Capitalist Fools: The Impending Commercial Real Estate Bust

Commercial real estate is dominated by financial professionals, not hustlers looking for a quick flip. So why is the market about to melt down?

By Megan McArdle
The Atlantic Monthly, January/February 2010

Few places in New York are less likely to inspire grand dreams than Stuyvesant Town and Peter Cooper Village, the twin housing projects that sprawl across 80 acres of the Lower East Side. Built by MetLife in the 1940s, the project encompasses block after block of boxy brick apartment buildings and stolid public spaces, entirely barren of inviting corners or eye-catching detail. The critic Lewis Mumford dubbed it “the architecture of the Police State”; a slightly kinder motto might have been “What do you expect for $68.50 a month?” Yet when MetLife spruced up the complex and put it on the market in 2006, real-estate moguls jetted in for the sale. A joint venture put together by Tishman Speyer and BlackRock carried the day through its willingness to, as The New York Times noted, “pay up—way up—to unlock future profits in the sprawling Manhattan properties.” At $5.4billion, their winning bid made the sale the most expensive real-estate deal of all time. Three years later, however, those profits were still securely locked inside the property’s 11,232 apartments—many of which remained rent-controlled, despite strenuous efforts to convert them to upscale market-rate rentals. With net income well under projections, the partnership started spending down its reserves. Then, in October 2009, a court ruled that the partnership had improperly decontrolled the rent for thousands of apartments, and would have to return them to their original status. As of this writing, analysts are predicting default in a matter of months unless the partnership’s debt of $4.4billion can be restructured—a shaky prospect, given that the owners may owe tenants of formerly rent-stabilized apartments as much as $200million in rent overcharges and damages. Stuyvesant Town might soon set another record: the biggest real-estate default in history.
That default would be one of the first tremors of an earthquake about to roil financial markets: a commercial real-estate crisis mirroring the catastrophe in the residential market. October brought both the Stuy Town deal’s first death rattle and the bankruptcy of the real-estate financier Capmark. As annual bank failures topped 100 for the first time in almost two decades, Federal Deposit Insurance Corporation Chair Sheila Bair fretted over the threat posed to lenders by losses linked to hotels, malls, and condominiums. But even as this new impending crisis unsettles commercial lenders and borrowers, the story of its origins can shed new light on how we got into this larger financial mess in the first place.
Commercial mortgage lenders basically have to worry about two kinds of default risk: cash-flow risk, and asset-price risk. Cash-flow risk is what happens to homeowners when the primary breadwinner becomes unemployed, and to landlords or hotel owners when rental prices plummet. Since commercial tenants typically sign relatively long leases, this problem tends to grow slowly except in hotels—and, apparently, in rent-controlled properties with litigious tenants. But the risk posed by falling asset prices is a big problem for commercial landlords, and for their bankers. The value of much commercial real estate is tightly linked to employment—if employers don’t have bodies to put at desks, they don’t need more rooms to put the desks in. With unemployment north of 10percent, and retail suffering, the nation’s stock of commercial real estate is suddenly less valuable than it used to be. In some ways, price declines are a bigger problem for landlords than for homeowners. Unless forced to move, homeowners with long-term mortgages who make enough to cover their payments can sit tight and hope the market recovers. Landlords, however, typically take out commercial loans for shorter terms of three to 10 years. In normal times, landlords coming to the end of a mortgage simply roll the debt over into a new loan. But collapsing asset values have wreaked havoc on this process. Now, as loans come up for renewal, lenders have to reassess how much credit they’re willing to extend. Take a property that was worth $100million in 2007, when it was financed with a four-year, $70million mortgage. That’s a reasonably conservative 70percent loan-to-value (LTV) ratio. But if the building is worth only $70million when it’s time to roll the loan over, keeping the LTV at 70percent means that the owners can now borrow only $49million, and have to come up with tens of millions to pay off the original loan. Worse, as the markets tighten, lenders tend to want to see a lower LTV in the deals they finance. That suggests that a lot of commercial loans are going to go bad. According to Joseph Gyourko, a Wharton real-estate professor, at least $250billion worth of commercial loans are going to roll over in each of the next few years. When they do, many landlords will probably be caught short—and so will their bankers. Although most U.S. residential mortgages were bundled into mortgage-backed securities, only a fraction of commercial mortgages were securitized. Some bank or finance company still carries the rest on its books and will have to write them down if they can’t be rolled over; some of those banks will ultimately have to be taken over by the FDIC. As the banks’ loan portfolios are sold off, the write-downs of the underlying collateral will give bank examiners a new, lower reference price for the collateral held by other banks, possibly tipping those banks into insolvency as well. You get the picture. That said, the repercussions from the commercial collapse will not be as great as those from the housing sector. The commercial market is considerably smaller than the residential market. The existing FDIC system can handle the decline, which will likely hit smaller banks harder than those in the “too big to fail” bracket. Moreover, fraud was probably much more prevalent in the residential than the commercial market, where even the newbie investors tend to be financial professionals or established businesspeople, not hustlers looking for a quick flip. But given how experienced those investors were, why are our problems now as bad as they are? Fraud aside, Gyourko notes that at the height of its bubble, the commercial real-estate market displayed most of the pathologies that characterized the residential side. Only 50percent of the increase in prices between 2003 and 2008 resulted from rising rents, he says; the rest was just inflated optimism about the rents landlords would be able to charge sometime in the future. And just as in housing, banks joined the folly, increasing the LTVs and requiring less amortization over the life of the loan. Take the Stuyvesant Town deal. The investors aren’t shady subprime lenders or naive kids. Tishman Speyer has been in the real-estate business for decades, and the investors who trusted the firm with their money are sober institutions like the Hartford Financial Services Group and the California Public Employees’ Retirement System. Yet according to TheWall Street Journal, when Stuyvesant Town was sold, lenders were projecting that the Tishman Speyer–BlackRock partnership would be able to triple its net income in five years through building upgrades and decontrol. That’s why the principals paid a premium for the property, and financed the purchase with loans totaling more than 80percent of the price.
Even before the financial crisis sapped demand in the rental market, this plan was questionable. The buildings simply weren’t built as deluxe rentals—the mosaic tile in the public areas has been replaced by marble, but in the cramped vestibules and narrow hallways, the effect isn’t luxurious; the buildings just look like they’re dressed up for Halloween. With mostly tiny kitchens, and no room in the lobbies for a doorman, these apartments were never going to command the kind of rents that would justify the partnership’s bid. Even though many of the apartments have been decontrolled, net income has barely risen. Besides, anyone who’s been in New York long enough to find Zabar’s without a map knows that rent-controlled tenants like to sue, and New York’s housing law is notoriously tenant-friendly. Even if the new owners had found tenants willing to pay top dollar, there was a good chance they would never have been allowed to charge it. Game theorists often speak of the “winner’s curse”: the tendency of auctions to be won by the people who are the most delusionally overoptimistic. It’s an apt description of what seems to have happened. Not just to the Tishman group, but to America.
One of the most persistent narratives of the recent crisis portrays a nation of unsophisticated home buyers led astray by greedy bankers. Supposedly those bankers were willing to write risky loans because they intended to pass them on to some unwary investor. But this explanation falters in the face of a legion of failing commercial deals. Prospective landlords had all the expertise they should have needed to put a fair price on properties—and the majority of lenders who were originating loans for their own portfolios had ample incentive to perform careful due diligence.
The best explanation for the calamity that has overtaken us may simply be that cheap money makes us all stupid. The massive inflows of international capital, which Ben Bernanke has called the “global savings glut,” poured into our loan markets, driving interest rates lower—and, since most real estate is purchased with borrowed funds, pushing up the price of property in both the commercial and residential sectors. Rising prices, in turn, disguised any potential problems with the borrowers, because if they ran into cash-flow problems, they could always refinance, or sell. Everyone was getting bad signals from the market, and outlandish purchases looked almost rational. That answer isn’t quite satisfying, especially in the face of another financial meltdown. We don’t want ambiguity and complex systems; we want heroes, villains, and a happy ending. But by now we should all know that real-estate markets are rarely the stuff of fairy tales.

This article available online at:
http://www.theatlantic.com/magazine/archive/2010/01/capitalist-fools/7824/

Wall Street's Next Crisis: Commercial Real Estate

by Jesse Eisinger

Now that the subprime shakeout is nearly over, another real estate mess looms, this time in commercial property. Commercial-real-estate developers are in for

the same trauma as many homeowners.

Conde Nast Portfolio

So far, the current credit crisis has zeroed in on mortgages for the less affluent. But easy credit was a sprawling millipede whose wobbly legs reached into the farthest corners of the financial markets. This is the year the other 999 shoes start to drop.Any loan to any borrower can begin to seem subprime if there's too little down and too much debt. And that, unfortunately, brings us to the commercial-real-estate market.For the past several years, the market for commercial property—offices, malls, apartment buildings, industrial plants, warehouses, and the like—has enjoyed the very best of times. Prices soared, and lenders lent readily. Owners had no problem meeting their payments. By early 2007, delinquencies had fallen to record lows. In their own way, however, commercial-real-estate loans were no less foolish than those made to home buyers with speckled credit. And as with the subprime mess, the reckoning will come. Just like what happened in other sectors already hit by the credit crunch, these loans will cause problems that will probably find their way beyond the obvious players in the commercial-real-estate market. Judging by the aspects of the credit crisis we've already seen, commercial-real-estate trouble will probably emerge sooner than people expect—and will be worse than they anticipate. The implosion is going to be a refreshingly simple and familiar story. The commercial-real-estate frenzy has none of the nagging complications found in the residential market. There aren't any targets of predatory lending. There are no huge failures by government regulators. The aftermath won't see people thrown out of their homes—an unadulterated societal ill regardless of whether they should have known better or were tricked into taking on loans they couldn't afford.Let's make it clear up front: The commercial-real-estate blowup—while ugly—won't be as bad as the current housing crisis. It's a smaller market, and any single property often has a diversified group of tenants with different sources of income. The supply of buildings didn't increase dramatically over the past several years, as in residential real estate. And the losses won't be as severe, because many commercial spaces can be refashioned for new occupants.But there will be trouble, in part because of the rise of the untested commercial-real-estate structured-finance market. Just as with residential mortgages, Wall Street banks package commercial-real-estate loans, slicing them up into tranches according to risk and parceling them out to a range of investors. In 1995, $15.7 billion worth of commercial-mortgage-backed securities were issued. Through the third quarter of 2007, $196.9 billion was issued, according to Commercial Mortgage Alert, a trade publication. That amount means 2007 will be a record year, even though issuance collapsed in the fourth quarter as investors panicked over the credit crunch. Right now, there is about $730 billion in commercial-mortgage-backed securities outstanding. "Not only have we been in a rising tide, but the loans are very different in underwriting standards than even five or 10 years ago," says Alan Todd, head of commercial-mortgage-backed-securities research at J.P. Morgan. "We haven't been through a cycle yet" with these new structures, he adds ominously.

The perennial lesson to be drawn from the coming slump: You can't protect greedy and myopic people from themselves. With residential mortgages, one of the most persistent myths to take hold in recent years was that home prices on a national level had never decreased in a given year. That wasn't true, but perhaps we can forgive people for being hopeful.The commercial-real-estate market has no such excuses. Everyone knew that the business is highly cyclical. Indeed, a huge downturn had occurred as recently as the early 1990s, within the memory of most of the professionals now in the market. Amid the tall office spires of America's cities, big-money pros have simply been playing a game of greater fool, trying to bring in huge returns with borrowed money and sell out before the arrival of the crash they knew was coming. And in this case, the fools won't just be famous developers. Some of the same banks and Wall Street firms now entangled in the subprime residential crisis will also be caught in the mess. The commercial-real-estate meltdown will be a market failure, pure and simple. We will be able to look at the wreckage in the next several years with wonder and awe, untroubled this time by sympathy for those left holding the bag.Here's what we know about what happened in commercial real estate: Lending standards fell, starkly. Or as I prefer to see it, they were thrown out of the 60th-floor window of that gleaming office tower in downtown Atlanta/Phoenix/New York/San Francisco/insert your city here. The gap between the cost of debt servicing and the cash actually being generated by the buildings narrowed. What's more, it used to be that banks made loans for no more than 80 percent of the value of a property to ensure a healthy cushion of protection, but by the early part of 2007, loans were sometimes made for 120 percent of a property's value. Who would be so crazy as to lend more than a property is worth? Anyone who believes in perpetual-motion machines—that is, that rents and underlying property values must always go up.A prime example is Tishman Speyer Properties, which paid a record price for two giant New York apartment complexes. To make the purchase work, the company must now figure out a way to kick out current tenants—many of whom have their rents stabilized by law—at a faster rate than has been managed in years past, in order to replace them with ones who will pay more. Historically, that turnover has been about 6 percent, says Todd, but Tishman Speyer is assuming a rate of more than double that for the first couple of years, and 10 percent for the next few after that.Free money frothed up the market. The clear top—as clear at the time as it is in hindsight—was when real estate mogul Sam Zell sold his Equity Office Properties to the Blackstone Group, a private equity firm. Blackstone had entered into a bidding war with Vornado Realty Trust for E.O.P. and ended up paying much more than it had initially bid. Yet Blackstone managed to unload so many E.O.P. properties so fast that the deal looks brilliant. The bag holders are ultimately the ones who will appear foolish. Indeed, in a sign of things to come, one titan already does: Harry Macklowe, a famed New York real estate buccaneer, leveraged himself to the gills to buy seven New York office buildings from E.O.P., a side agreement to the Blackstone purchase. He borrowed $7.6 billion, based on stratospheric valuations, while putting a minuscule $50 million of his own equity into the deal, financing much of the purchase with short-term debt. Since the summer, Macklowe has struggled to refinance the debt in increasingly choppy markets. And he has had to put up as collateral his trophy property, the General Motors Building in midtown Manhattan.Lending standards had been loosening across the industry for years. Standard & Poor's and Moody's both voiced early concerns in late 2004 and the beginning of 2005. Sure, "supply and demand is in balance, but that's not a license to loan more money against a given cash flow," says Tad Philipp, Moody's managing director of commercial-mortgage finance. "What we were seeing was riskier and riskier loans, and the loans got riskier still. And we are just past the top of the cycle."

Despite their misgivings, the ratings agencies kept slapping seals of approval on commercial-real-estate structures. Just as they did when rating securities containing residential mortgages, the agencies relied heavily on recent historical data, which were misleading. Such transactions are designed so that investors who take on the most risk stand to get wiped out first. What happened is that the level of cushioning shrank dramatically, meaning damage from bad loans will seep into higher-rated tranches more quickly than generally expected. To its credit, Moody's started requiring higher levels of protection in the spring of 2007. S&P and Fitch, according to a J.P. Morgan analysis, lagged significantly—and won market share as a result. Those two will come to regret that they didn't respond faster to the Moody's move. And of course, those stuck with the paper won't be able to ignore what they bought during the frothy times, when commercial-real-estate structured finance became a big, lucrative business for Wall Street. As financial firms pushed these securities out the door, the structures took on alarming qualities. As Todd explains, in the early part of the decade, commercial-mortgage-backed-securities deals rarely had any one loan that was so big it dominated the pool. But in recent years, the top 15 loans in a 200-loan pool could make up 40 to 65 percent of the pool's total value. In the old days, any single default wouldn't hurt a structure disproportionately. That's no longer true. Investors and ratings agencies haven't fully appreciated how hairy these structures have become, according to some commercial-mortgage experts. Todd calls this blindness to risk the agencies' and investors' "biggest mistake" with regard to commercial real estate. "You are disproportionately exposed to the largest loans.... It's been so good for so long, we don't have models set up to look at defaults properly," he says.In recent months, as real estate developers have scrambled for funding from lenders, a standoff has developed. The banks haven't been able to find buyers for structured financial products. At some point, the banks will have to come down in price, and then they will take losses, just as they have with leveraged loans made to corporations being taken over by private equity. Since the losses haven't happened yet and since we've reached the end of a very good year in commercial real estate, Wall Street is understandably reluctant to face reality. Why take losses that will eat into this year's bonuses if you can take the losses next year, when, as everyone knows, the market will be bad?We've seen this throughout the financial markets in 2007. This has been the season of see no evil, hear no evil, speak no evil—until you absolutely have to. But you can't hold off losses forever, as the huge write-offs at banks have demonstrated. Through the first nine months of 2007, Wachovia was by far the top contributor of loans in the commercial-real-estate-structures business, followed by Lehman, Credit Suisse, Morgan Stanley, and J.P. Morgan, according to Commercial Mortgage Alert. Now the firms are sitting on those loans, waiting to unload them. "The problem is there are no buyers. Nobody wants to take a really big loss and jump the gun too quickly," an investment professional at a commercial-real-estate investment trust told me. "There's a game of chicken going on." A few weeks ago, a hedge fund manager emailed me a PowerPoint presentation on the commercial-real-estate market. It opened with a typically dry title: "2008 C.M.B.S. Forecast."I clicked through to the first page, "Capital Markets." It had a picture of a derailed train. The next page, "Credit Fundamentals," included a photo of a bridge collapsing in a hurricane. Next came "Property Values," featuring an imploding skyscraper. The fourth page was "Economic Outlook"—a ship run aground on the rocks.And the slide titled "Conclusion"? A photo of the exploding Hindenburg.