Investors and Stuy Town

blitt chandan 5 Investors and Stuy TownThe real estate industry was abuzz last Thursday following the State Court of Appeals’ ruling in a lawsuit relating to rent increases at Peter Cooper Village and Stuyvesant Town. Under the luxury decontrol provisions of New York City’s Rent Stabilization Law, former owner MetLife and current owner Tishman Speyer have raised rents on thousands of units in the massive 11,200-unit apartment complex. Upholding a lower court ruling from earlier this year, the appellate judges determined-though not unanimously-that the landlords should not have been able to raise rent-stabilized apartments to market rates while enjoying certain tax benefits for renovations of the complex.

(The full text of the court’s opinion is available from the New York State Unified Court System here (PDF).

The ruling is in stark contrast to the understanding of at least one rating agency. In its early 2007 presale report for one of the related commercial mortgage-backed securities offerings, the rating agency assessed the situation as follows: “Councils from both Tishman Speyer and MetLife have done extensive research on the J-51 tax abatement laws. Both parties are very confident that this lawsuit does not hold any merit, and the J-51 program does not in any way limit their ability to turn stabilized units into market rent units.”

The presale report did not include any further assessment of the magnitude of risk should councils’ convictions prove to be misplaced.

Should the new ruling go the distance, the loss may prove particularly costly for the defendants. Under the terms of the relevant law, tenants may be entitled to treble damages on rent increases imposed in contravention of statute. In the event that tenants are allowed to treat past years’ overpayments as credit toward future rents, the property’s cash flow could drop precipitously. The court dismissed claims by Tishman Speyer and MetLife that “predict dire financial consequences from our ruling, for themselves and the New York City real estate industry generally.” This was a point of dissent, however, as Judge Read broke from his peers:

“While it is true that dire predictions often prove to be mistaken, this is not always the case just because it usually is. After all, the Trojans would have done well to heed Cassandra. And you do not have to be gifted with her powers of prophecy to foresee significant, if not severe, dislocations in the New York City residential real estate industry as a result of today’s decision.” (Page 12 of the opinion.)

In Homer’s Iliad and Lycophron’s poem on the Trojans’ unhappy fate, Cassandra receives the gift of prophecy from Apollo. The oracular son of Zeus and Leto is beguiled by Cassandra’s beauty, prompting the largesse. Because she does not requite his love, however, Apollo conflates his blessing with a curse: Notwithstanding her foresight, Cassandra’s auguring is never believed. She foresees the subterfuge of the Trojan Horse, as well as the murder of mighty Agamemnon following his return to Greece from Troy. And yet she is unable to avert these tragic events.

The irony of Cassandra’s invocation may have escaped the dissenting justice. While the real estate industry’s attention is now fixated on the potential for a default at Stuyvesant Town, this very outcome was suggested when the sale of the property was first announced in 2006. But the market observers who derided the deal at the market’s apogee were Cassandras in their own right. Today, they would suggest that the apparent collapse of Tishman Speyer and BlackRock’s $5.4 billion investment was easily foreseen and is altogether independent of the economy’s having fallen into recession.

The property cash flow in late 2006 was well below the debt service on the sum of the related $4.4 billion mortgage obligations. The loans were made under the premises that the property was purchased for more than $480,000 per unit. In particular, it was assumed that cash flow would grow at a brisk pace as apartments were renovated or otherwise escaped rent stabilization. In the interim, an interest reserve of $400 million was set up to cover shortfalls in debt service coverage. Like the interest reserve, additional upfront reserves of $250 million-principally $190 million in a general reserve and $60 million in a capital expenditure reserve-are now almost totally depleted.

In a defining bathos of the recent developments, a rating agency reported on Friday that is was reviewing certain bonds related to the Stuyvesant Town loans. In an early 2007 presale report for the CMBS, that same rating agency used its estimate of calendar year 2011 cash flow to calculate its “actual” measure of Stuyvesant Town’s debt service coverage. Employing a more pedestrian definition of “actual,” the Stuyvesant Town’s debt service coverage in late 2006 was approximately 0.4.

Apart from the specifics of last week’s decision, a default of the magnitude and visibility of the Stuyvesant Town loans bears implications for a broader class of investors’ perceptions of risk in holding CMBS exposure.

As a result, it may exert a chilling effect on current efforts to reignite securitization activity and liquidity in secondary CMBS markets. The fifth round of the term asset-backed securities loan facility (TALF) in support of CMBS was held by the New York Fed just last Wednesday, to no avail for new CMBS issuance.

Confounding efforts to rebuild confidence in securitization, many investors will view a prospective default at Stuyvesant Town as a result of systemic issues in the CMBS market that have yet to be properly addressed, and not just as an asset-specific issue.

Sam Chandan, Ph.D., is president and chief economist of Real Estate Econometrics and an adjunct professor of real estate at Wharton.

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