WHY COMMERCIAL REAL ESTATE IS OVER VALUED
The Deal was screwed from the get-go
…almost three out of every four properties that had been acquired between 2005 and 2007 and then resold in the first quarter of 2011 sold at a lower price. This is an ominous percentage considering that many of the "extend-and-pretend" loans are related to acquisitions made during the 2005-2007 period…
…The idea behind extend-and-pretend was the following: Properties facing loan maturities and that have current values that are lower than the current loan balance would have their loan maturity dates extended, as long as the property owners are current on their payments. This was intended to extend the time for the properties to recover their values, enabling successful refinancing of those loans….
…The result is a steepening of what has been called the "loan maturity cliff." In 2008, it was estimated that the United States would see $450 billion in 2011 loan maturities related to commercial real estate. Today that number is estimated at $900 billion. Each year that lenders continue this practice, this concentration risk increases… (1)
Here’s where the Fed’s Low Interest Rates Hurt NOT Help
EXAMPLE
Investor Buy Low-Sell High, LLC purchases an office building in 2001 for $1,000,000. The economy isn’t great, but it’s not at 2011 levels. The landlord wants to keep the occupancy high so, rates are not increased. He even throws in some free rent to keep tenants.
Along comes the BOOM in 2004. The landlord sees his building value increase to $2,000,000. Hey, it’s time to increase rents. I’ve been good to my tenants, it’s time to kick in some better cash flow. So, he increases rents and the tenants eat the increase. Times are good.
The economy keeps getting better and Buy Low-Sell High LLC, gets an unsolicited offer from Investor I –Can’t – Miss- Out- On – Boom, LLC. For $5,000,000. I-Can’t- Miss- Out –On – The- Boom figures they can increase rents and hold the building for less than 5 years. Then, sell at a hefty profit. I- Can’t- Miss-Out –On – The- Boom leverages cash from their other property and finalizes the purchase. After all, times are good and property prices always go up.
Upon finalizing the deal, rents are raised to almost twice the previous rates. At renewal, some tenants don’t renew. Occupancy begins to fall. Then the Un-Thinkable happens; the Property Bubble Pops and the Recession hits. Now, I- Can’t- Miss-Out-On- The- Boom has a real problem. His anchor tenant files Ch 11. Building occupancy falls well below debt service levels. He also has the same problem with the other building that he leveraged to buy this one.
Seeing no way out, the landlord gives the property back to the lender.
Price “Discovery” Problem
Now, the real problem is the property has a “value” of $4,000,000, according to the lender. The existing rents are inflated due to the higher loan service. So, what does the lender do? They list the property at $2,700,000, thinking this a bargain that will be snapped up in 30 days. The lender wants to keep the remaining tenants so they drop the rent to keep the tenants happy, but not too much.
A prospective buyer of the REO should determine through good due diligence the following:The property adjusted for inflation is only worth about $1,400,000.Rents should only be about 1/3 more than the 2001 rents. So what happens? The building will sit for months. Sucking more & more capital from the lender until, the property is auctioned for $1,400,000 or lower.
So what happened here? Low interest rates fueled leverage and extreme risk. Leverage allowed the sale of a property at almost 3x it’s true value. Low Interest Rates & Leverage are OK as long as the music doesn’t stop.
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