The day the debt crisis hit commercial business

Real Estate Weekly,  August 29, 2007  by Daniel Geiger

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Patrick Hanlon remembers the day, the moment even, when the tumult in the debt markets and the affect it could have on a commercial real estate transaction became fully apparent.

An executive and principal at the capital advisory firm, Ackman Ziff, which arranges the financing for commercial real estate acquisitions, it's Hanlon's job to be a particularly observant spectator on the cost and availability of capital. But nothing brings home the emotions and urgency of a crisis like being thrust suddenly into a position to potentially suffer its consequences.

It was late in the afternoon on July 27, a Friday, and Hanlon was just about to leave the office to celebrate at the beach house of Rob Rosania, an executive and partner at the real estate owner and operator, Stellar Management. Hanlon had just arranged the financing for Stellar's successful $904 million bid on a large portfolio of residential rental buildings being offered by the apartment REIT, Archstone Smith.

"We had been working for weeks on the deal and Rob and I and others involved in the transaction were going to his house for the weekend to finally relax," Hanlon said.

But before they could go, Credit Suisse, the bank that was providing virtually all of the financing for the deal, called unexpectedly and informed Rosania and Hanlon that the terms of the loan would have to be renegotiated. Touched off by subprime defaults, the debt crisis had hit. And although there was nothing out of the ordinary about the terms for Stellar's loan, its low spread--a byproduct of the ultra competitive lending market that had prevailed until that moment--had suddenly made it unsellable to the usual buyers of securitized debt who had now become spooked by the credit crunch.

"That for me right there was the inflection point, when I knew that things had changed," Hanlon said.

Stellar's deal had been struck during a time when abundant levels of inexpensive capital were allowing a growing list of bidders to compete for available real estate assets. The result of this was that buying auctions had generally become more competitive, allowing buyers less and sometimes virtually no time to conduct financial analyses on the assets they were vying for. Besides accelerating the pace at which sales transactions were done, the increasing popularity of real estate as an investment also allowed sellers the leverage to command other favorable conditions.

To formalize its winning bid and secure the portfolio, Stellar Management, for instance, had to put down a massive $50 million non-refundable deposit in May. The timing of Steilar's offer, which, if it was like any other deal at the time, was predicated on cheap financing, subjected it to the potential pitfalls of a fast-changing lending environment.

Many buyers have depended on high leverage in recent years to come up with the funds to buy real estate at a time when most property types have risen to record values. Because mortgages have consequently become so substantial, the impact of higher interest rates has been magnified. Stellar, it seemed, had been caught in a merciless phase shift of the market, having had to pay peak values bred from an extended period of inexpensive capital, yet then raise its money when suddenly that financing wasn't so cheap.

Spectators questioned whether the deal could even fall apart. Although that seemed like a dramatic sounding possibility, other, lower priced deals had crumbled. Around the same time, Antares Investment Partners was in contract to purchase the Devonshire, a residential rental building in Manhattan, but had to back out after it couldn't secure financing for its aggressively priced bid, losing the money it had used to conduct due diligence on the asset.

"The first thing that Credit Suisse told us was that we were going to close, but that the debt was likely going to have to be a little more expensive because of what was going on in the market," Hanlon said. "The way they handled it was just incredible, any bank could have said, 'yeah we'll call you back' and walked away and the deal would have been finished. But from the very first moment, they made it clear that there was no question that we were going to close."

Meanwhile, Stellar's business plan could withstand the higher cost of financing.

"This was a solid buy, we didn't even think about renegotiating the price, it didn't even cross our minds," Rosania said, referring to the generally frowned upon option a buyer has in Stellar's situation to chip away at the sales price in order to compensate for the higher financing costs and push the deal through. "We have a long term strategy and this is such a valuable portfolio of properties in quality locations that even if you have to pay a little more in the end, it still overwhelmingly makes sense. We're not the kind of buyer that was looking to go on the market to trade this next year and try to ride the momentum of just appreciation."