Pay your loans or I’ll foreclose, threatens the lender, believing that to be an effective threat.

Or is it?

As illustrated a The New York Times article from a couple of months, there’s a huge difference between property, loans, and assets:

When the New York developer Harry B. Macklowe acquired the Drake Hotel almost three years ago and began buying up surrounding properties, market specialists expected him to include the site in a mammoth luxury office development.

After the downturn in credit markets, however, Mr. Macklowe defaulted on his loans, and bidders are now vying for the Park Avenue site at fire-sale prices.

A year ago – how things change! – I profiled Mr. Macklowe’s situation, speculating that he would dodge the bullet:

I thought he was nimble enough

What we have here is a complicated game of possible wealth transfer.  Each of Mr. Macklowe’s creditors is entitled to something — but they do not have control over specific assets.  Mr. Macklowe, for his part, has plenty of assets, that he can turn into cash by selling.  What gets sold, and to whom, is his choice.  So if there are bargains to be got, Mr. Macklowe may choose who gets them.

Slightly used trophy properties for sale … cheap

Some of the wiliest players in the real estate business have already been circling Mr. Macklowe.

This past fall, Vornado Realty Trust, of which Steven Roth is chairman, bought a stake in loans collateralized by four of Mr. Macklowe’s buildings on an apparent bet it might snare some great real estate on the cheap, bankers and real estate executives said.

I admit, watching these titans maneuver for leverage is just plain entertaining.  Straight out of Field of Dreams and other melodramas of the prairie, Mr. Roth’s company — which now is probably glad it lost the Equity Office battle to Blackstone — is hoping that by owning a piece of the debt, it can increase its chances of eventually owning the equity.

 “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.”

William Macklowe is 100% right.  Will being right be of any value to him?

Cypher: I know what you’re thinking, ’cause right now I’m thinking the same thing. Actually, I’ve been thinking it ever since I got here: Why oh why didn’t I take the BLUE pill?

Yet even as Mr. Macklowe’s company clings to the control seat its equity gives it –

I can sling the bull with the best of them

– others are jockeying for better position in the Tranche warfare about to break out:

But the Drake site is not for sale directly. What is available is a $200 million mortgage for the swath of land, which covers a third of a city block between Park and Madison Avenues and 56th and 57th Streets. The buyer of this note will own a majority of the most senior piece of the debt, and so will most likely be paid back first should Mr. Macklowe have enough funds. If he defaults, the owner of the note will be in the best position to take ownership of the underlying property through a foreclosure.

My debt’s got position over your debt

This deal highlights a shift in the commercial real estate market, away from brick-and-mortar properties and toward the buying and selling of debt.  “We are expecting a flurry of deals like the Drake Hotel site, where it is the loan that is for sale, not the actual real estate,” said Robert L. Freedman, the executive chairman of Williams Real Estate, a New York firm. The company is now creating a distressed-property group to handle such transactions.

Lots of people are ‘creating distressed-property groups.’

We’re creating a ‘distressed animal group’

During the real estate boom of recent years, developers increasingly used debt to finance their acquisitions. Now, with the market cooling, some of these borrowers are beginning to default. This is leaving lenders — including banks, private equity firms and hedge funds — in the position of owning the real estate.

To be technically precise, to be able to own the real estate if they wish. 

“Loans don’t typically go into default immediately when there is a downturn in the market,” said Robert Knakal, the chairman of the brokerage firm Massey Knakal. “In the beginning, owners continue to make payments on their loans, hoping things will turn around, or if the loan is relatively new, it may have a significant interest reserve that is still carrying the note. So defaults on mortgages are a lagging indicator of market conditions.”

Knakal’s waiting for the lagging indicators

Some people don’t wish to become owners:

Many lenders are looking to offload these loans because they need to cash out quickly, or because they are not in the business of selling real estate and lack the necessary resources and expertise.

Who sells defaulted or soon-to-be-defaulted loans?

• Entities that need cash now.
• Entities that lack the expertise to make the quick and sharp choices necessary.
• Entities that have some expertise but other fish to fry.
• Entities that have written the loan down below its expected resale trading price, so they can get an earnings bump by disposing of the property.

We Sellers need cash now!

If something needs to be sold, enter the brokers!

This means that commercial brokers, who regularly negotiated the acquisition and sale of properties, are now marketing mortgages and other loans.

“I am being inundated with calls from banks who want to sell their loans,” said David Schechtman, a senior director at the commercial brokerage firm Eastern Consolidated.

Does he look inundated?  Schechtment

Who buys defaulted or soon-to-be-defaulted loans?

• Entities with cash.
• Entities that think they can make fast and smart choices.
• Entities that can transact on or operate the property or assets.
• Entities that think they can improve the property’s underlying performance if they can gain control of it. 

Well, maybe more confidence-inspiring than that

“In just the last few weeks, I have also collected a list of about 30 clients — primarily high-net-worth individuals, long-established real estate families and small opportunity funds — who want to buy up these loans.”

Observe the characteristics implied by that list:

• High net-worth means people with money.
• Long-established real estate families means people with expertise.
• Small opportunity funds means people who can move fast.

That’s the right mix of talents.

Cash-rich developers and wealthy individuals are maneuvering to take advantage of the shift.

We have the right mix to take advantage

Despite this delay, there are early indications of an increase in loan sales. “Clearly, there has been a pickup in sales volume,” said David F. Dorros, a managing director at CB Richard Ellis.

It’s called ‘creating liquidity.’

Some are buying performing loans, where the borrower is continuing to pay interest on the debt. In this case, the buyer acquires the loan at a discount, but continues to receive interest payments. Then, when the loan comes due, the buyer is paid back the full face value.

Markets thrive on asymmetry of information and asymmetry of perception. 

I see things you don’t

You may think the loan will default; I may expect it won’t. 

You may fear that after default, the collateral will plummet in value; I have a plan to recapitalize it.

“The cash bind that many lenders are in is much more acute today than in the early 1990s,” when the previous major downturn in commercial real estate occurred, Mr. Knakal said.

As the binds tighten, more people will want release from the headache.

Wait ’til we tighten this

Anticipating default and anticipating loss given default are the very stuff of secondary-market trades.

Others are snatching up nonperforming loans, where the borrower has defaulted on the payments. In this case, patient buyers, including developers and private equity firms, may acquire the debt at a discount and eventually take ownership of the underlying real estate — usually after court action.

Loans with an above-market interest rate can stay in defaulted-but-not-foreclosed status for months and years, if the parties work out a modus vivendi.

We’ve worked out a modus vivendi

In the current environment, however, the volume and complexity of deals are expected to be much greater than in the past because so many of the loans were grouped together and converted into bonds.

As we’ve seen, if the lenders can’t work together, then they all go over the cliff together. 

We’re sure someone is in charge

Volume, in fact, will overwhelm all. 

We’re hearing a lot of noise like this

Many of the distressed-debt buyers or asset managers will move into the space because they have the combination of capital and broad management expertise to work out the individual assets.  It’ll take both.

As the market grows accustomed to the sale of loans, many eyes will be trained on the Drake Hotel site.

“It will set a floor price, establishing new benchmark metrics for the new economic realities,” Mr. Freedman said. “The Drake is just the tip of the iceberg; stay tuned, there is more to come.”

Robert L. Freedman’s firm in Manhattan is forming a group to handle loan sales.  “We are expecting a flurry of deals,” he said.

Meet the undertaker.

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