Is There a Mastro in Your Portfolio?

For the past few months there’s been a storm brewing in Seattle over a long-time commercial real estate investor and his recent involuntary Chapter 7 filing that’s put investors in a bad place.

This past week, the local media increased its reports on Michael Mastro, his business and the $100 million loss Seattle-area investors will have to recoup. The PSBJ reports his bankruptcy is one of the largest in state history and the state’s Department of Financial Institutions is investigating his transactions with private investors.

However, many others are asking, “What’s this all about?”

Today I’d like to address the Mastro bankruptcy, and what it means for investors and the local investment scene.

Let’s start with the big question.

How did Mastro get in trouble?
The simple answer is leverage. The more complex answer takes further expansion of the structure. Throughout modern times, investors of all kinds have borrowed money at one rate hoping to earn more in interest and keep the rest as profit. We all do it everyday through home ownership, business loans and the use of credit. Mastro’s mistake was simply larger and more leveraged than most.

Several years ago, a very sharp local banker explained the “Mastro Friends & Family” program to me. Simply put, the investment process involved borrowing the down payment from a bank to acquire, develop and sell real estate. There was a time when banks would only lend 60 to 70 percent of the price, later it became much higher. As a result, certain banks would have some culpability in this mess. The rest of the purchase price came from down payments, called “equity.”
For you and me, we make the down payment ourselves. For Mastro, he further leveraged his purchase by borrowing that equity from a pool of personal investors, to whom he paid eight to nine percent interest. Using this process, Mastro had the potential to acquire real estate with no money down. The system worked very well as long as real estate increased in value and bank loans were prevalent.

Today, we find an economy that has suffered falling real estate prices and banks that need cash as badly as customers do. With banks unwilling to extend the maturity on Mastro’s loans and falling property values, the Mastro empire is now being forced to hand over properties to banks. The banks in turn will sell them off quickly to the highest bidder. I expect that within a few years we will see some of those properties change hands again for a sizeable gain while other holdings will stagnate because of poor quality. The majority of the real estate holdings in Mastro’s portfolio are not considered trophy assets that top real estate investors want to own.

This leads into our second question, did Mastro pull a Bernie Madoff in our local market?

Madoff’s story is one of deceit and deception. Mastro’s story is about the risks associated with leverage. For decades, Mastro paid his investors solid returns based on real profits. Madoff, however, never had the real profits to back up his plans.

The fascinating part of the story is the decline that the Mastro empire experienced in 1992. At that time, local real estate also went bust on its way to a boom in prices throughout the later 1990s. The word I hear is that although Mastro was bruised, he was not broken, and was able to repay his debts.

What should investors have asked and why?
The lessons about due diligence and proper investigation before you invest are similar with both Mastro and Madoff. For Mastro the issue for his investors is “where am I in the line of creditors?” For Madoff the issue is one of custodianship.

The primary reason that the Mastro Friends and Family investors will suffer losses is because they were not in first position as lenders. Let me explain what first position means.

When you acquire real estate and receive a loan from your bank or mortgage company, the lender is in first position, meaning they get their money back first. If the property owner then applies for a home equity loan, that lender is in second position, meaning they get their money second. If the property owner then gets an unsecured loan to make home improvements, that lender is in third position. Common sense suggests that you are better off being up the food chain in the strongest and safest position in line. Of equal importance is whether your lender has recorded their position or not. A recorded position means that upon the sale of the real estate the proceeds at closing must be paid to the lenders before the owners. This is such a core principal that there is rarely a situation where an investor should lend against real estate unless the loan is recorded.

The mistake Mastro investors made is that their loans were usually in second or third position and were likely unrecorded.

What is the fallout for investors, the local market?
The fall out from the crash of Michael Mastro is tremendous over the short term, yet fairly insignificant over the long term. The question many of us have been asking for more than a year is, “When will Mastro fall?”

It seemed inevitable that he would lose his properties to the banks yet surreal at the same time. Even more fascinating is how few professional real estate investors ever dealt with Mastro. The Mastro empire, much like the Madoff empire, was populated by unknown “mom and pop” types. For Mastro, his investors included the Italian club of Seattle. For Madoff, it included many Jewish cultural and religious groups.

The greater lesson here is the importance of understanding when and how to use leverage. When prices are low, expand your use of leverage. When prices have climbed rapidly and assets are at their highest values, leverage should be reduced along the way.

Resist the temptation to retain high amounts of risk simply because the media suggests that times are good.