A Balance Sheet Solution to the Economic Crisis

Mar 10, 2010, 17:13 ET from Dr. Tom McPeak, Ph.D.

ATLANTA, March 10 /PRNewswire/ -- The following is commentary by Dr. Tom McPeak, Ph.D., regarding private transfer fee covenants.

Real estate projects across the country have stalled, resulting in widespread unemployment.(1) It is not uncommon for a developer to owe $40 million on a project that was formerly appraised for $70 million, but which now appraises for $40 million.  At these valuations the project is no longer economically viable, and both the lender and the borrower are in distress.  As a result of the stalled project, both direct and related employment evaporate, property prices decline, government receipts drop, and taxpayer losses mount as banks fail.

Giving the borrower a $40 million loan, or an extension of an existing loan (a process cynically referred to within the industry as "extend, amend and pretend")(2), will not solve the problem because the project is simply not economically viable in the current environment.  In addition, while a decline in value from $70m to $40m (continuing the example above) represents a 43% decline, property values would have to increase 175% in order to restore the valuation to the prior level, an unlikely event under even the most aggressive scenario, particularly given the current lack of price discovery.

The solution is to restore the balance sheet and restore economic viability.  Simply stated, project debt must be reduced to an economically viable level.  In the current market, this can be accomplished one of two ways:  Increase the value of the project, or reduce the debt.  As discussed, in the current environment the former is unrealistic.  However, private transfer fee covenants successfully accomplish the latter, and it does so using the developer's own asset.

A private transfer fee covenant (also called a reconveyance fee covenant) assesses a "transfer fee" each time title to the real property transfers.  Private transfer fees have been around for decades, and have been used to fund environmental initiatives, green space, and HOA dues.  Recently developers have been utilizing transfer fees as a way to apportion development costs over time, instead of allocating development costs onto the first time buyers.

A developer imposing a transfer fee covenant has created a future income stream, in return for which the future payors enjoy the amenities and infrastructure installed by the developer as well as a lower sales price today.(3)

This future income stream has real value.  If a developer carves out this future income stream and sells it for its present value, the proceeds can be applied to the real estate project, reducing the loan indebtedness(4) and restoring economic viability. This is a balance sheet solution to a balance sheet problem.

When economic viability is restored, the inverse of the destructive cycle of declining property values and diminishing jobs occurs.  When a stalled project recovers economic viability, the impact on employment is immediate and sustainable.  Likewise, when development loans are brought within conforming ratios, the project owner's balance sheet is restored, the lender's balance sheet is restored, lender confidence is increased, and lending activity resumes, all of which has a positive ripple effect within the economy.  

A Manhattan-based company, Freehold Capital Partners (www.FreeholdCapitalPartners.com), has assembled a portfolio of private transfer fee covenants covering hundreds of billions of dollars worth of real estate projects across the United States.  The sale of this portfolio of long-term asset-backed income streams would inject liquidity into the most troubled areas of the economy, create jobs, reduce lender exposure to commercial real estate debt, and restore the balance sheet of distressed real estate projects.  More importantly, it would accomplish this using the developer's own asset, without creating additional debt, and it would benefit homebuyers in the form of a lower purchase price and associated transactional savings.

Private transfer fee covenants represent a fair and equitable way to apportion infrastructure costs.  In addition, these instruments offer the opportunity for injecting liquidity into communities and lenders across the United States.

About Dr. Tom McPeak, Ph.D.:  In 2000 I began teaching at one of the nation's top business schools, the Terry College of Business at the University of Georgia.  I received my Ph.D. in "Resource Development" (Land Economics) from Michigan State University.  I have studied private transfer fee covenants for several years.

(1) Signs of Recovery Don't Extend to Jobs. Wall Street Journal Online, Oct. 22, 2009.  http://online.wsj.com/article/SB125613391710198857.html

(2) See generally, Salmon, Felix. Should Banks Extend and Pretend? Reuters, Aug. 21st, 2009.

(3) Criticism of private transfer fees as "just another fee that does not benefit the homeowner" ignores the economic reality that the market adjusts to all encumbrances, and it further ignores the savings that accrue to the homebuyer when that adjustment occurs.

(4) Since an existing lender's lien position is superior to the private transfer fee covenant, the lender must be at the closing table.

SOURCE Dr. Tom McPeak, Ph.D.