Finance: Musical Chairs – Managing and Matching Debt to Real Estate

 

Where were you when the music stopped? More hard lessons are being learned every day in our industry about the risk of high leverage short term debt. As tempting as it is in good times to leverage development and acquisition activity with short term lines and other high leverage debt, the price can be very high in a downturn. Commercial real estate and short term exit/finance strategies are not a good match.

NorthMarq Capital’s mortgage servicing portfolio of $37 billion is comprised largely of fixed rate transaction based financing with staggered maturities. Even our shorter term financings that we now service were generally conservatively underwritten. Our overall 30 day delinquency rate is slightly over 1.0%. We cannot overstate how fortunate we feel that our clients largely chose to finance their properties in this manner.

Many commercial real estate owners are in the enviable position of minimized exposure to the current credit/value crunch because they effectively matched long term fixed rate transaction debt at levels that cash flow even in today’s environment. The best operators staggered their maturities so that no more than 10% of their portfolios mature in any one year. Some owners kept their development/acquisition activity in balance with their financial capabilities. What may have seemed at one point as very conservative financial management now appears so prudent.

So why would anyone make that short term bet? The flexibility, pricing and ease of bank financing at the height of the market; the misplaced belief that the lender/banker will always be there to extend the loan at maturity; the confidence that one will see the point to sell or convert to more conservative financial structure before the music stops and values drop? In the rear-view mirror all those concepts look ill-conceived. Some refused to make the bet.

What did those owner/developers see or believe that others missed? Perhaps the simple understanding that values don’t always go up. YES, IT IS POSSIBLE THAT VALUES OF ANY PROPERTY TYPE WILL BE LOWER IN THE FUTURE. Seems fundamental, but some are just now admitting to the concept. Whether we are talking commercial real estate or any other asset, the hard lesson is that values have always been cyclical and always will be. If you can time the market, high leverage can work. If you guess wrong, creditors will occupy your life. Maybe we forgot these basic concepts because the positive run had lasted so long; many were not even around to see the last meaningful downturn from 1989-1991.

It is a luxury to focus on cash flow and not worry about values in this down cycle. Some real estate owners are in that situation but in most cases it’s no accident they had their chair picked out before the music stopped.