Marking to market valuation returns - with a new twist

Real Estate Weekly, Dec 10, 1997

Essentially, in an economic climate in which rents were falling, lenders would discount all rems in a multi-tenant building to the currently achievable level to arrive at the building valuation.

Today, lenders are once again marking to market, but for an entirely different reason and with substantially different results.

Today, lenders are allowing owners to gross up all rents in a building to currently achievable levels. This reflects a best case scenario for valuation. It also allows the lenders to lend more on a given property without stepping outside their set loan-to-value ratios. Moreover, being able to lend more on a property makes a lender more competitive. It's an example of how competition among lenders is dramatically changing the economics of the real estate business.

"This is a very aggressive approach to lending," said Jerry Swartz, principal of Pergolis Swartz Associates, Inc., one of the most active commercial mortgage brokerage firms in the New York area. "But in some ways it was inevitable. When competition is very hot between lenders, there are only a few things that can give: rates, loan-to-value ratios and valuations. Essentially, this trend of marking to market upwards is a strong vote of confidence in the long-term health of the real estate market."

Swartz notes that marking to market has not yet become universal. It is most frequently seen only in the strongest market segments.

"Not surprisingly, we're only seeing this in the areas in which the lenders have the most confidence," said Richard Pergolis, also a principal in Pergolis Swartz Associates. "In Manhattan, the loft market has seen a lot of this activity, and Downtown, too, where space has grown very tight and achievable rents have skyrocketed, but where average existing rents are still depressed."

A typical example of marking to market might involve a Midtown South loft building which achieved rents of $20 per square foot in the 1980's. By 1990, the achievable rent for newly vacant space in the building might have fallen to $12 per square foot. At that time a lender would have valued the building based on an average rental figure of $12 per square foot, even though there were many tenants still paying the higher rents negotiated years before.

As this typical building experienced tenant turnover, average rents began to fall, hitting perhaps $15 per square foot on average. But as rents began to rise once again in the mid 1990's, the achievable rent quickly outpaced the average rent, hitting $18 per square foot.

The most aggressive lenders today are willing to assume an average rent for such a building of $18 per square foot.

"I don't think lenders are doing anything wrong here," summed up Swartz. "Just as it was actually appropriate for them to mark a building down when that was clearly the trend in rents and valuations, it's equally appropriate for them to mark up. It's good business as long as it isn't carried to an extreme. Most lenders learned in the 1980's how dangerous taking things to extremes can be. I don't think we'll be seeing the same kinds of mistakes."