Posted by: Aaron Pressman on April 1, 2009
The most iconic building on the Boston skyline, the John Hancock Tower designed by I.M. Pei, sold at auction yesterday for $661 million to bargain hunting investors Normandy Real Estate Partners and Five Mile Capital Partners. The sale followed a default on part of the debt used to finance the purchase of the building for $1.3 billion in 2006. The winning bid, the only bid in fact, was actually $20.1 million plus the assumption of a $640.5 million first mortgage.
How did the winning bidders maneuver into such strong position? By buying up a substantial stake in debt that was less senior than the first mortgage but came due much sooner. In January, the 2006 buyer, Broadway Partners, failed to repay the debt, known as a mezzanine loan, and Normandy and Five Mile moved quickly to put the borrower into default.
But what does the sale say about the value of outstanding commercial real estate loans made during the credit bubble years? According to “Tyler Durden,” the pseudonymous author of the great blog Zero hedge, the true value of the purchase was much lower if you consider the financing involved. Since the new buyers put up only $20 million of a $661 million deal, or about 3%, while keeping the prior mortgage, the deal’s loan-to-value ratio is about 97%. That may have been a reach even during the boom years but is nothing like the ratio that lenders would accept in a typical real estate transaction today. And the rate on that mortgage is a measly 5.6%. The lenders on that first mortgage should get their money back, it seems.
Citing some Wall Street analysis of the deal, Durden figures that in a more typical deal today, the first mortgage would be at a 60% loan-to-value ratio and a rate of 8%, so that would cover only $400 million of the Hancock Tower. Secondary financing on the remaining borrowed amount of $240 million — if it could even get done — would be in the range of 15%. That’s a blended rate of about 11%. The value of borrowing at 5.6% with an 11% yield is $190 million, by the analysis Durden cites, leaving the true cost of the building’s purchase at $470 million, just one-third of what it sold for three years ago. Look out below!
UPDATE: Economist Bill Conerly explains in simple terms why this type of default — where commercial real estate owners are current on their payments but can’t roll over their debt when it comes due — is going to become a tidal wave in coming years:
Suppose you bought an office building five years ago with 20% down, for an 80% loan-to-value ratio. You have not missed a payment, the building’s value has been stable, your amortization has paid down the loan balance by four percent of the building’s original value. A new loan will have a 76% loan-to-value ratio.
Here’s the problem: nobody will make a commercial mortgage loan with a 76% loan-to-value ratio today. You haven’t missed a mortgage payment, your building is fully leased, you’ve been working down your principal, but the lenders are all scared. Bank regulators are scared. Secondary markets are scared. So you have to pony up additional cash to bring the loan-to-value ratio down to at least 70%, and maybe even 65 or 60%.
What if you don’t have the cash sitting around to do that? You have a maturity default. Your problem is that credit standards tightened faster than you were paying off your loan.
(I updated the post on April 2 to make clear for those who didn’t know that Tyler Durden isn’t the Zero Hedge blog author’s real name and clarify that Normandy and Five Mile aren’t, broadly speaking, vulture investors)