Pre-crisis mortgage bonds still haunting investors

By Joy Wiltermuth

NEW YORK, Aug 25 (IFR) - A New York City property that investors were told would be the home of another iconic Apple store has instead wound up stuck in a mortgage bond facing hundreds of millions in unpaid debt.

Apple never built a store on the 34th Street site and, like much of the bond's remaining US$1.7bn collateral, not one penny of the principal on its US$100m mortgage has been repaid.

Wachovia Securities, which sold the commercial mortgage-backed bond (CMBS), long ago went out of business.

A majority of loans left in the deal come due by December, including on 34th Street, and nervous investors are facing potentially big losses if the underlying mortgages default.

The saga of the deal - broken promises and a mountain of debt - is a reminder of how pre-crash securitizations are still punishing many CMBS investors a full decade later.

"Bond buyers that bought into the securitization bought into the propaganda provided to them," said one investor, who asked not to be named but said he had purchased some of the bonds.

"They were buying in with Apple as a tenant," he told IFR. "The bondholders are going to take a bath."

LOAN BEHOLD

The CMBS market was riding high in 2006 when Wachovia offered investors a chance to get in on the future of the 21-25 West 34th Street site in a busy shopping corridor of Manhattan.

The property was such an important part of the pool of nearly 150 mortgages in the deal that Wachovia included an artist's drawing of an Apple store on site in the bond prospectus.

Apple agreed to pay the property's owners - Wharton Properties and then-partner SL Green Realty - an average of US$6m per year in rent over 15 years, according to bond documents reviewed by IFR.

Apple looked to be a promising long-term tenant, and the developers convinced the computer company to pay for building the store itself, after the existing building was razed.

Typical of the churn-and-boom mentality before the financial crisis kicked in, Wharton and SLG then took out loans on the property for even more than its US$125m appraisal value.

Wachovia provided a US$100m senior loan and others provided US$28.6m of mezzanine debt.

Wachovia then put the entire senior portion into a pool of 149 commercial mortgages that it securitized in a US$3.4bn CMBS bond sale.

Today, banks can less easily wash their hands of such risks. Post-crash rules taking effect later this year will call on major parties selling a deal to retain 5% of what they securitize, in order to keep some skin in the game.

Back then, that was no problem for Wachovia. The problem became that Apple decided not to move in to the property.

DOES NOT COMPUTE

The rental incomes generated by properties are the cornerstone of any CMBS deal, and with an Apple store gone, 21-25 West 34th Street was a decidedly less attractive proposition.

Under the terms of the contract, Apple still had to build something at the site. But it erected something about 30% smaller - and with far less eye appeal than its stores.

Moreover the building was not completed until late in 2009, after the financial crisis had kicked in. The building has been vacant for about four out of the past six years.

News reports said the current tenant, UK clothing retailer Superdry, agreed to pay US$3m annually in rent, or half what Apple had committed to.

But a source with knowledge of the transaction told IFR that Superdry is actually paying US$1.5m in rent - or just one-quarter of what Apple had agreed on.

"At the end of the day," said Steve Kuritz, managing director in the conduit CMBS surveillance group at Kroll Bond Rating Agency, "the value of the property is directly dependent on the income it will produce."

Kroll estimates the property is currently worth US$75m-US$85m - a far cry from the US$125m valuation used to underpin the bonds when they were structured 10 years earlier.

"You're in a market right now where you have oversupply of retail and a challenging retail market," said Richard Cohan, a consultant at the 34th Street Partnership, a non-profit association that promotes business on the street.

Cohan said landlords on the same block as Superdry have been asking for rent in the range of US$650-US$900 per square foot.

But Superdry is paying around US$300 on the most expensive ground floor - and only about US$100 on the building's upper levels.

"Some are asking for US$800 a square foot," the person with knowledge of the transaction said. "But that's not the world we live in today."

PIE IN THE SKY

One final twist in looking at the valuation is that Wharton - the sole owner since buying out SL Green's stake in 2013 - has already sold off the property's lucrative air rights.

The right to build upward, or prevent someone from doing so, is vital - and expensive - in a place like New York City, where room on the ground is maxed out and up is the only way to go.

Two industry sources said they estimated that the air rights for the 21-25 West 34th Street property would easily be in the tens of millions of dollars.

According to public documents, Wharton sold them off privately earlier this year to its former partner, SL Green.

Once sold off, they are gone forever. So the property can never be raised any higher than its current handful of stories, making 21-25 West 34th Street now even less valuable.

And in a move that has raised eyebrows among those following these events, Wharton did not use any proceeds from the air rights sale to pay off even a tiny part of the senior mortgage.

Wharton Properties did not answer multiple requests for comment. Apple and Superdry both declined to comment.

Yet the bond investor said he believed that something had clearly gone wrong for those, like him, who had bought into the bonds with the belief that they would be repaid.

Of course, Wharton Properties and the other debtors still have some four months or so to clear up their mortgages.

But according to data from analytics company Trepp, which tracks commercial mortgages, only US$14m of principal has been repaid on the nearly US$1bn of the biggest loans outstanding.

The bond has taken an almost US$95m hit on other loans that have gone sour already.

US regulations have attempted to curb exactly these kinds of risks in CMBS, and they have largely worked.

In 2006, when Wachovia sold the bond, some US$214bn of CMBS bonds was sold in the US market, according to industry group Sifma. The following year, it was US$241bn.

This year so far, just US$30bn of CMBS has been sold.

But those improvements make little difference to those saddled with pre-crisis debt like the Wachovia deal, which still faces a precarious outcome one decade later.

"You are talking about losing a big number here," the investor said.

"You'd never know unless you are really digging through the weeds. This has the fingerprints of a bad deal from day one." (Reporting by Joy Wiltermuth; Editing by Marc Carnegie, Shankar Ramakrishnan and Jack Doran)