Here in New York, we are seeing offerings of primarily mezzanine loans on investment grade properties. The interest reserves that lending institutions had required of purchasers have not as yet engendered a wave of foreclosures and properties being taken back by the lending institutions as REO in their own portfolios, but this may once again occur. Banks may not be as harsh as they were before, but eventually, they will have to protect their bottom lines. The question is whether the FDIC will require the lending institutions to protect their balance sheets by writing down the value of these mortgages.

Residential and office properties have maintained their basic values, with some increases in rental rates for the most part, especially in New York. There has been little vacancy increases especially in apartment buildings subject to rent regulatory guidelines and even with increases in operating expenses, these properties still generate sufficient income. Office properties will probably show an increase in vacancies because of the failures of Lehman Brothers, Bear Stearns and others and the subletting of existing spaces. However, there still has been no major drop in the rental rates in class A office buildings. The sector that will be most affected is the hospitality sector, where capital for new construction has virtually dried up.

If these properties have maintained their intrinsic values, how did the current crisis arise? The last few years have produced prices which we have not encountered before. Real estate normally adjusts in 10-year cycles and investors had been anticipating a correction which did not materialize. Prices kept escalating with cap rates as low as 3%. Investors were purchasing on the future value as opposed to the present value and the lending institutions supported this, with loans up to 90% of these projected values. Many investors purchased the properties with an eye to holding them for a certain term and then remarketing the properties at a substantial profit once the rent roll was increased to what they had calculated to be its future value. A cardinal rule of real estate is that you make your profit at the time of purchase, not at the time of anticipated sale.

Many of the large blocks of residential properties were purchased with the projection that there will be a significant turnover in the tenancies due to normal attrition and illegal occupancies. In New York, nothing is as valued as a rent-regulated apartment, whether it is rent-stabilized or rent-controlled. Granted, there have been abuses by tenants regarding their legal status, but for the most part, successful investigations of tenants' illegal occupancies have not been that overwhelming.

Another factor that investors considered was the large number of preferential rents granted to tenants. Although the law changed in 2003, allowing the rents to go from the preferential rent to the legal registered rent upon the expiration of a lease as opposed to the unit being vacated, in actuality many landlords were not able to achieve the registered rents from the tenants and continued to offer preferential rents.

Based on the high prices paid and the high debt service incurred, many investors are finding insufficient cash flow available to satisfy the debt service as well as projected capital improvements. In order to preserve ownership, the lending institution may require additional interest reserves or to pay down a portion of the mortgage in order to protect the loan to value ratio. Investors may choose to cut their losses rather than contributing additional capital to a project, thereby generating a foreclosure.

As mentioned before, real estate is cyclical. Although we have not experienced such a downturn in all phases of the economic system, real estate has always come back and will again, probably not to the levels of 2007, but to a more rational level based on actual balance sheet numbers and lending institutions will once again finance purchases.

Marcia Rose Yawitz is senior director at Eastern Consolidated. To contact the author, click here.

The views expressed in this article are those of the author and not Real Estate New York.