July, 01, 2008

Developers of flagging residential condo projects in the city may be faced with a new real estate Catch-22: the prospect of having to provide additional equity to lenders or take out more loans if they want to cut prices to attract buyers.

The bind is a direct result of the weak housing market, which is forcing developers to reduce prices at the same time banks are reeling from the credit crunch and have become unwilling to compromise on their loans.

The developers who do discount prices can get caught in the financial squeeze because of a little-discussed item from their mortgage known as a "release price."

What happens is that early on, the lender and developer agree on a price for each condo unit (generally about 90 percent of the sales price in the offering plan) until most of the condos are sold.

As part of that agreement, the developer cannot go below the release price without consulting with the bank, because that revenue is reserved for the lender, so it's the first entity to be paid off.

Gerald Kray, senior director at Marcus and Millichap, a national real estate investment advisor, said although prices remained strong in most of Manhattan, they were falling in borderline neighborhoods, especially in Brooklyn, Queens and the Bronx.

"The boroughs are a totally different story; that market has cooled down a lot, and the prices have fallen off," Kray said.

If a developer does need to go lower than the release price, the bank may ask the developer to bring on additional partners or to take out more loans to cover the bank's reduced revenue.

And now, those extra loans are more expensive because credit has dried up.

Plus, "the lender is going to require additional equity," said Kevin Comer, senior managing director of Beck Street Capital.

Just a year ago, banks were lending at about a 75/25 loan-to-value ratio. Now, that is closer to a 60/40 ratio.

"The well-heeled can renegotiate, [but] the weaker borrowers are going to have problems. They are getting hit on two sides: They need equity, and the cost of debt is going up," said Russell Schildkraut, principal with the Ackman-Ziff Real Estate Group.

Comer expects the weakness to expand. "We see, every day, condo projects in emerging markets of New York City such as Williamsburg or Red Hook ... where the developers are trying to get out of those deals in one form or another without having to restructure loans," he said.

"We haven't seen it in Manhattan itself, but I suspect over the next nine to 12 months, we will see it as well, especially in emerging neighborhoods like the Lower East Side and Harlem," he added.

Sofia Kim, vice president of research at StreetEasy, said developers have resisted slashing prices, which is costly and can reflect poorly on the project.

"Developers don't like to cut prices, so usually, that is the last resort," Kim said.

Abraham Hidary, president of brokerage and development firm Hidrock Realty, said he would need approval from lenders if he dropped prices by more than 15 percent in any of his deals.

"But we have never had to do that. And I can't imagine selling below that price, because we wouldn't be making any money," Hidary said.

Kray said he expected to see smaller developers lose buildings, especially in transitional neighborhoods such as the Rockaways or Bedford-Stuyvesant.

"In my own opinion, it is going to reach that point, especially with the third-tier and second-tier developers, who don't have the experience. They are usually the first to go," he said.

Developers may try to get the bank or lenders to refinance the loan at a lower rate, but real estate financial experts said that is unlikely.

"They can always go to the original lender to ... maybe reduce the rate, which is more uncommon," said Albert Marengo, chief financial officer at Gary Silver Architects, where he also consults for other developers.

Borrowers are also seeking to extend the terms of the existing loans, in hopes that the market will improve later this year.

"Banks will be receptive. No bank wants to take over a property, and at the same time, they make money," Marengo said. "I've definitely seen six-month extensions."

Elan Padeh, president and CEO of the Developers Group, said banks were aggravating slow sales by pressuring developers to market units before enough construction had been completed.

"Banks are their own worst enemy by forcing developers to do a bad thing: open a project too early," Padeh said. "It is happening to me right now. It shows the banks are panicking."

Matthew Landau, a principal with Connecticut-based real estate investor Westport Capital Partners, said lenders are simply trying to protect their profits.

"The bank just has to decide what is in its best interest. That might be foreclosure, or letting units sell cheaper, or forcing the borrower to put in more equity," Landau said.

Author: Adam Pincus