Harry Macklowe Illustrates the Business Cycle

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Introduction

Several
years ago in 2003 New York's Harry Macklowe made the news for buying
the GM Building. To get the 50-story tower occupying an entire city
block at the corner of Central Park he paid 1.4 billion dollars,
when one billion was an unheard of sum for a building. A few years
later in February 2007 he bought a bunch of skyscrapers for 7 billion,
using only $50 million of his own money. He also put up the GM building
as collateral — estimated to be worth 3 billion or more. Now he
owes Deutsche Bank 5.8 billion and Fortress Investment Group 1.2
billion — and the bill is coming due now. Due to the credit crunch
there is no one willing to refinance. His multi-billion-dollar empire
is cracking up.

The
reporting of Macklowes' story in the New York Times and other
papers illustrates the business cycle's crack-up boom. The Austrian
School of Economics has shown how the business cycle is the inevitable
result of any system that allows artificial increases in the money
supply. Increases in the money supply are inflationary and distort
prices, leading to unsustainable malinvestment primarily in capital-intensive
sectors during a boom period. This is then followed by an inevitable
bust where the economy readjusts to gain a stable footing for sustainable
growth. There is a wealth of detail here as to how this plays out
in the real world, and good documentation of how perceptions can
change as the business cycle proceeds through its boom and bust
phases.

The
Boom

In
2003 Macklowe set a record for buying the GM building from Donald
Trump — who had paid what seemed the extraordinary sum of 800 million
in 1998. In December 2006, when the real estate boom was going strong,
the New York Sun did an article on Macklowe and the boom.
The title A Booming Real Estate Market Gives Harry Macklowe the
Last Laugh New
York Sun Dec 2006
sets the tone for the article and gives
strong insight in to the boom mentality. During a boom people want
to buy and invest — prices and profits can only go up and there's
plenty of cash available.

Choice
quotes from the New York Sun show how the boom begins. Entrepreneurs
invest heavily in a sector expecting increasing profits. Ready credit
financing is available to help them bid up prices. Those who get
in early make a bundle.

While
just three years ago the idea that a New York City office building
could be worth more than $1 billion seemed preposterous, today
real estate experts say the very same building could be worth
more than $3 billion…

The
global chairman of CB Richard Ellis, Stephen Siegel, said the
value of the GM Building has increased at least $1 billion in
the last three years.

“Harry
was a little earlier and had a little more vision than most,”
Mr. Siegel said. “The market had just begun to pick up momentum,
but there hadn’t been any rent growth yet. There were people out
there — other bidders included — who thought the number was high.”…

Mr.
Siegel said he could not recall another time where as much appreciation
occurred in such a short timeframe. He said the boom is being
driven by low interest rates, an influx of capital into the New
York real estate market, and soaring rents, which he said could
rise between 6% and 18% next year…

“The
overwhelming majority of people thought the price was off the
charts, and didn’t make any sense,” Mr. Knakal said. “The office
leasing market had not yet started to take off and strengthen
the way it has since then.”…

He
called Mr. Macklowe a “genius.”

This
is the beginning of the boom — people who get in early look like
prescient geniuses. There were of course good reasons why people
didn't think his deal would work in 2003.

The
chairman of GVA Williams, one of New York’s largest commercial
property managers, Michael Cohen, said that when Mr. Macklowe
bought the GM Building at a record-setting price, many questioned
whether the cash flow generated from rents would justify it.

“People
were dead wrong,” Mr. Cohen said. “The purchase turned out to
be inspired, if not prescient.”

Now
commercial rents in Midtown are soaring towards all-time highs
on top of falling vacancy rates. More and more deals are topping
the once seemingly insurmountable barrier of $100 a square foot
a year.

But
by 2006 people think the good times are there to stay. Things will
just go up and up.

“All
the fundamentals say this will be a healthy market for a long
time to come, and people are putting their money in it,” Mr. Siegel
said…

“To
put the New York market in perspective, relative to London, Paris
and Tokyo, New York is still pretty cheap,” Mr. Knakal said.

Mr.
Cohen, of GVA Williams, said rents of more than $100 a foot a
year have persisted in London for some time, proof that the trend
is sustainable.

Of course this
was said in December 2006 and by August 2007 everyone knew there
were serious problems in the financial markets.

Their explanation
discusses the sheer quantities of available money driving the boom
in prices.

Part of the
explanation of rising real estate prices, experts say, is due
to a paradigm shift in the way that investment capital is allocated.
Capital, including money from overseas, is increasingly liquid
and finding its way into the city’s real estate market, and Wall
Street is paying more attention to the real estate industry. At
a recent real estate conference sponsored by NYU, several participants
noted that the panels were dominated by investment bankers, not
real estate guys.

The president
and CEO of Cushman Wakefield, Bruce Mosler, said recently that
real estate is now considered a “respectable asset class.”

Large pension
funds and other institutional investors are now partnering up
with local operators, property managers and developers, and driving
big deals. An arm of the Black Rock Group, which has more than
$1 trillion under management, partnered with Tishman Speyer in
the recent $5.4 billion purchase of Stuyvesant Town and Peter
Cooper Village from Met Life. A California state pension fund
has partnered twice recently with Silverstein Properties.

A director
for Real Capital Analytics, Daniel Fasulo, said the supply of
capital for real estate investment in the New York is contributing
to the boom.

“There are
investors from all over the world trying to get their money into
this high priced area of Manhattan,” Mr. Fasulo said. “When you
have more capital than available property, it is common sense
that prices would be driven up.”

As the New
York real estate market continues to perform as an asset class,
investors are shifting funds from other traditional investments,
like the debt and equity markets.

Mr. Fasulo
added, “There is so much money floating around, and the other
assets classes haven’t been blowing it out, which would make real
estate less attractive.”

The
downside of these deals is that they assume that rents will rise
dramatically over the next few years. They were not good deals if
one assumed rents would stabilize.

Mr. Cohen
said the jury is still out on the $1.8 billion that the Kushner
Companies paid for 666 Fifth Avenue.

“The $64,000
question is do we have the same situation here as with the GM
Building — is this an inspired and prescient purchase, or is this
a purchase made at the top of the market on expectations that
will not be met,” Mr. Cohen said.

To justify
the purchase price of about $1,200 a foot, he said the Kushner
Companies would need to achieve office rents north of $100 a foot.

“While that
seemed outlandish a year ago, today it doesn’t seem outlandish,”
Mr. Cohen said. “If you are to be a buyer in this market, you
need to believe in double-digit rental growth in the next couple
of years.”

The
Top of Bubble

The
preceding was written only a few months before Macklowe's huge 7
billion dollar deal. In 2007 Sam Zell sold his Equity Office Properties
Trust to the Blackstone Group for 39 Billion. This was high considering
measures of the Trust's cash flow from rents. The Blackstone Group,
having put in only 3.9 billion, then proceeded to sell off as many
of the buildings as it could, and did so for record amounts. One
of the buyers was Henry Macklowe — who bought 7 prime Manhattan
towers for 7 billion.

After
four years of rising real estate prices, Macklowe now looked like
a prescient genius instead of a reckless gambler, wonton speculator,
madman, crank, or a fool who is soon parted from his money. Banks
and investment funds had money to invest, and they had to invest
it somewhere. Macklowe's track record made his projects a good investment.
Rents and property values were rising year after year and plenty
of cheap financing was available. The buildings were occupied by
real profitable businesses willing to pay increasingly high rents
to be in Manhattan — not like developers selling homes to speculators
or people who could barely afford their mortgages. All the signals
were there to keep investing in commercial real estate.

In
August
2007 the New York Times
wrote up Macklowe. At that point
the credit market bust had already begun.

Mr.
Macklowe was already well represented in the Midtown market, where
rents were rising at a staggering rate. His 2003 purchase of the
General Motors Building on 59th Street and Fifth Avenue for $1.4
billion, though derided at the time as reckless, had been vindicated
as the value of the building soared, enhancing Mr. Macklowe's
reputation as a visionary tycoon.

It
therefore seemed like a good idea at the time to loan 7 billion
to Macklowe to buy a bunch of office buildings. He had the magic
touch and the banks would get their money back. The down side was
that throughout the market for office building the deals assumed
rapidly increasing rents and no increase in interest rates. If rents
stayed stable it would be impossible to pay back lenders.

…bond
ratings analysts and others have warned that competition among
commercial lenders has become so feverish that many are willing
to finance 90 percent or more of the cost of the transaction based
on overly optimistic projections that rents will continue to rise
at a furious pace. In recent transactions, including Mr. Macklowe's,
the expected initial income from the buildings was less than 4
percent a year, with cash flow projected to rise significantly
as leases expired and rents reached market levels.

But
in the recent hot market, said Adrian Zuckerman, a real estate
lawyer at Epstein Becker & Green, "people were not buying
the income stream; they were buying the building for what they
could sell it for in a year or two years."

The
New York Times Article from January 2008
explains the
logic of investors in detail.

The
annual rent for the seven Midtown buildings was generally $55
to $59 a square foot, according to William Macklowe, but Deutsche
Bank and Fortress underwrote the deal on the assumption that rents
would soon rise to $100 a square foot.

After
all, the commercial real estate market was higher than ever. The
vacancy rate had fallen to record lows, while high construction
costs made new buildings prohibitive. Landlords at prime office
buildings were getting more than $100 a square foot annually,
while the average rents for first-class Midtown buildings rose
to $73.31 by the first quarter of 2007 from $55.21 in the first
quarter of 2005, according to Reis Inc., a New York office research
company.

At
the same time, average prices for large office buildings in Midtown
more than doubled, to $745 a square foot from $357, according
to Real Capital Analytics. Investment banks and foreign companies
began pouring capital into real estate. Lenders, in turn, took
more risks, often providing financing for 90 to even 100 percent
of a building's price. Investors became ever more willing to accept
a lower initial rate of return, known as the capitalization rate.

As
with the residential market, the money flowed easily because lenders
did not keep these risky loans on their balance sheets — as the
commercial banks and savings-and-loan associations did to their
peril in the early 1990s. Instead, Wall Street repackaged hundreds
of billions of dollars of loans as commercial-mortgage-backed
securities and sold them to investors.

"Loans
with more aggressive terms that weren't available in '03 and '04
became the norm in '06, when suddenly lenders became very accommodating,"
said Mike Kirby, a principal of Green Street Advisors, a research
company in Newport Beach, Calif., that specializes in real estate
investment trusts. "The attitude was, u2018Gee, we're not going
to own this stuff; we get terrific fees for underwriting these
loans, and we can blow it out in a C.M.B.S. deal in three months.'"
[C.M.B.S. is the commercial mortgage backed securities mentioned
above.]

Macklowe's
behavior had worked well in the past, but it rested on unsustainable
assumptions. Continuing to repeat it would lead to eventual failure.
Macklowe also assumed there would continue to be plenty of ready
financing for his deals. He failed to take into account that credit
might dry up, and he financed his 7 billion dollar purchase with
short-term debt – a bridge loan for one year. His son considers
their problems to be derived from an inexplicable event.

"It's
not a real estate crisis but a capital markets crisis," the
younger Mr. Macklowe said. "Our legacy and acquired portfolios
are renting at market rates or better. In August, when the world
took a 180-degree turn, we and others got caught up in it."

A
recent Bloomberg
article from February 2008 on the situation found someone who still
feels similarly.

"The
market has totally changed,” said Howard L. Michaels, chairman
of New York-based Carlton Advisory Services Inc., which helped
Macklowe refinance the GM Building in January 2004. "He paid
an appropriate price at the time he bought the properties. It
was a major score for him. And it was unforeseeable by him or
anybody else that the market would change so drastically.”

Macklowe
failed to recognize that investment in deals assumed record increases
in rents and sales prices for buildings and that this implied investment
would dry up if the increases slowed or stopped let alone reversed.
A recent Bloomberg article lays out the key details relating
the inability to increase rents sufficiently and the lack of financing.

Office
building prices have come down from their peak in the third quarter
of 2007, said Sam Chandan, chief economist for Reis Inc., a New
York real estate data provider. By the end of the year, the falling
prices had returned most of the gains that followed Macklowe’s
purchase, he said.

Just
as much of an issue for Macklowe is the lack of lenders willing
to fund such large deals, said David Tobin, a principal at Mission
Capital Advisors LLC in New York, which advised on $5 billion
of property sales last year.

"There
is simply no expanding demand for $150-per-square- foot office
space in New York City,” Tobin said. "All of this excess in
the real estate markets has been fueled by financing and the financing
isn’t coming back for a long, long time.”

As
the New
York Times in August 2007
quotes Mike Kirby

"If
you're looking for a poster child for what's been going on, it
could well be that deal," said Mike Kirby, a principal of
Green Street Advisors, a research company in Newport Beach, Calif.,
that specializes in real estate investment funds. "It had
all the elements of the froth in the market — assets flipping
left and right at ever-higher prices and excessive amounts of
debt at ultracheap prices."

Good
Managers Driven Out

The
New York Times August 2007 article also points out one of
the notable effects of booms.

Scott
A. Singer, the executive vice president of the Singer & Bassuk
Organization, a real estate finance and brokerage company, said
long-established investors "have often found themselves on
the sidelines while other players without a strong track record
have bid up deals, using a lot of leverage."

Among
the relative unknowns who gained prominence in this market was
Scott J. Lawlor, the chief executive of Broadway Partners of New
York, which made its first real estate investment in 2000 by buying
a former school building in Hartsdale, N.Y., for $4.8 million.
Since then, Broadway has bought more than $15 billion worth of
office towers, including the John Hancock Building in Boston,
keeping most of them a few years or less and then reselling them
for a handsome profit.

Entrepreneurs
without strong track records are able to outbid experienced entrepreneurs
who've created real wealth. In many cases entrepreneurs will sell
out — as Sam Zell appeared to do. Management of capital will move
in to weaker hands, increasing the likelihood of losses.

The
Crack-Up

Already
in 2007 it was clear that problems were inevitable. The New
York Times August 2007
article mentions –

But
as the crisis over subprime residential mortgages spills over
into other real estate sectors, causing a severe tightening of
credit, there is widespread talk in the industry that Mr. Macklowe
is in deep trouble — so much so that he could lose control not
only of the newly acquired portfolio but also of the G.M. Building
and other properties that were used as collateral for short-term
debt that must be repaid six months from now…

As
with residential mortgages, commercial loans are pooled and packaged
into bonds that are sliced into portions carrying different degrees
of risk. In recent weeks, investors have largely shunned these
securities backed by commercial mortgages.

Highly
leveraged loans "are not being made or are very rare now,"
said Robert O. Bach, a senior vice president at Grubb
& Ellis
, a national brokerage company. "So, some
people would say, there's been more of a return to sanity."…

The
reason was explained in the New
York Times January 2008
article.

EARLIER
this year, however, the real estate winds shifted. In April, just
two months after Mr. Macklowe bought the Equity Office properties,
Moody's
Investors Services, the bond-rating agency, said it planned to
readjust how it rated commercial-mortgage-backed bonds to better
reflect their risk. The agency complained that lenders were making
overly optimistic projections about rent growth.

By
last summer, as the subprime mortgage crisis hit residential lending
and credit markets tightened, opportunities evaporated for developers
like Mr. Macklowe to refinance expensive short-term debt.

The
New
York Times August 2007
article further explains the upshot
for Macklowe.

The
problem for Mr. Macklowe is that much of the debt — $3.4 billion,
according to Commercial Mortgage Alert, a weekly trade publication
— is in the form of a short-term investment known as a bridge
loan or preferred equity that must be repaid in February. Of that
amount, about $900 million came from the hedge fund Fortress
Investment Group
, with the rest supplied by Deutsche
Bank
, Mr. Macklowe's longtime lender. Mr. Macklowe pledged
the G.M. Building and other assets as collateral.

But
with credit now far less available, Mr. Macklowe is expected to
have a harder time refinancing to repay the short-term debt. And
typically, said Mr. Zuckerman, who was not involved in the Macklowe
transaction, when the rent does not cover the debt service, the
difference is added to the loan principal.

The
Macklowes were sure they would be fine however.

In
an interview in his sleek corner office at the G.M. Building overlooking
Central Park, the younger Mr. Macklowe, who is known as Billy,
shrugged off the concerns and said the company had always planned
to take on new partners. He said it was in "advanced discussions"
with three groups that could replace the bridge loan with permanent
capital.

"That's
how we always looked at the deal," he said. The company's
next steps may also include "one or two divestitures"
of some of its buildings, he said.

By
January 2008 the situation had still not improved according to the
New
York Times article
that month.

As
often happens in real estate, a once-frothy national cycle is
losing steam and the market has turned against many buyers. Mr.
Macklowe, with his empire of 15 prime office towers and two development
sites in one of the world's best business districts, is awash
in expensive, short-term debt at the very moment that financial
backing for megadeals has all but shut down. One of his loans
is backed by a $1 billion personal guarantee, and he is already
in default on $510 million in development loans for a Park Avenue
project.

Mr.
Macklowe's predicament marks the denouement of an unprecedented
four-year period in which developers threw gobs of money at real
estate as prices for office towers, especially in Manhattan, doubled
and tripled almost as fast as sales could be recorded. Investment
banks avidly underwrote the binge, often basing loans not on existing
rents but on projections of rental income well into the future.

All
of this worked swimmingly so long as the economy hummed along
and banks could pool the loans and sell them to investors. Now,
the economy is showing signs of stress, and Wall Street's repackaging
machine is sputtering.

"In
hindsight, everybody should have been more cautious," said
Robert Bach, the chief economist at Grubb
& Ellis
, the national real estate brokerage firm. "We
all knew this wasn't going to last, but we hoped it would end
with a whimper, not a bang."

According
to the New York Times things aren't too bad — but they do
describe how bad things got even fairly recently in the early nineties.

Analysts,
bankers and developers are not predicting the imminent collapse
of the commercial real estate market, a reprise of the early 1990s,
when property values dropped by half, vacancies soared and banks
were crushed under the weight of soured real estate loans. But
developers who jumped in at the top of this market are likely
to feel some pain because purchases were built on the assumption
that rents would keep escalating and that the value of buildings
would keep appreciating.

Macklowe
in particular will be feeling the pain.

With
building owners no longer able to refinance their properties and
pull out cash, Mr. Macklowe and his son, William S. Macklowe,
have only a month to repay $7 billion, work out a new deal with
their bankers or risk the breakup of their empire. There is widespread
speculation in the real estate industry that the Macklowes may
be forced to unload some of their properties at a discount to
creditors — including a sizable stake in the G.M. Building. At
worst, they could be forced to shed much of their portfolio.

"This
is very high-stakes poker," said Scott A. Singer, the executive
vice president of the Singer & Bassuk Organization, a real
estate finance and brokerage company in New York. "To owe
more than $5 billion in this environment is tremendously risky.
There are a very, very limited number of lenders who can make
multibillion-dollar loans now."

Macklowe
is not alone and his story illustrates larger trends.

THE
Macklowes aren't the only real estate barons in a tight spot.
The Kushner Companies, also family owned, plunged into the Manhattan
real estate market in 2006, paying $1.8 billion for 666 Fifth
Avenue, at 53rd Street. The cash flow from 666 Fifth represents
only about two-thirds of the amount needed to service the debt
on the building — a shortfall of about $5 million a month — according
to Real Capital Analytics, a research company in New York. [The
article gives several other big blow ups.]

Macklowe
is now in the position of potentially losing practically all of
his properties. However the properties won't do his lender Deutsche
Bank much good. When you owe someone enough money it often becomes
their problem not yours. The latest reports indicate that Macklowe
would manage the 7 properties while Deutsche Bank puts the towers
up for sale. Of course if no buyers can be found, then Deutsche
Bank is left holding the bag. [See New
York Times Feb 2008
.] Apparently the Macklowes have told
friends they might be able to buy the buildings from Deutsche at
a discount. Whether this is delusional or accurate remains to be
seen. His loan from Fortress is personally guaranteed and the GM
building is collateral, so now he's putting the GM building up for
sale. All told the fire sale is for assets Macklowe considered worth
about 10.5 billion.

Conclusion

The
story of Macklowe illustrates the boom and bust of the business
cycle. Behavior that is successful during the boom leads to failure
during the bust. Perceptions of the behavior change depending on
which stage it is in the business cycle. The
New York Times article
even mentions that Macklowe had lost
control of his prime properties during the deep NY recession of
1989–1992.

Like
many other developers in the early 1990s, Mr. Macklowe took a
beating during a severe real estate recession, ultimately returning
both the Riverbank West tower on 42nd Street and the Hotel Macklowe,
now known as the Millennium Broadway Hotel, to the lenders.

Rather
than disappear, Mr. Macklowe did a series of smaller projects
in the mid- to late 1990s, building less-glamorous apartment houses
or renovating office buildings on Madison Avenue.

Apparently
little was learned by Macklowe or the banking community from his
earlier experiences. Maybe in 2018 the Macklowe's will be back setting
new records for real estate. Given the present systems love of the
inflationary credit and banking system the business cycle is likely
to continue to be with us.

March
11, 2008

Anders
Mikkelsen [send him mail]
is a cost management consultant in New York City.

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