There is no way to spin it. Commercial real estate is in serious trouble, and without financing it will get worse.
That’s what The Financial Crisis Inquiry Commission was told recently by Dr. Ken Rosen, Chair of the Fisher Center For Real Estate and Urban Economics. “We estimate that between $800 billion and $1 trillion of losses to commercial real estate equity and debt will be realized over the next few years.
The annual volume of commercial mortgage maturities is expected to increase each year through 2013, according to Ken Rosen, during the Commission’s first hearing on January 15, 2010.
“This means that losses for banks, life insurance companies, commercial mortgage backed securities (CMBS) holders and other investors will continue to mount unless borrowers are able to find alternate funding sources,” he said.
By ‘alternate funding sources,” one assumes an alternate to the king of all funding-cash. “Investment activity remains severely depressed because of a lack of financing options and poor market conditions.” According to Real Capital Analytics, investment volume in all commercial real estate in the 12 months through November totaled just $48 billion, compared with $157 million one year earlier and a cyclical peak of $547 billion in the 12 months through October 2007. As long as capital markets, including the CMBS market, remain tight, transaction activity is unlikely to increase significantly. This begs the question: How long are the capital markets expected to “remain tight?”
“Commercial buyers are out there, but not buying. They are waiting for the bottom to fall out and for lenders to start lending again, hopefully sometime around the third quarter of 2010,” ‘according to Orlando bankruptcy Attorney R. Scott Shuker. Shuker should know. He represents some of the largest bankruptcies in the central Florida region, where bankruptcy filings have increased fivefold in three years, according to the Orlando Sentinel. His largest bankruptcy in the past two years was a company that owned 25 hotels in Daytona Beach and another 30 pieces of property, with $500 million in debt. The most high profile Orlando case is a large downtown condominium about to go on the ‘bulk” auction block with a $20 million minimum bid.
What happened to the commercial real estate market?
According to Dr. Rosen, “Like the residential market, a flood of liquidity led to a surge in investment volume in commercial real estate properties. The peak in domestic CMBS issuance of $230.2 billion in 2007 coincided with the peak in commercial property sales, which totaled $544 billion in the 12 months through October 2007, compared with less than $100 billion in properties traded four years earlier.
“As CMBS issuance plummeted in 2008, so did property sales.” An estimated $2.2 billion in CMBS was issued in 2009, leading to $47 billion in property sales in the 12 months through November (the latest data available) – a 91% decrease from the peak sales level in 2007, according to Dr. Rosen’s report.
As exciting as this might be to some astute prospective buyers, it is a pathetic situation for developers facing Chapter 11.
Shuker offered encouraging words and made some interesting observations in the February 1, 2010 Orlando Sentinel. “Debtors used to view bankruptcy as an alternative that was worse than death; to them, it meant they were a failure and had done something morally wrong.
“Now it is often used as a business tool for dealing with a recalcitrant lender or transitioning the property to a new owner. “I think owners view Chapter 11 as their failure to run their business. The current economic situation shows these Chapter 11s often have nothing to do with what the owner or manager did,” Shuker said.
“It takes the taint of failure out of it, particularly if you have your property decrease by 50 percent, and if you were counting on selling properties as part of your business and lenders won’t make end loans. “Creditors are willing to take less than they were a few years ago,” according to Shuker. Quite a bit less, evidently. “I am doing a lot of workouts where the borrower is unable to pay the loans but has a contact with a person or company that will buy the bank’s note at a discount. “With a condo in Maitland that owed $9 million to Wachovia, for instance, we found a party to buy the mortgage and note for $3 million,” Shuker said.
“I am seeing note purchases of 40 to 60 cents on the dollar. Before the real estate slump, the biggest discount we could get at that time was maybe 10 percent.” Shuker told Realty Times that if the developer has a choice, he may choose to apply for a forbearance agreement, whereby the lender lowers or defers payments for six months or a year to give the developer more time to generate enough income to make the mortgage payments or find a buyer on his own.
Can this happen again?
Dr. Rosen’s proposes the following reforms for the commercial real estate finance system:
“Like the residential market, the problems in the commercial real estate sector also relate to excessive leverage and poor underwriting, and therefore our proposals to reform the commercial real estate finance system target these issues. The purpose of these reform proposals is to increase the equity cushion for real estate debt transactions and to get a better alignment of interest for the parties in the debt transaction.
Similar to the residential mortgage market, maximum loan to values should be set countercyclically to minimize the number of borrowers becoming overextended at the market’s peak. On average, loan-to-value ratios for stabilized properties should be 75% including the first mortgage and mezzanine debt. When values are at peak levels (when cap rates are less than 150 basis points above 10-year Treasuries), the maximum LTV should be reduced by 5% for each 50 basis points less than normal spreads. Debt coverage ratios for fixed-rate mortgages on stabilized assets should be at a minimum of 1.25 to ensure that properties are generating sufficient NOI for owners to meet debt obligations.
Construction and development loans should be restricted to 50% of cost so that developers have a greater financial stake in their projects.
In securitized transactions, originators and packagers of loans should be required to defer a portion of their fees until a loan seasons successfully. By sharing in the risk, these parties would have a greater incentive to underwrite and securitize high-quality loans that are likely to be repaid rather than passing on all of the risk to investors.
The Foreign Investment in Real Property Tax Act (FIRPTA) should be substantially amended or repealed in order to attract much-needed capital to the domestic real estate markets. FIRPTA discourages foreign investment in U.S. real estate by assessing a tax on capital gains, unlike other asset classes including stocks, bonds and interest-bearing bank accounts that are not taxed by the U.S. government.
The revision or elimination of the tax would provide some of the capital needed to refinance the hundreds of billions of dollars of mortgages coming due during the next few years, driving transaction activity, creating jobs and stabilizing asset values and thus, the broader financial system, Dr. Rosen’s report concluded.
Meanwhile, if you need to talk to an attorney about your alternatives, you may want to call for an appointment soon.
“In the last three days I’ve had three hotels call me, the smallest of which had debt of $15 million,” Shuker said.
Good for him, investors and real estate brokers, but sad for commercial real estate developers trying to protect their equity, their livelihood, and their reputation in a fight they did not start.
Dr. Rosen’s Full Report can be found here.
For more on this topic see, “The Coming Great Recession of 2011 – 2012“