Charting the Market’s ‘Irrational’ Behavior

NEW YORK CITY-An upbeat outlook may be a welcome contrast to the end-of-the-world mindset that hung over the industry following the capital markets meltdown, but Morrison Foerster’s Mark Edelstein is concerned that it’s a little early to morph into Sunny Jim. “We had irrational exuberance a few years ago, and now we have irrational optimism,” Edelstein tells GlobeSt.com.

Chair of his firm’s real estate finance and distressed assets practices, Edelstein notes that there is enough market activity to justify a positive mood swing, with the CMBS revival gathering steam and new funds being launched. But he points out that real estate fundamentals by and large really haven’t improved so much as they’ve stabilized.

Earlier this year, MoFo sponsored a lenders panel at the Grand Hyatt in Midtown. At that time, Edelstein recalls, “there was such a sea change” in the market from a year earlier, when “everyone was depressed, conferences were down, people going there thought the end of the world was near. Then you fast-forward a year, and everybody’s happy.”

At the conclusion of the two-hour panel, Edelstein says, “I asked everyone, ‘Does the optimism in the market outstrip the reality?’ The answer, unanimously, was yes. Even the guys who are active on the market now all thought that people were happier than the reality, because the fundamentals really hadn’t changed in a year.”

Edelstein’s sense at the time was that despite the lack of improvement, industry members were nonetheless more optimistic “because they felt that the market wasn’t in a free-fall anymore. They didn’t know when it would get better, but they knew it wasn’t going to get a whole lot worse.”

Today, he says, “people are still optimistic, but less so than six months ago. People were expecting to see lots of new deals; there have been some deals, but not an avalanche. Lenders are chasing around after the same handful of deals.”

Eight or nine months ago, Edelstein says, “we had clients who wouldn’t finance a deal unless they had at least 300 basis points over their interest rate. Six months ago, it was 200 over, and now they’re bidding deals at 150 over,” a margin more in line with “top-of-the-market pricing” circa 2007.

He acknowledges that the market “isn’t at a complete standstill” as it was a year ago. “There’s liquidity out there, which is good,” says Edelstein. “But the liquidity can’t really be deployed. Partly it’s that there aren’t enough good deals, and partly it’s that even deals which are maturing, and are good deals, are still overlevered.”

Edelstein cites the recent example of the Takashimaya Building at 693 Fifth Ave., which sold for $142 million last month. MoFo represented the seller, Japanese retailer Takashimaya. On the first round of bids, “we figured they’d come in at $700 to $800 per square foot. They came in at $1,300.”

That was followed by a second round with a smaller group of prospective buyers, “and they bid it up another $200 per foot,” Edelstein says. “So people look at that and say ‘wow, the market must be much better and healthier than we thought it was.’ My sense is that it’s not that the market is great; it’s that there’s so much capital chasing deals.”

With some players, including a few REITs and similarly well-capitalized families,  “bidding on almost every deal of any quality,” the result is “almost as though we’re in a Manhattan mini-bubble,” says Edelstein. The extent to which this effect applies outside of Manhattan “depends on what market you’re in and what product type you’re talking about.” While Manhattan is in generally better shape, Edelstein notes that fundamentals are still declining “pretty precipitously” in markets such as Arizona and Nevada.

But the firm was involved early with the workouts of homebuilder debt, and so while the markets in housing-bust states are still on the wane, “the healthier homebuilders are starting to land things,” Edelstein says. “They’re quietly buying properties of adjacent failed projects for cents on the dollar. In a couple of years, they’ll start building again and they’ll have a very low basis on the land.”

The fact that the federal government is allowing lenders to kick the can down the road is only one of the ways in which this downturn has differed from previous ones. In fact, says Edelstein, he hasn’t really seen anything like it before. “We’re doing new deals and workouts simultaneously,” he says.