Price Declines, Losses on Legacy C.R.E. Loans Remain Factor for Many Assets
Jotham Sederstrom Oct. 25, 2011, 10:28 a.m.
No one transaction can fully capture a market’s dominant trends. But even one transaction, however idiosyncratic, can serve as a cautionary note when the market’s investment and lending trends calls for temperance. Last week’s widely reported announcement of the sale of the North Building—or Clock Tower—at 5 Madison is a case in point. In mid-2007, SL Green, RFR Holdings and Ian Schrager sold the landmark structure to Africa Israel USA for the hefty sum of $200 million. Earlier that same year, Mr. Schrager indicated that he might forgo a planned hotel redevelopment given the unsolicited bids that had recently arrived for the property.
Just over four years after it purchased the building, Africa Israel has reportedly sold the Clock Tower for $165 million, roughly 83 percent of its initial investment before fees and other costs. The transaction is expected to close in mid-December or mid-January at the latest. Earlier this year, a $170 million bid by Tommy Hilfiger reportedly failed to secure favorable financing. While the asset’s price decline and the circumstances of its sale are more nuanced than recent sales out of distress, the downward adjustment is instructive for lenders who anticipate that New York’s investment momentum precludes further losses from legacy lending activities.
In New York City more than any other market, expectations with regard to loan losses have been informed by higher recovery rates on the most visible assets. In some cases, assets are trading above their previously observed peaks, suggesting that losses are limited. But at the same time, data on recovery rates that account only for senior debt and that do not factor in lenders’ related costs may grossly underestimate losses on heavily encumbered and relatively smaller assets. In the case of assets where the highest and best use may demand redevelopment and repositioning, the value and recovery upon resale or disposition may be further impaired.
In contrast to the prevailing observations relating to trophy asset price gains, an analysis of a more complete set of 2011 repeat sales in the New York City office and apartment markets shows that properties were resold at lower values in almost two-thirds of cases. Declines were relatively more severe where sales were related to distress and relatively less severe where dispositions were more orderly, even if the buyer was motivated by a pending refinancing. Excluding those cases where significant improvements have been made between original and subsequent sales, the average price decline for 2011 sales was 16 percent. Losses narrowed for assets where the initial sale was made before the market’s valuation peak in 2006 and 2007. Even in the case of older vintage transactions where loans were made on more conservative measures of value, losses were invariably larger than is suggested by the simple price decline once other costs are accounted for.
Given the extent to which New York City property prices have been buoyed by strong investment inflows and a positive outlook for the local economy, the potential for a slowdown in the recovery suggests that lenders should be cautious in updating loss estimates in a manner that overweights the most visible sales. Even in the scenario where the recovery accelerates, both property values and refinancing costs will come under pressure as tightening monetary policy and rising bond yields push on cap rates and lending rates. Across the potential scenarios, the evidence suggests that losses will remain an observable element of most lenders’ legacy resolutions.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.