The unexpected hanging: Part 2, Too many banks here anyway

July 24, 2015 | Austria, Banking, Consumer protection, Currency risk, Eurozone, Global news, Homeownership, Lending, Mortgages, Risk, Swiss franc | No comments 261 views

[Continued from yesterday’s Part 1.]

By: David A. Smith

Yesterday’s Part 1 told half the story of an Austrian homeowner and acquaintance of columnist/ pundit David Frum. as described six months ago in The Atlantic (January 29, 2015), whose astonishment at being assessed a €12,000 mandatory loan prepayment demand, because though paid in Euros and living in a Eurozone country, he had chosen to borrow in  a loan denominated in the stronger and neighboring currency:

Enter mortgages denominated in Swiss francs. Interest rates in Switzerland have historically ranked among the lowest in the world. (You can get a Swiss mortgage today for a fixed rate as low as 1.5%.)  

Of course it never occurred to Mr. von Trapp that his bargain rate came with a stinger – the currency risk.  In effect, he was being paid a ‘currency risk premium’ equal to the difference between the interest rate he would have paid had he denominated the loan in Euros (his own currency, mind you!) instead of Swiss francs.


There’s a reason Euro rates are higher than Swiss franc rates

During the real-estate bubble of 2005-2007, mortgage rates in Central and Eastern Europe could cost in the double digits. Many homeowners were tempted to borrow in Swiss francs instead.

But Mr. von Trapp didn’t think about that – he just grabbed the lower ‘teaser’ rate, except that unlike US subprime borrowers, the teaser reset wasn’t a date certain, it was an unexpected hanging based on the currency and mortgage markets.

The temptation was especially acute because it was invisible. As a paper published by the Swiss central bank explained, Swiss-franc mortgages “rarely involve cash flows in Swiss francs. All loans are disbursed and all installments are paid in [local currency]. It is merely the value of the installments due and the value of the outstanding loan which are indexed to the [Swiss franc].”

That’s an awfully generous interpretation of Mr. von Trapp’s blithe ignorance.


We’re happy in our oblivion!

Typically, the lending institution was not a Swiss bank either, but the same retail bank where the customer made deposits and wrote checks.  

The loans looked extra cheap because local currencies in Central and Eastern Europe were gaining value during the real-estate bubble, as investors anticipated Poland and Hungary joining the eurozone in short order.

That makes me even less sympathetic to the borrowers; they were riding the currency game up, never expecting it could go down.

In Central and Eastern Europe, however, Swiss debt flowed into the household sector: Roughly 90% of all Swiss-franc debt in Poland was loaned to households.

As our friends the Greeks have just found out, Timeo germani praesertim dona ferentes [Translation courtesy of Matthew Healy – Ed.], or if you borrow in Danegeld, you may never get rid of th Dane. 

Altogether about 566,000 Polish households, 150,000 Romanian households, and 60,000 Croatian households bought Swiss-franc mortgages. Most astonishing of all was the Hungarian case: half of all households in Hungary contracted foreign-currency debt, almost always in the form of Swiss francs.

It was, in a word, epidemic.


We don’t want to catch a franc-loan

Foreign-currency mortgage holders suffered badly during the financial crisis of 2008. In a crisis, investors turn to the familiar and the seemingly secure—and few financial assets on earth are as familiar and secure as the Swiss franc.

This is precisely the reason Swiss franc borrowing was cheaper than euro borrowing, and it’s the same phenomenon – the Minskey moment – I reported on this blog so many years ago.


The value of Central and Eastern European currencies relative to the franc tumbled, as the monthly payments on mortgages linked to the franc proportionally spiked. Governments desperately scrambled to relieve debtors. Poland banned new Swiss-franc lending; Hungary experimented with postponing interest payments and adding them to the principal ultimately due.

As I’ve written many times, never borrow across borders, and never lend across borders.  Both sides take risks they don’t understand and can’t well hedge.  If you’re providing cross-border funding, either make it really low leverage, or make it an equity-type instrument.

Then, in 2011, an unexpected respite arrived. The euro crisis of 2010 presented Switzerland with a nasty dilemma.


Don’t borrow in Euros

The same search for safety that devalued the Polish zloty and Hungarian forint in 2008 now devalued the euro against the franc, sending the cost of doing business in Switzerland soaring. In 2011, the European Union’s statistical agency rated Switzerland’s consumer costs as the continent’s highest. Swiss exporters and service providers were in danger of being priced out of business. Responding to their complaints, the Swiss central bank pegged the franc against the euro in September 2011 at a rate of 1.2 francs to the euro.

Peg all you want; if there’s trading, you have to deal with the flows, otherwise things are overpriced or underpriced.


We can hold things in place that way

Currency pegs usually end badly, but that’s because countries typically peg in the face of downward pressure on their currency: a central bank says that one Ruritanian dinar is worth one US dollar, the markets test that claim by selling dinars back in exchange for dollars, and the Ruritanian central bank eventually runs out of dollars and has to give up.

But the situation is very different when a central bank is pegging against upward pressure. If the markets think the Swiss franc is worth more than 1.2 to the euro, they’ll keep selling euros to buy Swiss francs. The Swiss central bank, in turn, will never run out of Swiss francs. There seemed every reason to believe that the Swiss franc-euro peg would hold forever—or, at least, for as long as Geneva hotel owners wished to remain in the international conference business.

The Swiss, in short, could keep printing francs, and as long as Euro customers kept buying them, the Swiss were exporting the most intangible thing of all – their credit rating.  The Swiss central bankers must have been bewildered.


Is the Eurozone going poopie?

Everywhere in Europe, traditional modes of leadership and established institutions are unraveling.

Then, without warning, Switzerland changed its mind.

Perhaps because the Swiss had lost all confidence in the eurozone’s management, say for instance its mangling of the perpetual Greek crisis.


It’s all in the name of principle

On January 15, 2015, the Swiss central bank ended the peg—and the franc almost instantly rocketed up 20% against the euro, and even more against the currencies of Central and Eastern Europe.  


Sure looks like something happened all at once

Imagine having your mortgage indexed to the price of gasoline during a gas-price spike, and you’ll have some idea of the shock that greeted people like my breakfast companion.

Good metaphor.


Way to go, California!

It’s not clear exactly why Switzerland did this. Whatever the motive, what matters here are the consequences for Central and Eastern Europe: an even deeper plunge into a mortgage crisis, and further destabilization of already troubled democracies.

Croatia has announced that it will peg its currency, the kuna, to the Swiss franc for a year to protect mortgage holders. It’s a desperate measure, one that could cost Croatia at least 30% of its currency reserves as skeptical investors sell kuna to buy francs.


Let’s not amputate our economy, okay?

Arguably even more dangerously, if the peg to the franc does somehow hold, and if the franc continues to rise against the euro, Croatian goods and services could seem more and more expensive to German, French, and Italian customers. But Croatia’s already unpopular Social Democratic government is terrified, and terrified politicians make reckless decisions.

Reckless and shortsighted decisions, often with no endgame or exit strategy.

The Romanian parliament is debating a similar move. Poland’s populist Law and Justice Party is demanding that the government freeze Polish Swiss-franc mortgages at the January 14 exchange rate, but the government is hesitating to go that far.


Polish zlotys per Swiss franc

Instead, it’s trying to negotiate a “pain-sharing” agreement with national banks and threatening them with “social pressure” if they do not comply.  

Ominously, one regional government has gained a huge boost of prestige as a result of the crisis: Viktor Orban’s in Hungary. After all its other debt-relief measures failed, Orban’s regime in the fall of 2014 ordered all mortgage lenders in Hungary to convert their Swiss-franc loans into Hungarian forints.

Most of the press I read implies that Mr. Orban is an autocrat heading toward strongman and then dictator. 

Orban explicitly rejects the idea of “liberal democracy,” identifying Russia, Turkey, and China as more successful models for ambitious nations.


Make up your mind, then act

Perhaps he is out of the mold established by Ataturk (Turkey’s first prime minister, in office for 15 years, until his death) and emulated by Lee Kuan Yew (Singapore’s prime minister for 31 years, followed by another 14 as ‘senior minister’ and 10 after that as another special minister), but if so, he at least has the autocrat’s virtue of decisiveness:


“David, you should be more decisive.”

“Maybe … maybe not.”

This high-handed measure imposed heavy losses on the banks, which Orban shrugged off.

Hungary’s banking sector is heavily foreign-owned, and the ultra-nationalist leader has little sympathy for foreign business, especially financial business.


The forint stops here

Orban’s central bank chief sent a blunt message to the Austrian, Italian, and Belgian banks that dominate the local market: We have too many banks here anyway.  

The entire Eurozone is based on an elaborate dream – that all disputes can be settled not only without war or violence, but also without confrontation. 

After the events of January, his example may look more creditable to Europeans in search of escape from seemingly unending financial and economic crisis.

Let us not forget, Mussolini and Hitler both came to power out of national humiliation brought on by economic contraction caused by unserviceable debts.


Said simultaneously:

”Can you believe I have to work with this pompous prig?”

”Can you believe I have to work with this pompous prig?”

The unexpected hanging: Part 1, Before it was pushed

July 23, 2015 | Austria, Banking, Consumer protection, Currency risk, Eurozone, Global news, Homeownership, Lending, Mortgages, Risk, Swiss franc | No comments 174 views

By: David A. Smith

The man was sentenced on Saturday. “The hanging will take place at noon,” said the judge to the prisoner, “on one of the seven days of next week. But you will not know which day it is until you are so informed on the morning of the day of the hanging.”

Martin Gardner, The Unexpected Hanging


A man who lived (unexpectedly) to 96

To borrow is to take on risk, and risks divide into two sets of two dimensions – perception and influence – of those we cannot influence, we tend to undervalue those we poorly perceive or understand even as we overvalue the benefits of things we both perceive and control.  That, in a windy nutshell, explains why borrowers do foolish things like taking a lower rate (perceptible benefit) in exchange for an abstract uninfluenceable risk (currency fluctuation) – even sophisticated people who absolutely should have known better, as reported by David Frum (a good reporter, though no expert in finance or economics) six months ago in The Atlantic (January 29, 2015):


Pundits gotta talk, don’t they?

My breakfast companion looked gloomy.

[For what it’s worth, Mr. Frum’s column, along with a half-dozen others, appeared roughly two weeks after my blog post, Better to be franc? – Ed.]

For convenience, we’ll call the Austrian borrower Mr. von Trapp.


Why ever would you pick that name?

He’d flown into Washington from Vienna the day before. When he deplaned, he found a shocking email waiting for him: a demand from his banker for immediate payment of €12,000.  Although a resident of Austria, he had taken a home mortgage in Swiss francs, which carried a lower interest rate than mortgages in euros.

At points like this, I always wonder, What were you thinking?  Did you think lower interest was free?

Two days earlier before he had arrived in the United States, the Swiss franc had surged by 20% against the euro.

That action requires a flashback to two weeks earlier, as reported in the Economist (January 18, 2015; buff blue font):

So on January 15th, when the Swiss National Bank (SNB) suddenly announced that it would no longer hold the Swiss franc at a fixed exchange rate with the euro, there was panic.


The franc soared.


Predictable or unpredictable?

On Wednesday one euro was worth 1.2 Swiss francs; at one point on Thursday its value had fallen to just 0.85 francs. A number of hedge funds across the world made big losses. The Swiss stock market collapsed. Why did the SNB provoke such chaos?

The SNB’s action almost perfectly demonstrates the predictable- unpredictable paradox I first encountered in Martin Gardner’s The Unexpected Hanging:


This is an expected hanging

The judge was known to be a man who always kept his word. The prisoner, accompanied by his lawyer, went back to his cell. As soon as the two men were alone the lawyer broke into a grin. “Don’t you see?’ he exclaimed.  “The judge’s sentence cannot possibly be carried out.”

“I don’t see,” said the prisoner.


“Let me explain. They obviously can’t hang you next Saturday.  Saturday is the last day of the week. On Friday afternoon you would still be alive and you would know with absolute certainty that the hanging would be on Saturday. You would know this before you were told so on Saturday morning. That would violate the judge’s decree.”

“True,” said the prisoner.

“Saturday, then is positively ruled out,” continued the lawyer. “This leaves Friday as the last day they can hang you. But they can’t hang you on Friday because by Thursday afternoon only two days would remain: Friday and Saturday. Since Saturday is not a possible day, the hanging would have to be on Friday.”


“I get it,” said the prisoner, who was beginning to feel much better. “In exactly the same way I can rule out Thursday, Wednesday, Tuesday and Monday. That leaves only tomorrow. But they can’t hang me tomorrow because I know it today!”

In brief, the judge’s decree seems to be self-refuting. There is nothing logically contradictory in the two statements that make up his decree; nevertheless, it cannot be carried out in practice. That is how the paradox appeared to Donald John O’Connor, a philosopher at the University of Exeter, who was the first to discuss the paradox in print (Mind, July 1948).

Mr. von Trapp, like our imaginary prisoner, used logic to rationalize that his execution was impossible, even though sentence was passed four years earlier:

The SNB introduced the exchange-rate peg in 2011, while financial markets around the world were in turmoil.  

Investors consider the Swiss franc as a “safe haven” asset, along with American government bonds: buy them and you know your money will not be at risk.  

I’ve previously posted how the dollar’s implausible strength derives from America’s image as capital’s safe haven or bolt hole – but when one buys a currency (or invests equity in that country), one is also buying a currency-exchange risk. 


They look equal to me

Investors like the franc because they think the Swiss government is a safe pair of hands: it runs a balanced budget, for instance.

The US has the further advantages over Switzerland of (a) size, including of investable assets such as real estate, and (b) of tolerance for immigrating capital and people. 


I was wobbly there for just a minute

Having decided to hold the currency’s appreciation against the larger and wobblier Euro, the Swiss National Bank found itself in a situation not unlike AIG’s: it was the sole counterparty against a strong market tide.

As investors flocked to the franc, they dramatically pushed up its value. An expensive franc hurts Switzerland because the economy is heavily reliant on selling things abroad: exports of goods and services are worth over 70% of GDP. To bring down the franc’s value, the SNB created new francs and used them to buy euros.  Increasing the supply of francs relative to euros on foreign-exchange markets caused the franc’s value to fall (thereby ensuring a euro was worth 1.2 francs).

As a result of selling a commodity everybody wanted (Swiss francs) at a price lower than the market thought they were worth, the SNB bought a ton of the commodity that it didn’t want:

Thanks to this policy, by 2014 the SNB had amassed about $480 billion-worth of foreign currency, a sum equal to about 70% of Swiss GDP.

Most of that specie will be in Euros – and there came a point when the SNB had had enough:

The SNB suddenly dropped the cap last week for several reasons.

[1] Many Swiss are angry that the SNB has built up such large foreign-exchange reserves. Printing all those francs, they say, will eventually lead to hyperinflation. Those fears are probably unfounded: Swiss inflation is too low, not too high.


Swiss inflation is lower than the Eurozone’s, but closer

In the short run, anyhow, but in the intermediate run, who can say?

But it is a hot political issue. In November there was a referendum which, had it passed, would have made it difficult for the SNB to increase its reserves.

Elections have consequence, don’t they, Mr. Tsipras and Ms. Merkel?

BERLIN, GERMANY - MARCH 23:  German Chancellor Angela Merkel and Greek Prime Minister Alexis Tsipras depart after speaking to the media following talks at the Chancellery on March 23, 2015 in Berlin, Germany. The two leaders are meeting as relations between the Tsipras government and Germany have soured amidst contrary views between the two countries on how Greece can best work itself out of its current economic morass.  (Photo by Carsten Koall/Getty Images)

BERLIN, GERMANY – MARCH 23: German Chancellor Angela Merkel and Greek Prime Minister Alexis Tsipras depart after speaking to the media following talks at the Chancellery on March 23, 2015 in Berlin, Germany. The two leaders are meeting as relations between the Tsipras government and Germany have soured amidst contrary views between the two countries on how Greece can best work itself out of its current economic morass. (Photo by Carsten Koall/Getty Images)

“You’re a lying deadbeat.”

“You’re a self-righteous idiot.”

[2] The SNB risked irritating its critics even more, thanks to something that is happening this Thursday: many expect the European Central Bank to introduce “quantitative easing”. This entails the creation of money to buy the government debt of euro-zone countries.

In fact, the ECB did start printing more money, so the SNB was prescient:

That will push down the value of the euro, which might have required the SNB to print lots more francs to maintain the cap.

Clearly the SNB jumped before it was pushed.

[3] There is also a third reason behind the SNB’s decision. During 2014 the euro depreciated against other major currencies. As a result, the franc (being pegged to the euro) has depreciated too: in 2014 it lost about 12% of its value against the dollar and 10% against the rupee (though it appreciated against both currencies following the SNB’s decision). A cheaper franc boosts exports to America and India, which together make up about 20% of Swiss exports. If the Swiss franc is not so overvalued, the SNB argues, then it has no reason to continue trying to weaken it.

That may have been true, but I think it was cover and Reason 2 was the real one.


It’s just a cover story

The SNB should not be lambasted for removing the cap. Rather, it should be criticised for adopting it in the first place. When central banks try to manipulate exchange rates, it almost always ends in tears.

It certainly put a frown on Mr. von Trapp’s face:

Angela Merkel frowning

I get so tired of listening to Schauble

That currency appreciation had wiped out his equity in the house. His frightened banker wanted a new infusion of cash to replace the vanished equity.

Although not stated explicitly, one can deduce that the loan contained provisions requiring the borrower to maintain certain solvency ratios – probably a maximum loan-to-value (LTV) and a maximum debt-service-to-income (D2I), and if the interest rate was reset upwards (by the currency revaluation), then the monthly debt service would go up, and to keep D2I in line would have required paying down principal on the loan.

All this would have been spelled out in the loan and mortgage instruments, in clear if technical language, and Mr. von Trapp would have ignored it, as would nearly every borrower.

In small European countries, especially those that don’t use the euro, local banking markets are not very competitive and often dominated by foreign banks.


The Bank of China opening a regional hub in Budapest

As capital is increasingly global, banking efficiency tends to scale upward – it’s just cheaper for the customer. 


Hungary for your loans

Of course, it’s even better for the lender if the foreign bank can persuade local borrowers to accept a foreign-denominated instrument with foreign-bank standardized provisions:

These foreign banks, which typically borrow in euros, worry about the risk of lending in the local currency. If that currency depreciates, the lending bank could suffer severe losses. Bankers being bankers, they look instead for ways to offload that currency risk onto their customers.

While it’s understandable that banks would want to shift these risks, it’s bad policy and a bad idea for market dynamics.  Lending risks come in three basic buckets:


1. Internal risks, those within the borrower’s knowledge and control.  These include whether the borrower is telling the truth about income prospects, the borrower’s intention to keep a job, and others.

2. Future household risks, which the borrower may not fully control but at least can influence: loss of income, personal injury, divorce, children’s educational costs, and more.

3. External risks, such as interest rates rising, a sudden drop in the economy, and even a major downturn in home resale values in the neighborhood.

Sound business underwriting implies that each risk should be taken by the party best able to handle it – to evaluate it, bear it, avert it, and mitigate its downside.  So the borrowers should take their own internal risks, the bank should take the external risks, and the future household risks should fall mainly on the borrower.

(To be sure, this allocation won’t work perfectly, because borrowers are individuals, so they can’t diversify, hedge, or maintain specialized knowledge the way financial institutions can.  But it’s a good working principle.)

In those years [2005-07], cheap Swiss-denominated debt spread across Europe. In Western Europe, however, franc borrowers were concentrated in the business and financial sectors, where (one hopes) they understood the risks they were incurring—and could, if they wished, hedge against them.  

Individual borrowers shouldn’t take exogenous currency-fluctuation risks – they can’t properly evaluate them, certainly can’t hedge them, and can suffer painfully if the currency goes the wrong way.  All this is a sensible role for consumer protection (Senator Warren, take note):

United States Senator Elizabeth Warren (Democrat of Massachusetts), a member of the U.S. Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Financial Institutions and Consumer Protection, listens to testimony during the hearing entitled ?Examining the GAO Report on Expectations of Government Support for Bank Holding Companies? on Capitol Hill in Washington, D.C. on Thursday, July 31, 2014. Credit: Ron Sachs / CNP / NO WIRE SERVICE Photo by: Ron Sachs/picture-alliance/dpa/AP Images

United States Senator Elizabeth Warren (Democrat of Massachusetts), a member of the U.S. Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Financial Institutions and Consumer Protection, listens to testimony during the hearing entitled ?Examining the GAO Report on Expectations of Government Support for Bank Holding Companies? on Capitol Hill in Washington, D.C. on Thursday, July 31, 2014. Credit: Ron Sachs / CNP / NO WIRE SERVICE Photo by: Ron Sachs/picture-alliance/dpa/AP Images

You think I don’t know this already?

That didn’t happen in Mr. von Trapp’s case:

[Continued tomorrow in Part 2.]

Built upon the lands of time: Part 3, 8.2% annual appreciation for 32 years

July 22, 2015 | Apartments, Co-ops, Elevators, Housing, Land leases, Land value, Mobile homes, New York City, Rental, Reversionaries, Rule of four-sevenths, Urbanization, US News, Verticality | No comments 127 views

[Continued from yesterday’s Part 2 and the preceding Part 1.]

By: David A. Smith

Rio Sand Castle

Rio Sand Castle

After capital reinvetsment

While the story reported in The New York Times (12 June 2015) of the Tower – Trump Plaza at 167 East 61st Street –


Lease expiration imminent

– has already had its Magus and its Fool, its land-sundered conception was the brainchild of the Hierophant of New York real estate himself:


Does this make my face look orange?

As for Trump Plaza, when Donald Trump built the co-op in 1983, he struck a deal with the landowner in which for 40 years, the building would pay a below-market annual rent of approximately $1.2 million.  

In fact, Mr. Trump was no fool: he sought to buy the land as well (Wall Street Journal, November 12, 2014, navy-blue font):

As Donald Trump planned the limestone-and-bronze tower on East 61st Street in the early 1980s, he said, he was unable to persuade the land owner, Donald Ruth, to sell the property. “He was totally attached to it,” Mr. Trump said recently. “He wanted me to do the deal, but he didn’t want to sell.”

Mr. Trump, ever a dealmaker, bought a long enough land lease to make the property developable (40 years) with a tail (interval not stated) to bring it up to the Rule of Four-Sevenths.

But in 2023, the rent would become 8% of the value of the land.

I mentioned above that under-market land rent gives owners a false sense of their property’s value, and so it proved here; when the end-of-bargain period appeared on their personal time horizons (basically, with ten years to go), that foreknowledge began disrupting market prices:


Apartment 11C at Trump Plaza

Mr. Corcoran could not estimate what that might be, but he advised the board that today the land would be worth about $200 million, making the annual rent $16 million. 

Trump Plaza has 175 apartments in 38 floors.

By this calculation, Mr. Cooper’s monthly maintenance fee on his three combined apartments would rise to just over $33,000 a month from the $11,000 he was paying before the land purchase earlier this year.

Of course, that’s by no means an unaffordable jump: a 200% increase over 32 years (1983-2015) working out to roughly 2.8% annual compound appreciation. 

Or done another way, of the 1983 land rent, $1,200,000, represented 8.0% of the land’s value back then, it must have been worth $15 million, and today the land is worth $185 million, a 12x increase equivalent to 8.2% annual appreciation. 


Apartment 24B at Trump Plaza

Evidently the land owner, Donald S. Ruth, was no dummy either; by hanging on to the land, he bequeathed his heirs an enormous sum (that passed, I’ll warrant, without paying estate taxes on the appreciated value).

“The building’s monthly maintenance charges were already well above the market, and this would have tripled it, essentially rendering the apartments without value,” said Jonathan J. Miller, the president of the appraisal firm Miller Samuel, who advised Trump Plaza on the deal.

Either Mr. Miller was misquoted (likely) or he misspoke; while the boosted lease payments would clearly have given the apartments’ resale value a knock, had it been likely to render them worthless the landowners would never have sold at a price that enables the residents to live happily ever after.

Residents said they were told that the price was steep but could lead to the doubling of their apartment values.

Over and over in real estate, value is lost when ownership of land is sundered from ownership of the property built on that land; reuniting them (called ‘marriage premium’ in the trade), however expensive, adds value.

The price works out to $706 a gross square foot in the building, or $825 a salable square foot. Some Manhattan land prices have topped $1,000 a square foot.

Mr. Trump, who still owns two apartments in the building, said he supported the deal, which he said would cost him more than $3 million. He said the cost to each owner was “a lot of money” but would take the building to a “whole different level.”


Just another level

Mr. Cooper and most of the owners understood that; and of course, because like likes living with like, in the living clubs that are co-operatives, most of the residents had self-selected to live with other wealthy and financially savvy people.

The Trump Plaza deal was anything but certain. “We had multiple conversations, but the owners were never interested in selling,” Mr. Cooper said. “Then lo and behold, last summer, there were issues going on with the extended family that owned the land, and there was a frothy market, so they decided to put it up for sale.”

So often it is the fracturing of beneficiaries who own slices of a high-value legacy asset that eventually induces them to sell their way out of their lost capacity to be a landowner.

The co-op had the right of first refusal –

Just as in states with mobile-home owner protection laws, the right of first refusal (which is badly phrased, it’s a ‘right to match market price’) is a critical anti-gouging consumer protection.

– so it scrambled to find the money. It could have taken out a mortgage, but then the building would have been highly leveraged.

And taking a mortgage out across the entire building would simply internalize the intra-building allocation of the capital-raising requirements, and set up complicated and argument-inducing accounting and tracking requirements, as well as forcing everybody to finance the purchase via collective action, when doubtless many of the co-op members had plenty of liquidity lying about. 

Of the $190 million it raised, $112 million came from residents who took out their checkbooks and cut a check.

Far simpler to force the issue and have each member pay his or her assessment. 


Time to borrow $185 million

“Our feeling was, taking a mortgage out was jumping from the frying pan into the fire. It was better to bite the bullet and pay it now, or not do it at all,” Mr. Cooper said.

It was; but that raised the allocation question – who should pay what fraction of the total bill?  Of course that question would have arisen in a collective mortgage; here it sharpened the question when it was still prospective (in the future), and it flushed from cover those whose capitalization was limited.

That meant Trump Plaza had to assess each shareholder based on the size and location of his or her apartment; some owners faced bills of millions of dollars.  

The assessments varied, with units on higher floors of the 39-story building paying more. Those on the 20th floor, or roughly in the middle, paid $780,000 for a one-bedroom, $1.025 million for a two-bedroom and $1.56 million for a three-bedroom, according to John Janangelo, a vice president of Douglas Elliman Property Management, which runs Trump Plaza.

I deduce that the board engaged an outside firm (perhaps Douglas Elliman, perhaps a fully independent broker or appraiser) to do an intra-building allocation, if only so they could reduce the charges of conflict of interest of board members deciding how to assess their own apartment.

Several owners, however, could not afford to pay outright. For them, the co-op had to find a solution. Some banks were wary about giving mortgages to help pay the assessment –

That’s understandable; some of the people living in Trump Plaza might not have ‘income qualified’ were they not incumbents.  Still, for common civility as well as practicality (avoiding disgruntlement by a shareholder who might choose to start a frivolous but distracting and potentially disruptive lawsuit on some ground or another), the board set and achieved a goal of 100% participation:

– but the board was able to work out a deal with Wells Fargo, which wrote approximately $50 million worth of mortgages for building shareholders.

Kudos to Mr. Cooper.


Still others could neither pay the assessment nor obtain a mortgage.  

The co-op lent them the money at 5% interest until they could sell their units and use the proceeds to pay off their share. To pay these “support loans,” the co-op board borrowed the money with plans to repay it within the next 12 to 18 months, as the apartments are sold, Mr. Janangelo said.

I feel confident that, worries aside, those who had to sell their apartments will come out fine.

[November 2014]: Ms. Park, who was raised in South Korea and studied art in California and New York, said her income was uneven.  Some years she her paintings sell well, while in others she sells nothing. That makes it impossible to get a large mortgage.

Ms. Park is, in fact, informally employed in that she is self-employed.  Debt is not for her.


WSJ 11/14/14: “Suh Park in her 30th-floor co-op in Trump Plaza. She is selling the unit because of a new land assessment.”

Working with her broker, Marilyn Fleming of Halstead Property, Ms. Park listed her 1,000-square-foot apartment for $1.7 million.

That price includes the $800,000 her apartment would have been valued at a few weeks ago and the roughly $900,000 assessment that will be due.

She said she “completely understands” that the building didn’t have any options. Still she said, “it is very depressing.”

Even the ‘unlucky’ Schoemans:

Once the land deal came through, the Schoemans were assessed $2.8 million. They re-listed the apartment for $6.595 million, raising the price because the building no longer had a land lease. They readjusted the price to $5.995 million after 45 days on the market, and are now in contract for somewhat below the asking price, Mr. Schoeman said.

After the sale closes, with the additional taxes and other fees, they expect to walk away about $2 million poorer.

That’s partly because the Schoemans over-improved their apartment, not internalizing the bump in ongoing costs occasioned by the land-lease renewal or the land purchase. 


Lots our land lease

“We took a storied building from what could have been the depths of despair and restored it to where it is now on par with some of the best buildings on the Upper East Side,” Mr. Cooper said.

Now that Mr. Schoeman has come to terms with his departure, he is philosophical:

“I got hurt. A few other people got hurt,” Mr. Schoeman said. “But by and large, it was the best thing that could have ever happened to Trump Plaza. Without doing what they did, nobody would have ever been able to sell their apartment.”


The future looks good

Built upon the lands of time: Part 2, The Rule of Four-Sevenths

July 21, 2015 | Apartments, Co-ops, Elevators, Housing, Land leases, Land value, Mobile homes, New York City, Reversionaries, Rule of four-sevenths, Urbanization, US News, Verticality | No comments 167 views

[Continued from yesterday’s Part 1.]

By: David A. Smith


End of lease approaching

In yesterday’s Part 1 chronicling the happy if expensive ending of a 32-year saga of a co-op that ‘forgot’ to buy the land underneath its apartments, reported in The New York Times (12 June 2015), we had met our Magus, Marc Cooper of Peter J. Solomon, and for every Magus there must be a Fool, or even a pair of Lovers:


Shall we married and live in a co-op?

I can’t afford it

How about a leased-land co-op?

Michael and Diane Schoeman [Collectors of vintage radios – Ed.] received one of the support loans. They say they did not know that the land rent would rise in 2023 when they purchased two units at Trump Plaza for $2.315 million in February 2011. They then spent $1.5 million combining and renovating them.

[The Schoemans have had amazing adventures in NYC real estate. – Ed.]


Published in Boston, the home of knowing nothing

I have immense difficulty believing that the Schoemans could have been so uninformed; rather, I expect that many people told them, including their real estate attorney, and they brushed aside the concern as being theoretical, and far in the future.

After their son had twins, they decided to downsize in New York and buy a home closer to their grandchildren in Connecticut. The couple put their home on the market in 2014 for just under $5 million, and say they had two potential buyers before they learned of the land rent situation.


All’s well that ends well – isn’t it?

“Then no one would pull the trigger,” Mr. Schoeman said.

Though Mr. Schoeman’s phrasing implies the buyers had failures of nerve, I think rather that the buyers (perhaps unlike the Schoemans) had proper legal or real estate advisors – someone like the aforementioned Mr. Dankner:

He had a buyer who recently fell in love with an apartment at the Beekman, a land-lease co-op at 575 Park Avenue.

“I talked him out of it. When you look at an apartment that’s been on the market for 48 weeks, and is a great apartment at a good price – “

That alone should have been a clue; if the price is so good, how can it be that in nearly a year on the market, in one of the nation’s most sophisticated residential environments, nobody jumped at it?


“– you need to understand that if you buy it and then look to sell, you will face the same set of circumstances. It is unfortunate, but true.”

Unfortunate is the word I would use only for those who did not know and could not know; for everyone else, it should be factored into the price, and willing to take some risk and invest some of their own time in understanding and managing the risk.


It’s been a series of unfortunate events

Some people consider land-lease apartments a buying opportunity –

Judging by the quotes that follow, those who are selling such land lease apartments.


Things I sell are always buying opportunities.

– “We have found that many sales to date have been people who are sophisticated in financial real estate and who are comfortable with the terms,” said Julia Hodgson, the director of development for the World Wide Group, which is building a land-lease condominium at 252 East 57th Street with Rose Associates.

While a property developer who is retaining the land can be expected to downplay the risks of not owning the land. 

 “There is perceived risk and that accounts for a portion of the discount.”

Though Ms. Hodgson is laboring womanfully to phrase things well, some perceived risks are real risks, and indeed some real risks are higher than they are perceived to be.

Objects in Mirror are Closer than they Appear

A larger risk than it appears?

In New York, many land-lease co-ops date to the late 1960s and early 1970s, when the market was strong and there was a housing shortage.  

With a couple of downturn exceptions, ever since rent control came to New York City there has always been a housing shortage.


We bought into the co-op when it first opened

In recent years, as the price of land surged to historic levels, some owners of land-lease apartments began biting their nails. Many land-lease buildings pay the landowner rent based on a percentage of the value of the land.

That shouldn’t be a surprise; most land leases should be so based, because otherwise the land lease payment loses correlation to the broader market, which means either the leasehold owner/ land tenants are overpaying, in which case their property is being drained of residual value (the mobile home case) or they are underpaying (the concessionary development-oriented lease), in which case they’re


Land values escalate as verticality potential escalates

“All over Manhattan, land values are escalating at a very rapid pace,” said Brian Corcoran, an executive vice president of Cushman & Wakefield who advised the Trump Plaza board on its land purchase.

That’s because the value of urban land is a residual – the excess of potential fully-built-out value over cost to build – and as New York goes ever more vertical, those empyrean realms become not only within reach, but value-additive to the earth below.

“There are many co-ops on ground leases and it is rare that shareholders get a chance to buy the land. But if they do, it is in their best interest to do so if at all possible.”

Naturally, and for the same reason mobile home owners should buy their land: without it, their security of tenure erodes as time passes, steadily and at an accelerating rate.

The Excelsior, a land-lease co-op at 303 East 57th Street [Built 1967 – Ed.], is facing a potential rent increase.


Going up, and not just in the air

According to the terms of its lease, every 10 years the rent resets to 6% of the value of the land.

While in 1967 six percent would have been a normal or even low yield on land value, in today’s world of suppressed interest rates, it’s now a high annual ground rent, the more so as the yield is 100% minus epsilon certain.

The co-op’s next reset will be in 2018. With prices rising, particularly along 57th Street, where a dozen luxury towers are underway, shareholders are growing anxious that the land rent could rise precipitously.

‘Could’?  Would.

“There is a potential for a high rent payout,” said Arnold Rosenshein, the president of Excelsior’s board, “but it depends on how it falls out with the economy. If the city goes into a tailspin, then the rent goes down, but if the values stay as high as they are now, it could go up.”

Evidently Mr. Rosenshein is an expert in real estate, for he has mastered the art of saying nothing.


Mr. Rosenshein and his wife Paola

Fortunately, the Excelsior’s rent-reset process has evolved the prisoner’s-dilemma game theoretical solution of mutually efficient multiple-round games.

Because the Excelsior and its landowner have gone through rent resets before, a bargaining process has been established, whereby each side presents its case to a neutral arbitrator who then determines the land’s market value. The building is in talks with the landowner to work out a deal or, possibly, a sale, but if nothing pans out, arbitration will proceed.

In these cases, arbitration benefits the ground lessee (the co-op owners) much more than the land lessor (the land owner) because it gives the co-op owners security of tenure (at a price) if not controllable occupancy cost.

Co-op owners in land-lease buildings must also confront lease expirations. Every lease is different, but most are lengthy, extending 99 years or more. But as they tick down, problems may arise.

Long ago, when first teaching myself the business via the workout case method, I developed the Rule of Four-Sevenths:

The Rule of Four-Sevenths (4/7)

The amortization period for a loan on residential property should never be greater than four-sevenths of the remaining useful period, which is the smaller of (1) the building’s remaining useful life and (2) the ground lease, including any extensions.

Example: A property with a 55 year remaining useful life and a 45 year ground lease (unextended) should not be financed with a loan amortizing any later than 25 years [(4/7 * MIN(55,45)].  Extend the ground lease to 75 years and the property can be financed with a 30-year term.

The Rule of Four-Sevenths is universal and is especially important in the emerging world, where land ownership can be highly cloudy, as it holds for any form of tenure and any type of residential property.  If a squatter can secure a no-eviction certificate with a term of 7 years, one can prudently finance a loan amortizing over 4 years.

The Rule of 4/7 explains this British graphic:


Not so much fly as plummet

For instance, residents of buildings that have less than 30 years left on their leases may have difficulty securing mortgages. “Banks are a little bit wary of land-lease buildings,” said Ace Watanasuparp, the regional manager for Citizens Bank. “If a buyer takes a 30-year mortgage, but the land lease only has 17 years left, who knows what will happen.”


Watuanasuparp’s with that?

I’m surprised Mr. Watanasuparp phrases it as a hypothetical question, because with the Rule of Four-Sevenths the answer is self-evident: No rational lender would give such a loan, any more than a bus would intentionally drive onto a bridge that doesn’t fully span the chasm.


Not financing that, no sir

The rule of Four-Sevenths covers only loss of land use, not dramatic increase in land rent, such as applies to Trump Plaza and Mr. Cooper’s co-op:

[Continued tomorrow in Part 3.]

Built upon the lands of time: Part 1, Land value = Property value

July 20, 2015 | Apartments, Co-ops, Elevators, Housing, Land leases, Land value, Mobile homes, New York City, Rental, Reversionaries, Rule of four-sevenths, Urbanization, US News, Verticality | No comments 231 views

By: David A. Smith


This post has a hero – and an unlikely one to be spotlighted in a story from The New York Times (12 June 2015) – an investment banker:


Who was that unmasked man?

Marc Cooper knew exactly what he was getting into in 2011 when he purchased three apartments at Trump Plaza at 167 East 61st Street,


Great building, great location; just one eentsy-beentsy land problem

There’s a reason caveat emptor is Latin: the emergence of land as an economic commodity (apart from its value growing crops or serfs) must date from the rise of cities, and Rome (including its out-stations like Pompeii and Herculaneum) created the world’s first cities as economic hubs.


History’s first verticalized city: ancient Rome

“I always knew it was a spectacular building. But I also understood the risk,” said Marc Cooper, a vice chairman of the Peter J. Solomon Company, the investment bank. “I always said my goal was to get on the co-op board and buy the land.”


I have the land deed right here

It is no given that the owner of a building owns the land upon which it sits – leasing of land, in fact, dates back probably earlier than ownership of land, because land could be leased from the sovereign for pasture or cultivation, giving rise to medieval or Russian serfs.


Land cultivation, not land improvement

While I haven’t researched it, I suspect that America is the first nation to have been founded with the expectation that most of its citizens would own their property – freehold, as the English term has it, to contrast with leasehold. 

The co-op was on a land lease, which meant the building did not own the land on which it stood, and paid rent to a landowner.

Most of the Caribbean was in huge agricultural leases – in Haiti, they are called affermages. 


An affermage from 1760

In Mexico, ejido land, a cultural and political heritage dating back at least to Zapata if not before, has had the century-enduring unintended consequence of impoverishing millions of Mexicans (World Bank reprint: Mexico Land Policy, A decade after the Ejido Reform; brown font):

From the 1917 revolution until 1992, Mexico has implemented a large scale, though slow, process of land reform. It distributed more than 100 million hectares, or 50% of the arable area, from large farms to the so-called “social sector”, households organized in ejidos, rural communities modeled after a mixture of soviet-style collectives and pre-colonial indigenous social structures.  

However, a continuing mandate for land redistribution undermined the security of property rights, legal provisions that made usufruct [The right to use land and then profit from its cultivation – Ed.] of ejido lands conditional on self-cultivation limited rental markets while centralized intervention by the state in day-to day governance of the ejido decreased local governance and responsibility. As a consequence, ejidos became synonymous with backwardness and poverty up to a point where living in an ejido was estimated to increase the probability of a household being in extreme poverty (Velez 1992).


Gateway to joint poverty

In fact, while rural or agricultural land suffers no value impairment from being rented and worked, urban land always does because and to the extent that the incentives of structure owner and land owner diverge.  And this divergence magnifies as the lease approaches is end, when in fact the incentives on both sides can become perverse.

That rent was scheduled to skyrocket in 2023, which would triple monthly maintenance fees and affect the value of the apartments.

In societies, such as England and America, where freehold homeownership is the expectation, urbanization and verticality posed a new challenge.  As the buildings went up, more and more individual homes would be contained within a single structure – sharing the same dirt footprint – so the two nations had to evolve group-ownership mechanisms.  Co-operatives came first, begun in New York City in the 1880’s, followed by the emergence of condominiums, which are a superior form of ownership.  But New York City, the cradle of American apartment living, had and has a large inventory of extremely high-value co-operative living clubs, whose governance challenges are even greater than those faced by high-rise condos such as Boston’s Harbor Towers.

Approximately 100 buildings in Manhattan have land or ground leases, according to several people in the real estate industry.


Owning air, not owning the ground below: apartment 21A at Trump Plaza

To the land lease anomaly, add the co-operative anomaly, and the result for the roughly 100 or so lease-land co-ops (leasing land under a condominium is generally illegal in New York City, a bit of consumer protection that I only recently discovered) is a double impairment of value relative to the ‘optimal’ land and building ownership structure:

They are mostly co-ops, although the list includes some condominiums. These buildings tend to have high monthly carrying charges because of the rental payments for the land.  

The ‘high’ monthly will connect directly, in a rational market anyhow, with the decreased value of the co-operative apartments.

Land-lease apartments tend to cost less than the competition. “Discounts in land-lease buildings are 25%, although I’m beginning to think it is more like 35% to 40%,” said Susan Landau Abrams, an associate broker at Warburg Realty.

The rational price discount depends on pure and calculable real estate economics, based on:

1.     Current lease payments versus the real estate taxes that would otherwise be paid.

2.     The lease tail (how long to a rate reset).

3.     The formula (or index) by which land rent will be reset.

4.     Whether, upon lease expiration, the property owners have a right to buy the land, at Fair Market Value (FMV) or any other formula, or whether they risk losing their property altogether.

With a bit of financial knowledge, all this can be calculated without much trouble, and in fact, in England the financing of ground leases has been thoroughly regularized:

Many buildings in London are subject to ground leases that can run for 1,000 years, said Stuart M. Saft, a partner at the law firm Holland & Knight.

Most, in fact, are no longer than 99 years.  And there is UK law allowing the land lessee (that’s the property owner) to buy extensions of the lease for formula-based payments that assure the ground lessor (the landowner) a fair and market-adjusted return as the price of land rises from time to time.

The cultivation of taming of land leases, in fact, was a triumph of urban economic governance, because it successfully balanced the rights and equities of land owners and building owners. 


A question whose asking bespeaks well evolved ecosystem

No such luck in New York, however, where land leases are much rarer than their prevalence in London, and where end-of-lease risks are much more ad hoc.

As the co-ops do not pay real estate taxes, shareholders cannot deduct as much from income taxes as shareholders in typical co-ops do.

The deductibility of real estate taxes, together with the companion and much larger deductibility of home mortgage interest, is itself an anomaly of the US tax code, one that I’d favor repealing (which, of course, puts me in the very small minority of American homeowners).

Ms. Abrams lives at 190 East 72nd Street, a land-lease co-op, and is marketing a four-bedroom there for $4 million, with a monthly maintenance fee of $14,000. She says it is deeply discounted. “This unit would probably be $8 million if it wasn’t a land lease,” she added. 

Observe that here, as in Trump Plaza, the land value is roughly equal to the building value; or said a different way, land cost equals almost 50% of total cost. 

As an illustration, and hypothesizing where necessary, let’s assume that:

·         Ms. Abrams’ land lease payments today equal 5% of land value as of 2000, and do not rise until rate reset.

·         The land today is worth 3x its year 2000 value.

·         The effective cost of capital to buy a New York City co-op is 5% (4% on the debt, 10% on the equity, at 120% coverage).

The price difference, $4,000,000, translates to $200,000 per year in differential land-related costs, or $16,700 per month.  That $4,000,000 difference also means the land today must be worth $6,000,000, versus $2,000,000 in 2000.

And that’s the ratable share of the land for one apartment in the co-operative.  You can see that Manhattan high-density residential real estate must have enormous value.

“The value of the apartments decrease because the maintenance is so obnoxiously high,” said Robert Dankner, the president of Prime Manhattan Residential.

[Each time I post about New York City real estate, I am lost again lost in the vastness of its development, sale and resale, management, regulatory and rent control system.  Whatever else NYC real estate may be, it is one long strange elevator-enabled trip. – Ed.]


Hogwarts Prep School admission, 13th floor

Mr. Dankner must be lumping the ground lease payment even with the monthly ‘maintenance’ fee; a misnomer that may contribute to some buyer confusion:


[Continued tomorrow in Part 2.]