordable program; changes to FASB mark-to-market accounting rules; and bank regulators’ allowing lenders to hold loans on their books at par even though they know the value of the collateral is far below that level-these have all served to allow lenders to kick the can down the street. This strategy only makes sense if enhanced fundamentals in the short term allow lenders to appreciate their way out of their problems. We do not see this as a likely outcome in the short term.
The recycling process that will need to occur will add significantly to the supply of properties for sale. As supply increases, value decreases.
To counter these factors, all of which will lower value, is the massive amount of capital available to acquire commercial real estate assets. Billions and billions have been raised to purchase both distressed and core assets. The REIT industry has raised more than $20 billion from public markets to pay down debt and create war chests to enable it to pounce on opportunities to buy. Foreign capital is very visible in the market, from both institutional buyers and, particularly, from high-net-worth individuals who are in the market in numbers not seen since the mid-1980s. And we can’t forget about the locally based high-net-worth individuals and old-line families that have been gobbling up New York City properties for decades.
To a large extent, how our commercial real estate investment-sales market performs over the next two to three years will be dependent upon which of these factors prevail after an apparent bottom is reached.
Robert Knakal is the chairman and founding partner of Massey Knakal Realty Services and has brokered the sale of more than 1,050 properties in his career.
