December 3, 2007


When the subprime crisis first appeared, it showed up in city neighborhoods and suburban developments, as homeowners who had bitten at the chance to own a home by signing up for mortgages that appeared to be pain-free, were stunned when their two-year teaser rates were reset beyond their ability to pay. As the foreclosures started to build, investors in mortgage-backed securities that contained subprime loans found themselves holding investments they couldn’t move, and the growing shock wave — in the form of a tightening of credit — rolled quickly from Elm Street out to Wall Street. And now, even as Wall Street is taking its own hits, the wave is rolling on, knocking back those segments of the economy that were tied, directly or indirectly, to the subprime market.

While the most obvious results of the subprime mess were foreclosure notices, Wall Street’s reaction has ramifications in commercial real estate and through the entire housing market, stretching out to municipalities and their tax base.

“The credit crunch started in early to mid-August,” said Jeff J. Marwil, a partner at Winston & Strawn.

“A number of participants in the credit markets woke up one day and realized that the investments they were purchasing for their portfolios — collateral debt obligations — are not without risk,” he said. “When people started to realize that many of those loans were made without regard to risk, some guys said, `I’m going to get hurt because the subprime piece is a material-enough piece to create a loss for me,’ and they were not being compensated for the increased risk, so they stopped buying, which caused illiquidity.”

And, what does illiquidity mean for commercial real estate, which did not use subprime mortgages?

“It’s a very interesting phenomenon,” said James L. Beard, a partner at DLA Piper. “Subprime affects capital provided for the commercial real estate market, even though it is a different type of debt securitization than CMBS [commercial mortgage-backed securities],” he said, “because investment banking firms were participating in both.

“So the subprime market crunch hit those investment banking firms directly, and they, in turn, tightened the terms and standards on all commercial loans and the rating agencies did the same.”

“There’s a huge market of commercial mortgages that are sold in the secondary market; it’s a big part of the commercial financial market,” said Mark C. Simon, a partner at Katten Muchin Rosenman. “Commercial securities haven’t gone bad, but there is concern about how much they’re worth.

“The more immediate problem,” he said, “is that a lot of the loans investment banks made were commercial loans with the intention of converting them to securities. They can’t do it now because there’s so much turbulence in the market, they’re stuck holding them.

“So, big banks are sitting on a huge inventory of mortgages they can’t sell, so they don’t liquidate to make new loans,” Simon said. “This is a huge portion of a Wall Street firm’s balance sheet, and it has affected decision making in other parts of real estate, because they’re not as liquid in one area. If you’re out of whack, it affects your ability to do other things — if you’re not liquid, you can’t make other loans.” Delays in funding According to Beard, the effect of the credit crunch on a typical commercial real estate transaction has been to make it much more difficult to get a project financed.

“Deals are still getting done; we’re not doing different work,” he said, “but the primary effects I’ve personally witnessed are delays in lenders’ funding.”

Before the subprime crisis threw the market “out of whack,” a developer could work with Wall Street investment banks and acquire financing, much of it from CMBS lenders, for 90 to 95 percent of the project.

“You could effectively purchase the building with little of your own money,” Beard said. “Wall Street investment banks were providing various levels of structured finance so the buyer didn’t have to be hugely capitalized to get into this.

“Now, the bank has less proceeds to get, so you as a buyer have to come up with more of your own equity, plus interest rates are higher, so you can only afford a lower price to make a successful purchase,” he said. “Buyers don’t have access to money.”

“The CMBS [commercial mortgage-backed securities] market has slowed to grinding halt,” said Daniel Perlman of Paul, Hastings, Janofsky & Walker. “Many CMBS originators are slowly being able to sell their bonds in the ordinary course of business, but it’s a very slow process. Originators don’t want to make loans that they can’t sell — so until the CMBS market gets back on its feet, loans are hard to come by.”

Irony seems to be at work here. The lack of real value in the subprime mortgages that fueled much of the growth in real estate caused the tightening of credit that has slowed financing of commercial projects the have real value in themselves.

“People haven’t lost money in commercial real estate in many years,” said David R. Dlugie, a partner at Katten Muchin. “There still have not been great deal of defaults or workouts. Those loans that were made were not fundamentally bad — the property still supports the loan, but I see it coming back to a liquidity issue.

“A financial institution making a $1 billion loan was confident they could carve up the loan into pieces and sell it — they might have held $200 million, and sold $800 million of it within 30 days of closing,” he said. “But the number of buyers of loans has decreased, so you have to think twice and line up buyers ahead of time.”

But homeowners, who don’t have the ability to line up buyers, have been dealt the first substantial hit by the subprime mess. It’s more directly personal than a credit crunch on Wall Street, but the fallout from a single home to neighborhoods and cities can be very serious.

“The crisis manifests itself in a couple of ways — the tightening of credit, in conjunction with scrutiny on predatory lending, causes lenders to be more careful about their loans, and that does make money more difficult,” said Ralph Schumann, of Schumann Law Offices in Elk Grove Village, and president of the Illinois Real Estate Lawyers Association.

“It may not be necessary to have a predatory lending statute because so many of these lenders involved in B and C paper have gone out of business and the reputable ones are policing themselves better, but it was a crazy concept,” Schumann said.

“In many cases lenders were looking with myopic attention to the borrower’s ability to pay in the first year or two, even when the mortgage payments were 50 percent of take-home pay at a teaser rate. How many people buy property to live in for 24 months, if they were stretching to make initial rate?

“A substantial number of people didn’t understand the risk,” he said. “They didn’t understand, they didn’t have representation, and they were sold a product with so many land mines,” he said. “When the rate ratchets up, they can’t make the payments — that’s no surprise.”

According to RealtyTrac, an online data service that lists foreclosures across the nation, 446,726 properties were served with foreclosure notices in the third quarter of this year, double the number of foreclosures in the third quarter of 2006.

And the House-Senate Joint Economic Committee estimates that, for the period 2007 through 2009, if housing prices continue to slip, “subprime foreclosures alone will total approximately 2 million.”

As might be expected, the foreclosure of a house doesn’t simply damage the value of that house — it reaches through the neighborhood.

Two researchers — Dan Immergluck of the Georgia Institute of Technology and Geoff Smith of the Woodstock Institute — writing in Housing Policy Debate, a Fannie Mae publication, found that “each conventional foreclosure within an eighth of a mile of a single-family home results in a decline of 0.9 percent in value. …”

“Less conservative estimates suggest … a 1.136 percent decline in that property’s value and that each foreclosure between an eighth and a quarter of a mile away results in a 0.325 percent decline in value.”

In Chicago, according to Immergluck and Smith, the 3,750 foreclosures in 1997 and 1998 reduced nearby property values by more than $598 million — an average of $159,000 per foreclosure. And the Joint Economic Committee, using a more conservative estimate of 1.3 million foreclosures (assuming stable housing prices) from 2007 to 2009, estimates that the total cost to Illinois of subprime foreclosures will be $5.3 billion, with an estimated cumulative loss of property taxes of $81.3 million.

“Foreclosures, particularly in lower-income neighborhoods, can lead to vacant, boarded-up, or abandoned properties,” Immergluck and Smith wrote. “These properties, in turn, contribute to physical disorder in a community, create a haven for criminal activity, discourage the formation of social capital, and lead to further disinvestment.”

“That’s the whole uncertainty,” said Michael Seng, a professor at The John Marshall Law School. “Nobody knows the depth of this. The victims here are the neighborhoods.”

But it’s not just city neighborhoods that are at risk. Condominium developments — in the cities and suburbs — and suburban housing developments are feeling the pinch, and then some, because their funding comes from the same pool as individual home mortgages. The housing slump Even a village as upscale as Highland Park has been suffering “an inordinate number of foreclosures,” said Steven J. Elrod, a partner at Holland & Knight.

“The housing slump affects commercial builders and owners of existing homes,” Schumann said. “It’s had a more widespread effect than people realize.”

“Tract builders are, in one form or another, experiencing difficulties,” said Jeffrey J. Stahl, name partner in Stahl Cowen Crowley. “Absorption — sales volume — has slowed tremendously. Without volume, tract builders are left without revenue, and without revenue, they can’t carry the interest and the debt service.

“The better-producing builders are performing okay, but almost all builders are experiencing the pain of slow absorption,” he said. “Those that saw it coming and were able to put cash aside are doing better, but I don’t know that a whole lot [of builders] put money into a bank account. A lot of home builders are downsizing their inventory, not closing on contracts, and walking away from contracts.”

The drag in financing doesn’t only affect new projects. Projects that are underwritten with appropriate financing and, as William J. Mitchell, a partner at Meltzer, Purtill & Stelle said, “well-grounded in equity and time,” are getting done, even if buyers have to work harder to acquire the financing.

But the credit crunch also ripples out to include work underway — as construction projects are delayed (the expression is “pushed out”) — the units in condominium and housing developments aren’t selling at the anticipated rate, because potential buyers are having a more difficult time getting mortgages.

“The way construction projects are financed, you don’t borrow against the total cost of the project. You only need a certain amount of the loan before you start to close units,” Mitchell said.

“The `high-water mark’ is how much you need to borrow and put equity against. Your equity, as the developer, is the real equity plus the deferred equity you get as units are sold, and the deferred equity is based on the crystal ball [projections of units closing].

“As units close, you use that money to pay off the loan and infuse real equity back into the deal cash flow,” he said. “Well, as projects start to push out, the units aren’t closing as projected, but you still have to finish the building and you still have to build all the units. The need busts through the high-water mark and you have to go back and now there needs to be shared equity [between the developer and the lender] on the loan.

“So, now, performance is taking longer, the high-water mark is higher, and the interest cost is more expensive.” Delays and problems And now the ripples start to spread.

“What’s happening is that deals are getting stretched out, sales are slow,” said Brian Meltzer, name partner at Meltzer, Purtill & Stelle. “A 200-unit subdivision five years ago — they’d sell it out in a year. Today, it’s going to take five years.

“The longer the developer is in the subdivision, the more chance there is for disputes with the people that are there,” he said. “They get upset because the subdivision isn’t completed. When that happens, you get more problems, you have to make adjustments, so we’re busy fixing things up in our documents — all these options, disaster scenarios — and we’re starting to implement them.”

With foreclosures on individual homes, there’s a clear impact on the other homes in the neighborhood. How far the impact extends beyond the immediate neighborhood is not so clear. But the delays in closing urban developments and suburban subdivisions can find their way into the financial well-being of the municipalities themselves.

“One effect this is having,” Meltzer said, “is that municipal income is down — that’s having an impact now. All this stuff that they had been anticipating growing each year, it’s kind of dried up.”

In order to prepare for that anticipated growth, municipalities will often issue bonds to support development projects; the primary methods of municipal financing are TIF (tax increment financing) and SSA (special service areas).

TIF financing, which Chicago has used extensively, primarily in low-income areas, uses projected increases in taxes to finance the current improvements that will, in turn, create those tax increases.

The municipality issues bonds to finance the development, with the expectation that the gains in property taxes will more than cover the cost of the bonds.

“TIF dollars are given to developer on the basis of anticipated repayment,” said Mitchell. “That repayment is going to come from incremental tax revenues: What are the taxes today, what will the taxes be once the project is developed and on the tax rolls?

“That increment,” he said, “is going to pay back the money we gave them, and there’s a spread, and that justifies giving money to the developer.” Special service areas. “A lot of these subdivisions are financed with public improvement special service areas,” Meltzer said. “It used to be that a builder comes in and builds roads, builds the infrastructure, and builds that into price of the house. With SSAs, they come along and the village issues bonds to finance the improvements, and the bonds will be repaid with property taxes. So, theoretically, they can lower the price on the house by the amount that’s being paid per home for the infrastructure — so you accelerate sales by selling a $200,000 house for $180,000, with $20,000 in the infrastructure.”

With both these types of financing — as with the financing for construction — there are projections built into the structure. In the case of TIFs, that the development or redevelopment will spur growth that will, in turn, increase the tax revenues. SSAs, Meltzer said, are based on a projection that the tax assessment on the development will be paid off with a reasonable absorption of the houses. But if the projections don’t hold, the municipality can find itself in trouble.

“When they did this bond issuance, they assumed there’d be houses there,” Meltzer said. “But in this 1,000-lot subdivision between six major national builders, that was going to happen in three years, so you capitalize the interest of the loans, bonds get sold, the improvements get put in, and they build.

“Well, now you’ve got 500 of these 1,000 units sitting there not being developed in 36 months, you don’t have capitalized interest to carry them, so the tax bill on these lots are going to start kicking in, and they’re going to start supplying their share of the SSA tax,” Meltzer said.

“So, now these lots that haven’t been built on are going to have a much higher carry because, in addition to the interest that they’re accruing on the loans, they’re also going to have a tax bill.”

“Anytime you have assistance like SSA or TIF, it’s like a loan,” Mitchell said. “If it doesn’t go according to pro forma you’ve got a deficit. It’s scary.

“There are municipalities today that know they’re woefully underfunded to the infrastructure they’ve created, based on their vision of what their community should be, and the amount of money they’ve collected for their vision.

“Unfortunately,” Mitchell said, “these municipalities have developed roads, parks, schools, and all this stuff in anticipation of growth, because they were going to be prepared when they become Naperville.

“But if projects are delayed and don’t come online,” he said, “there won’t be any increment generated, or it will be generated later, and there’s less increment available to pay those bonds, so you’ve got a problem. It’s musical chairs, and when the music stops, there aren’t enough chairs.”

Steven Elrod, of Holland & Knight, represents a number of municipalities, and, while recognizing the potential risk to municipal finances, doesn’t think villages and cities are in dangerous territory yet.

“TIFs have enjoyed tremendous success over the years,” he said. “But if anything occurs to upset real estate values in an area included in a TIF, that will step-by-step affect the money expected to be generated by the TIF.

“A TIF district can suffer to the extent that the subprime issue results in property with a lower Equalized Assessed Valuation,” Elrod said. “That will in turn lower the incremental valuation and ultimately the increased revenue expected to be generated by the TIF. If the municipality had bonds secured by revenues generated by the TIF, those bonds could be in jeopardy. If the developer was guaranteeing payback to the municipality for fronting any kind of money, the developer could be in trouble.

“I don’t think we’re in or headed toward doomsday,” Elrod said, “but cautious practitioners need to alert their clients.”

The subprime crisis is only about four months along, and, as Michael Seng of John Marshall said, it’s uncertain where this is all going to end, though for Citigroup’s Charles Prince and Merrill Lynch’s Stanley O’Neal, last seen parachuting out of Wall Street, the end came quickly.

The market will recover, though millions of homeowners will be bruised if not broken, and development will be slowed for a time. And money will start to flow again, though it may not be flying out the window as it was a couple of years ago, but that has to be to the good.

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