‘Extend and pretend’ strategy won’t avoid the inevitable

Office building values have plummeted in value as much as 50 percent since their 2007 peak. The factors causing this decline were many. Fully cognizant of the real estate value implosion and the general economic malaise, office tenants wonder, “Why haven’t rental rates come down more?” Good question.

Unlike past downturns in commercial real estate, particularly the one that took place in the 1980s, rising vacancies were not driven by an oversupply of new office product, but primarily by a lack of demand as tenants contracted due to recession-caused layoffs or going bankrupt. Nationally, the absorption of office space has been negative for seven consecutive quarters.

The problem will get worse than currently reported as the real estate cycle typically lags the economic cycle, so vacancies often rise even though the economy may be recovering. This is due to the increase in the number of “shadow vacancies” that is empty space still under lease, but unused by companies still able to make lease payments. Fortunately, the Houston economy is faring better than the national economy due to our main economic drivers: Energy, health care and the Port of Houston.

Couple rising vacancies with falling rental rates caused by decreased demand and rising cap or capitalization rates (net operating income divided by cost or value) and you have identified the factors in the erosion of office building value. Understand that cap rates are something of a measure of risk and are driven by spreads. Office buildings are now considered to be much riskier than they were a couple of years ago.

Appreciate, too, that there were often insane projections underlying the underwriting of real estate loans, based on ever increasing rental rates, which in turn led to grossly inflated property valuations, something of a “greater fools” theory. Exit cap rates drove values. Annual cash flows were discounted to zero due to the cheap debt promulgated by the Fed. Combine these factors with higher loan-to-value ratios (in many cases, in excess of 90 percent) and you have promiscuous borrowing/lending.

What a difference 18 months makes! Today, the financial markets are in turmoil. In fact, they have essentially ground to a halt. There is about $3.5 trillion in outstanding in commercial real estate debt, about $1.4 trillion of which will require refinancing in the next four years. The CMBS (Commercial Mortgage-Backed Securities) market, which accounts for about a quarter of the outstanding commercial real estate indebtedness, has virtually disappeared, though there have recently been some signs of life. Most of the loans financed with this product were interest only/balloon loans with 5-7 year horizons, almost all coming due in the next few years, and fully two-thirds of them are not currently re-financeable. In Houston, 332 of the approximately 1,300 Class A and B buildings in town are financed with CMBS.

Many bank loans to office building owners are also troubled, but you can take some small comfort from the idea that banks in this lending cycle were more likely to have required personal guarantees and required lower loan-to-value ratios in their underwriting of loans than conduit or CMBS lenders. Why is a personal guarantee important? Well, the minute you give the property back to the bank, you trigger a monstrous taxable gain. Suddenly, the forgiveness of the debt on your loan becomes taxable income to you. If you are a borrower who is personally on the hook, why would you want to hasten the call on your personal guarantee? You want to hang on as long as possible, because hope springs eternal.

Banks are in deep trouble, for in order to compete with CMBS, they had to be super aggressive and they made loans with very little spread. They have been hesitant to foreclose on delinquent loans, for selling at current prices would have required write-downs they were reluctant to take. Doing so would have bankrupted many hundreds of banks had they been required to have “taken their licks” on the commercial real estate loans in default in their loan portfolios. It is now official Treasury Department policy to allow the banks to “extend and pretend” on commercial real estate loans. If you can make an analysis that says that even though the current value is less than the loan, but if you extend for three to five years, and the economy gets better, and the loan can be amortized down to where the loan is no longer more than the value (a lot of “ands”, ain’t it?), then the lender does not have to take a write down, or in banker’s terms, an impairment (their capital ratios are not impaired).

In essence, as long as cash flows can cover interest payments, loans will be modified with rate reductions, deferral of reserves, and deferral of amortization, whatever. This will further delay the final reckoning. Ultimately the reliance on cash-flow coverage will prove untenable when interest rates rise and/or rental rates fall further, constricting cash flow.

Truth be known, the banks couldn’t auction off their bad assets if they wanted to, because it would reveal the true extent of their losses; thus the Fed has “injected capital” into the banks so that the banks can amortize their losses over several years.

The “extend and pretend” strategy did not work for Japan’s banking system, and it won’t work for the United States’ either. It won’t work because it will eventually lead to a two-tiered commercial property market. In one tier, we’ll see property owners with affordable mortgages cut rental rates in order to fill their vacancies. In the other tier, we’ll see property owners and lenders hoping for a return to “bubble” values, and maintaining a high-mortgage, high rent-strategy.

Property owners in the high-rent tier may be making payments on their underwater mortgages for now. But once the low-rent tier starts winning most of the scarce leasing activity, vacancies in the high-rent, high mortgage tier will accelerate and property-level cash flow will drop dramatically.

Just because a mortgage happens to be currently performing does not mean it will be viable in the long run. As landlords with negative mark-to-market equity (they are upside down vies a vies their loans) watch their tenants flee, they will stop making mortgage payments and surrender their properties to their lenders. Thus, sooner or later (presumably later), commercial real estate will find its way down to prices that will attract new investors and speculators. This process is known as “price discovery.”

By rolling over the maturing bubble-vintage loans made to underwater, but cash-flowing properties, the banking system has established an artificially high price floor. Such industry-wide collusion has slowed the realization of “real-world” pricing – the kind that would attract new investment.

Currently, the working of the free market is suspended. In order for private sector (read “real”) jobs to be created, among the things you need to do is to lower rents so that the cost of occupancy is at a level to encourage more hiring. With the artificial buoying of commercial real estate loans, true office building values are not understood. Thus, new landlords can’t acquire assets and then reduce rates to make taking space by tenants truly economically viable.

There has to be a massive “value reset” for commercial real estate, particularly office buildings. I sincerely believe what is happening now is simply deferring the inevitable.

But the biggest risk to office building owners from the wave of maturing debt is that the Federal Reserve will be forced to significantly raise interest rates to control inflationary pressures and dollar depreciation. As interest rates rise and rent rolls deteriorate, I believe that delinquencies will rise, and office building values will then fall even further, complicating the refinancing of these assets even more.

Whatever, long term, there’s going to be a huge opportunity as the massive restructuring and deleveraging that has to occur takes place.

But I am of the opinion that it is going to take years. We will not have a replay of the Resolution Trust Corporation’s fire sales and wholesale reductions in price as we did a couple of decades ago, and we are a long, long way from the bottom. The winnowing out will be prolonged. As a tenant representative, a big part of my job is to manage expectations.

Essentially, the office building market is no longer rational and each office building stands alone, thus “Caveat Emptor” tenants.

Know your landlord, understand his financial wherewithal. If he has a $30 million loan on a building now worth half that, do you think he is going to update his failing HVAC or malfunctioning elevators? Is it a “gut-lock-cinch” that he can fund tenant improvements or pay your broker? Nope. To quote that 1970s pop hit: “You’d better shop around.”

This article originally appeared in the Houston Business Journal, March 8, 2010.