Monday, June 1, 2009

Is this the end? Or only the beginning?

by Alexandra Lebenthal

“Every new beginning comes from some other beginning's end” — The Semisonics

New York is a real estate town, always has been and always will be. Some of the greatest family fortunes in our city are derived from generations of savvy investing in the buildings in which we all live, work and shop. Over much of this decade, while much of the country has been wrapped up in the residential real estate boom and bust, commercial real estate, particularly in New York, enjoyed its own inexorable upward climb in value. For home prices, we have all learned that trees planted in the sand of easy credit couldn’t grow to the sky, and the same is true for commercial real estate. But how the story will play out is a slightly different tale.

George Vanderpool loved to run. In good times he felt the elation of having closed a great transaction. He could run for an hour on the adrenaline of making money. In good times he ran to clear his head. In bad times it was to get the sense of failure out of his system.

Recently though it was all he could do to make it the full loop around the Jacqueline Kennedy Onassis Reservoir in Central Park. He’d managed to stay one step ahead of the crisis as he watched while colleagues and competitors were crushed by a sea of debt. Now it was his turn and things were starting to close in.

George had started in real estate at Goldman Sachs right out of college in 1993. Those were equally heady days, when Wall Street began to realize how much things were worth, a great change from how antiquated New York City was even in the first part of the 1980s.

Class B office buildings stayed that way; old elevators, windows painted shut and creaky radiators in the winter. There were areas of the City that were written off as unattractive. Then the securitization of real estate changed that.

A class B building was now like an ugly duckling ready to be made over into a super model and an opportunity to do a total renovation, not to mention increase the rents by double or why not triple? Who would ever have imagined that $100 per square foot would be cheap for certain midtown locations.

Ultimately George was ready to take advantage of it himself so he could make more money. He and a few colleagues tired of waiting to make partner, established Broad Street Real Estate Partners, “BSRE,” in 2002. Their fund was designed to take advantage of rising commercial real estate prices, and for a while it worked when credit was freely available. They would find a premier property, put some of their own money in and borrow the rest through “securitization,” which isn’t too much different from cutting up a birthday cake. One wants a corner piece with the extra icing. Another will take the slice with the writing. She’s on a diet so give her a sliver, while another takes two pieces. And of course the birthday boy always gets the rose.

It’s a nice analogy, but securitization has more at stake than the weight one might gain from an extra slice.

The way securitizations sliced up the cake — or the purchase price based on the value of the building at acquisition — each slice had a certain return expectation based on risk of loss. Those slices (or “tranches,” in finance-speak) with the lowest risk of loss were the most senior in the securitization, and they carried a low return, while the equity slice carried the highest possible return based on the expectation for increasing the occupancy and rental rates in each building. As the decade passed, the prices paid for buildings by BSRE, along with countless other funds, banks and investors got further and further from reality.
When The Oak Building on Fifth Avenue, one of the trophy properties in New York City, was first rumored to be on the market, George and his partners were in a frenzy to acquire it. Nestled in the heart of Midtown with stunning Central Park Views, some of the floors even had terraces. It was one of the favorites of the hedge fund crowd.

Nothing showed their investors (and each other) how powerful they were than a full-on view like that. The restaurant in the Lobby became a cigar bar in the evening where the crowd could light up while drinking aged brandy at $150 a snifter.

It was going to be the deal that would put them on the map.

So when they beat out some of the top names in real estate in August 2005 and purchased the prime New York City office space, little did they know it would be their undoing. The building was purchased for $1 billion — BSRE put up $50 million in equity and financed the rest through securitization. At the time, financing it was easy.

The birthday cake was sliced up in different slices: $600 million of the financing was in the so-called “super duper senior” debt tranche, and was funded by a life insurance company; $200 million of the funding was in the “AJs” or the junior triple A tranche that was funded by several banks and debt funds; $150 million was the “mezzanine debt” tranche and bought mostly by hedge funds. And the last $50 million of equity — what George and his partners put in — was the slice of cake with the rose. While the investors at the top would get their steady coupons and return of principal at the end of the term, the equity gets all the upside but holds the first loss position in the event rents fall, or building occupancy declines. At the time of acquisition, George and his partners projected higher rents into the future, and when they ultimately re-sold the building for $1.1 billion in a few years, BSRE would walk away with $150 million in total.

But while rents may have increased at certain increments, to make the numbers work, BSRE projected increases of 30% over the next five years. At first, all seemed to go well. The flagship tenant was an expanding investment bank that quickly snapped up 300,000 square feet. They signed up five new hedge funds totaling another 250,000 square feet. They joked that they might have even projected too low.

But then as the financial crisis hit things began changing and as the latter months of 2007 blurred into 2008 and then 2009, the investment bank melted down, leaving their space vacant. Several of their “hedgie” tenants went out of business and several long time tenants started looking for cheaper space in less desirable locations. Even the restaurant in the lobby closed its doors.

BSRE had put $50 million into an interest reserve fund, but with the changing tide that got quickly eaten away when it was used to make interest payments. As George goes for his run today he knows that there isn’t enough money to pay the next interest rate payment to all the tranches, and that means the next step is a notice of default.

First the lower tranches absorb any losses, but ultimately that senior investor, BJH Insurance, will take ownership of the building. Rather than making money they will lose their entire $50 million, and potentially their reputations.

There are many different markets people can invest in and things go up or down more quickly in some than in others. The stock market goes up or down every day. The housing market, which people thought would never go down, took some time to fall, and commercial real estate is the next to come. The story of George Vanderpool and BSRE is one that we will be reading more and more about over the coming months. There is $3.5 trillion in outstanding commercial real estate loans with about $1.4 trillion in interest payments due over the next five years.

For example, Stuyvesant Town, the iconic housing development in our own backyard, is a $5 billion deal heading for such a denouement, because the owners couldn’t get enough of the rent-controlled apartments converted to market rates.

At the end of March, we read about the sale of the Hancock Tower in Boston for $660 million, half of the $1.3 billion paid in 2006, because of the market downturn. Only the senior tranche-holders got paid back.

George’s fund was $2 billion in 2007. The loss on the Oak building will be a total loss, but not fatal in and of itself. However, George has many investments in a similar position and many of his investors have been submitting redemption notices because they need liquidity in their own portfolios. George is learning the hard way that leverage magnifies the upside as well as the downside of any investment.

For those who might expect another Schadenfreude ending, think again. George’s run today as he expects the downfall is a hard one, but he didn’t get where he is without being clever. BSRE will fold soon enough, having lost substantially all of its investors’ money.

But soon George will start marketing a new distressed real estate opportunity fund that will extol the virtues of his experience in troubled real estate and seek to buy buildings at the now absurdly cheap prices that he helped create.

We have no doubt that just as surely as the sun follows the moon greed follows fear in the investment world and he will have little problem reestablishing himself as ... Phoenix Partners.
Alexandra Lebenthal learned from her father, Jim Lebenthal, and grandmother before that about the basics of finances and investments. Today she is the CEO of Lebenthal & Co., LLC and its wealth management division, Alexandra & James Co.