The short answer is both simple and surprising: in many cases, lowering the rent on a building will force the bank to foreclose on it.
Foreclosure is very bad for both the bank and the operator, so both parties would rather “extend and pretend,” leaving the building vacant while they wait and hope for the market to change.
This seems absurd. Surely everyone would be better off it they just lowered the rent and got some use out of the building — getting some rent must be better than getting no rent, right?
Intuition fails because normal people think of a building as a building, when in the majority of cases, a building is not a building, but a financial product. Behavior that makes no sense for buildings can make perfect sense for a financial product.
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The important thing to understand here is that the actual building is not an important part of the value calculation. We’re not really looking at the replacement cost, the unique design, the amenities, the location, etc. Those things influence the assumptions about the gross rent we can get, or the cost of operating the building (higher cost means less net rent), but at the end of the day it isn’t the building that has value, it’s the income stream.
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Remember, the building isn’t a building, it’s an income stream. Before, the operator and the bank had a model that said the operator would be able to make $1M per year. Now, reality has proven the operator can only make $700k per year.
700k per year is not worth $20M. Given our agreed-upon cap rate of 5%, this proven $700k per year income stream is only worth $700k/0.5 =$14M.
In this scenario, the building has proven to only be worth $14M, but the operator owes $16M to the bank, so he is now $2M underwater on the loan. In two more years he’ll have to pay off the full $16M, and he doesn’t have that much cash, so he’ll need to refinance.
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When year five rolls around and the loan on the building comes due, both the original bank and the owner would like to avoid losing a combined $6M. And so long as the operator can afford to keep losing $140k per year on the building… they can!
What they need to do is stick to the original model. Don’t lower the rent. Just claim that there was a blip in the market, nobody could have seen that coming, it’s all going to be fine.
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The only sticking point here is that the building operator is still losing $140k per year. But remember that if he gives up, he loses the $4M he’s already put into the building. Even if he ended up paying $140k per year for 10 years before things turned around, losing $1.4M is still better than losing $4M.
So both the operator and the bank have a lot of incentive to extend and pretend, rather than lower the rent and face the consequences of having overpaid for the building.
I found out about this book value thing a few years ago when I was looking into why my high street had so many vacant properties. I was in the first mentioned block of people who would think that...
I found out about this book value thing a few years ago when I was looking into why my high street had so many vacant properties. I was in the first mentioned block of people who would think that surely something is better than nothing, and the trail led right down your quoted list.
Eventually the wheel falls off and the buildings go for re-lease.
Sadly, most of the property around here is ultimately owned by the local aristocracy which they attempt to lease out, so there's not much incentive for him to put much effort into finding new tenants, so the lovely buildings get slowly more dilapidated over time, as more become long term empty.
A small cafe came up for lease and I looked into the finances of it, the property lease per year alone would make it not viable unless you literally had enough money not to take an income at all. Probably why the business failed. And also why they can't shift it on.
From the article:
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I found out about this book value thing a few years ago when I was looking into why my high street had so many vacant properties. I was in the first mentioned block of people who would think that surely something is better than nothing, and the trail led right down your quoted list.
Eventually the wheel falls off and the buildings go for re-lease.
Sadly, most of the property around here is ultimately owned by the local aristocracy which they attempt to lease out, so there's not much incentive for him to put much effort into finding new tenants, so the lovely buildings get slowly more dilapidated over time, as more become long term empty.
A small cafe came up for lease and I looked into the finances of it, the property lease per year alone would make it not viable unless you literally had enough money not to take an income at all. Probably why the business failed. And also why they can't shift it on.