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
