Thursday, December 18, 2008

Leverage and Lenders taking Sponsor Risk

The generally accepted driver of the financial crisis is leverage, made capable by virtually free money, thanks equally to our Federal Reserve, and the trusting buyers of virtually anything Wall Street could produce. The combination of a 0% to negative real return, and demands to maintain a minimum return threshold pushed normally conservative investors into new un-chartered markets of initially private MBS and CMBS, graduating to BBB-rated tranches, CDO's, CDS's, TRuPs and the various structures and exposures allowed by them.

As more and more reports are published on struggling CRE owner/operators, a pattern is emerging. For example, this well-known and respected NYC investor decided that he could take his equity off the table, and continue managing a noteworthy property, thus completely eliminating any chance at a loss, and preserving unlimited upside. That does not sound like a bad position to be in, especially with stringent rent controls in place tying management’s hands. Saying the owner hedged himself would be a severe understatement. In just 16 months the transaction generated a cool $93,000,000 profit on a $26,000,000 equity investment. In essence the entity that should be bearing the risk has transferred it to their lender at the most aggressive time in terms of property valuation and finance. The lender accepted unimaginable risks, while capping their upside.

What is particularly odd is that the borrower cashed-out, while the lender under-collateralized the property by allowing a $19,000,000 cash-flow reserve.

What are most interesting are the opinions that he remained a conservatively leveraged owner. What this indicates about the newer-vintage owners of real estate is quite scary, and should give pause to those claiming we have reached a bottom. The lax standards at the top of the bubble are postponing a long market digestion, which is both good and bad.

Llenrock Group

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