Debt as Intoxicant
[July 26, 2010]
When I was 13 my juvenile delinquent friends and I bribed a college kid into buying a case of beer, which we drank under an enormous weeping willow in the soft summer night hidden by a canopy of leaves. My first reaction was: “How do adults stand this nasty stuff?” But my buddies seemed to think it was the pinnacle of cool, so I'm proud to say that I drank the whole quart, although the last ounces took concentrated effort. Twelve years later as a freshly minted business school graduate I was approved for a construction loan for a whopping $32,000 to rehab a six-bedroom Victorian in West Philadelphia. Between the two experiences receiving the construction loan was far more intoxicating.
It was intoxicating because the loan gave me street cred; now subcontractors returned my calls and showed up on time. I was the real estate baron and they were my serfs. I felt the economic power coursing through my veins. Sitting on that pile of cash gave me the ability to implement business decisions that I normally would not have been able to accomplish. It gave me the illusion of wealth and prosperity. In the back of my mind I knew that the loan had to be repaid, but I was so confident in my plan to sell the property at a profit that the details of repaying the loan were dismissed as a foregone conclusion. Only when the purchase-and-sale agreement failed did it dawn on me that real money would be required to repay the loan. Real money that I did not have! Having burned through the interest reserve, the time before the jig was up could be measured in months, if not weeks. This was the first moment in my life when I viscerally understood the phrase: “blood running cold.” One's blood truly runs cold as the chill of reality moves from the cerebral cortex down the spine and out to the extremities.
Despite recent news reports of commercial real estate transactions completed at capitalization rates similar to the boom years between 2004 and 2007, there are still massive numbers of loans maturing that will go into technical default in the coming years. Many market participants seem all too eager to readopt the notion that a bull market lays before us. But tens of thousands of owners remain who are experiencing their own chill. The inconceivable notion that they could potentially lose their property has become reality. All this to say that the common intoxicant we all imbibed to support the asset bubble in commercial real estate was the hooch of cheap and easy loans.
Easy money is the precedent cause of real estate asset bubbles, not the result. Without easy and cheap money, none of the deals at the market’s top could have been contemplated or closed. Had bankers been more prudent in their underwriting, far fewer loans would have been issued. Those that were issued would have had more stringent, some might say realistic terms that would likely have required a price discount. Fewer transactions would have resulted and at lower prices.
During that heady time, nearly all of us in the commercial real estate industry drank the hooch and entered into the starry-eyed belief that future income would be sufficient to repay the enormous loans taken out against properties bought at stratospheric prices. We also entered into the belief that 85 percent loan-to-value, non-recourse loans at 5.5 percent with a 30-year amortization would continue forever.
In hindsight this shared delusion seems comical. Yet, while the party was hopping and the music was swinging, it somehow made sense. What's left from our inebriated, multi-year binge is the equivalent of stale beer in the carpet: thousands of loans once worth trillions of dollars that cannot be sustained by declining real estate fundamentals and cannot be refinanced at their current values.
Policy makers at the FDIC, the Federal Reserve and the U.S. Treasury are working feverishly to stabilize and re-inflate commercial property values to reduce losses on the $1.59 trillion in commercial loans currently held on the books of U.S. banks alone. They have been largely successful in preventing a massive fire sale of distressed commercial assets so far and have set the stage for the possibility of an “orderly disposition” of those distressed assets. However, stabilization is a long way from sustained asset appreciation. The debt bubble must deflate and deflate it will.
Recent groundbreaking work by banker Marc R. Thompson, CRE, CCIM, FRICS clearly shows that lax underwriting standards are a prerequisite to support an asset price bubble; that the emergence of a debt bubble preceded and was the cause of the enormous price run-up; and that this debt bubble must deflate to its historic mean aggregate level.
Thompson’s chart (CLICK HERE) illustrates the point using the Flow of Funds Accounts published by the Federal Reserve Board of Governors. The Fed tracks bank deposits and loans to identify geographic regions and industry sectors that have elevated economic activity. The black line represents the Consumer Price Index.
If the rate of inflation increases in 2011, 2012 and 2013, this line becomes steeper, decreasing the aggregate amount of outstanding loans needed to return to the historical mean. That means fewer loans will have to be written off and the loans that are discounted won't be discounted as steeply.
Practitioners of commercial real estate tend to think of debt financing as the caboose on the acquisition train. One must first identify the site, then do preliminary investigation, then make an offer, then negotiate a successful contract, then complete preliminary due diligence, and then make the loan application. This sequence makes sense because no investor wants to fork over the dough for appraisals, property condition reports, environmental reports and loan commitment fees until it is relatively certain that something is worth buying. However, in regards to a price bubble, it's important to remember that access to cheap debt precedes and causes pricing bubbles. Most commentary about the aftermath of the commercial real estate price bubble is focused on the fall of real estate prices and the return of a normal functioning debt markets. We all understand that the return of lending will support asset prices. But if we professionals were successful in deluding ourselves between 2004 and 2007, we should admit that we are prone to irrational exuberance and pay attention to our embedded belief systems before embarking on an aggressive acquisition campaign.
The mountain of commercial real estate debt will deflate on its own timetable until it is back to its historic mean. In the next several years we will all watch the equivalent of high-stakes musical chairs: Not everyone is going to get a seat; not everyone is going to get a loan. Those left without a seat will sadly see their movie end in tears. Those who keep their seats will see many acquisition opportunities as loans mature and are refinanced, discounted or foreclosed. The process equates to a marketplace processing the toxins of a hangover. It looks like we are going to have a headache until 2013.
