Editor: We last spoke in April, 2006, when real estate was on an uptick as compared to where it is today. Please remind our readers of your distinguished background as a real estate attorney.
Sernau: My history in real estate chronicles the various cycles that real estate has undergone for the past 20 years, covering both commercial and residential projects. Real estate is highly cyclical in New York City. In the late 1980s, speculative office development was the theme - speculators built office buildings without tenants. After the market's collapse, I went to Argentina for a year to represent Yacimientos Petroliferos Fiscales (YPF), the Argentine national oil company, in the disposition of assets as part of a privatization effort. Upon my return to New York in the early 1990s, the real estate market was beginning its recovery. I handled a considerable amount of commercial leasing and development work.
Editor: What types of clients do you represent?
Sernau: Generally, I represent real estate developers. I tackle the entire process, including joint venture formation, acquisitions, development construction, permanent financing, dispositions and leasing.
Editor: Significant changes have occurred in the commercial and residential real estate markets in the United States recently. Our readers would be interested in your comments, especially with respect to the current situation in the New York City metropolitan area.
Sernau: Yes, we are clearly in unprecedented times, but at least I'm old enough to have gone through this twice before. I remember in the late '70s when New York City was bankrupt or close to bankruptcy, the infrastructure was terrible and we thought it was the end. Then in the early '90s we again thought it was the end. There was no real estate activity in New York, and I left for Argentina for a year, as I indicated above. It took a solid four years for real estate to really turn around. The problem now is that financing is completely non-existent. No one really knows what the value of real estate is because the transaction pace has gone to zero, and no one knows where rents are heading. The vacancy rate is not huge although there's a lot of shadow vacancy, that is, space that isn't officially on the market. But it's not like the early '90s when we looked through empty buildings. Ultimately we're going to come out of this trough as we always do.
Editor: Is this downturn primarily showing up on the residential or the commercial side of the metropolitan area?
Sernau: Both. I deal in the residential market in the sense that we represent developers of commercial residential properties. In the last cycle residential development was unbelievable. It was pretty simple math: you could build an office building and sell it for $800 a square foot, but you could build an apartment building and sell it for $2,000 a square foot. So that's why there was so much residential development even in unlikely places. Today I'm sitting in my office on Times Square and looking out my window to see ten condominium developments in Hell's Kitchen. In the commercial world development has been wiped out. The only transactions that are taking place are where there is seller financing. For example, we just last week represented CBRE Investors in purchasing 1540 Broadway, the only material transaction that has happened in the past four or five months. In that instance the seller provided the financing, so the buyer really just put in fresh equity. At this time a year ago I was representing Boston Properties in acquiring the GM building and four other assets from Macklowe. But that was a distress situation where the existing lenders provided the financing, so there was no need for fresh debt. In sum, the lack of financing in today's market is just completely cutting off real estate activity.
Editor: At a time when many projects have stalled because of frozen credit markets or tenant caution, some developers have attempted to renegotiate or even rescind their commitments, asserting material adverse effects or force majeure clauses in their agreements. Our readers would be interested in your experience and views.
Sernau: Yes, that was illustrated by the Trump case in Chicago.
Editor: Have you seen this argument being used in other situations?
Sernau: I haven't. Most force majeure clauses will say that the failure to pay money can never be a force majeure basis for why you can't pay money. If you're telling me that there's a strike and you can't fix the elevator, that reasoning will stand, but the failure to pay money can really never be asserted as a force majeure event.
Editor: Are commercial tenants seeking to restructure leases?
Sernau: Yes, every day. We just finished representing Hines Interests in dealing with 499 Park Avenue where the Dreier law firm that went into bankruptcy had 130,000 square feet under lease. Every day tenants are saying: "Look, I just can't pay the rent" and the landlords are saying to themselves: "Well, I can throw the guy out but then what? To get that new tenant in I have to pay another broker, I have to give a new tenant an improvement allowance, and because the new guy is not going to be in there tomorrow, I have to face six or nine months of down time, best case." So the landlord makes a deal: "I'll give you a break now. When things get better you have to pay me back."
Editor: Has the proposal to give cram down power to federal bankruptcy judges affected the commercial and residential real estate market in New York City?
Sernau: It's not just cram down in the context of bankruptcy. Lenders might have very strong legal positions, but the last thing they want is to hold the real estate. Neither the borrower's nor the lender's side has much wiggle room The first thing you have to decide is whether or not the borrower is a thief, or he's just a victim. If the borrower is not a thief, and that's frankly the case 97 percent of the time, he's a perfectly legitimate borrower. It's simply the wrong real estate in the wrong market. Once the lender reaches that conclusion, what does the lender do? Is he able to do any better a job than the developer? The answer is usually no.
Keep in mind that most real estate loans are non-recourse, leaving the borrower personally off the hook. It's not as though the lender is in such a great position, especially in residential deals. A perfect example is a case where condominiums were sold before the building even went up. Assume the buyers have all put up their deposits, but the borrower now defaults. The lender is in a position to foreclose and take over the real estate. If this happens, all those purchasers who have made deposits have the right, under the terms of the Martin Act that governs condominium sales in New York, to rescind their contracts, because this would be a material change. So, if the lender forecloses, he loses his whole collateral.
Editor: Do you see parallels in the current climate with what happened under the RTC for resolving the residential mortgage problems? What about current proposals by the Administration to resolve the subprime and alt-A mortgage problems?
Sernau: A long time ago my firm represented the RTC in working out some loans. It appears that the present situation presents some of the same problems. If the lender does make a deal with the borrower, the borrower has tax problems that may cause the borrower to make an extra effort to accomplish the financing. Even if he is completely underwater, he might be enticed to make additional equity contributions to protect the real estate and to stay in the deal. Why? Because if the lender forecloses on an amount tantamount to the debt, the non-recourse borrower has a taxable gain equal to the amount of his debt relief - but no cash with which to pay it.
Editor: There was an article in the paper just the other day about some homebuilders trying to sell a new house, at let's say $250,000, and the same model, same design, in the same development is being sold by an original purchaser for a $100,000 less.
Sernau: Right. Once the market comes to the realization that values have dropped by 50 percent or 40 percent, the vultures start coming in and the sellers face the music and sell. Then you know things will pick up. But we are in this shoulder period of tentativeness now and there is just nothing happening.
Editor: The New York Times has just announced a significant sale and leaseback of its headquarters building. Do you see that as a trend in these credit markets? Will institutional investors, REITs and other sources of capital be looking to lend or otherwise invest in hard assets, rather than lend against corporate balance sheets?
Sernau: I don't know. I think that there are all types of people who say they are ready to be opportunistic. But I think that people just don't know where the bottom is and they are not quite ready to pull the trigger. The New York Times building, as I understand it, was really just a financing transaction to provide the Times with additional liquidity. It is as though the New York Times just went out and borrowed money, offering as collateral a lien on its real estate.
Editor: How do you see the redevelopment of the "Ground Zero" site progressing?
Sernau: That is a hard one. It is just so very political. The only tenants there are essentially government offices. I don't see how you can redevelop that site without real bona fide tenants. What I think should happen is that the United Nations, whose buildings on the East side of Manhattan are literally falling apart, should move downtown to Ground Zero. This happens to be the one use that would make sense for Ground Zero, but it would be such a political problem, nobody would ever do it.