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The title of this post says it all. Real estate is rarely in a state of crisis unless an earthquake or other natural disaster disturbs the structual integrity of the building. Real estate becomes distressed when too much leverage is used and the net income from the property is insufficient to meet debt service payments.Even in today’s stressed marketplace, owners who are very conservatively leveraged are doing just fine. For those who were seduced by tons of plentiful, cheap debt which was available in the market in 2005, 2006 and 2007, things don’t look so good.It is clear that the market must go through a massive deleveraging process. Properties simply cannot support the debt loads that currently exist and we have started to see this deleveraging process start. It is interesting to try to calculate the extent to which leverage must be taken out of the system. Let’s see what the New York City market shows us and try to determine what it means for the rest of the market.In 2005 through 2007, there were $109 billion of investment sales activity in New York. Based upon a breakdown of property types and their corresponding current price levels and the LTVs that had been available during the 2005-2007 years , Massey Knakal has estimated that about $80 billion worth of those sales, affecting about 6,000 properties have negative equity in them. If we add to this total those properties refinanced during this period, we add about 10,000 more properties which have negative equity levels. This adds about another $80 billion to the total debt on properties with negative equity. Using today’s metrics, what is the correct amount of debt that should be on these 16,000 properties?If we use a model which assumes a 20% reduction in rental revenue, a 200 basis point increase in capitalization rate and a loan-to-value ratio decrease from an 85% average to a more conservative 60%, the resulting debt level is 60% lower than the existing level. This implies that, of the $160 billion of debt on these underwater properties, the appropriate level of debt, based on today’s standards, should be only $64 billion!How did the bubble of 2005-2007 get so out of control? If I had a nickle for every time I heard someone say that we were in a new paradigm……..We clearly were not operating in a new paradigm. It happened because almost all of us lost sight of the fundamental rules of cyclical real estate markets. Our current economy and capital markets offer a reminder of some historically proven truths:

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