When Boston's landmark John Hancock Tower sold at auction in late March for a little more than half of the $1.3 billion that private equity firm Broadway Partners paid for it only two years earlier, many analysts pointed to the sales price as a new gauge of property values. But more likely it was the precursor to a tidal wave of commercial real estate foreclosures and auctions in the coming months.
“To me it's like a drain that's starting to clog but it hasn't spilled over the side of the tub yet,” says Bernard Haddigan, managing director with Marcus & Millichap Real Estate Investment Services in Atlanta. “I think the foreclosure business is going to be huge over the next five years.”
There are two main triggers for the coming tide. First, some $250 billion in loans originated during a three-year stretch beginning in 2005 and packaged and sold as commercial mortgage-backed securities (CMBS) are coming due by the end of 2009.
New York-based research firm Reis predicts that between now and 2012, building owners will face more than $1.5 trillion in maturing debt and that the default rate could reach 5%, the highest level since the early 1990s. With the credit markets still in lockdown mode, the ability to refinance that debt spells trouble.
The scenario is particularly somber news for the nation's commercial banks. According to researcher Foresight Analytics, banks were carrying some $3.4 billion in commercial real estate loans on their balance sheets at the end of 2008, up from $1.5 billion a year earlier.
Certainly the case can be made that banks — the primary lenders to the industry — have experienced their fair share of trouble lately. According to the Federal Deposit Insurance Corp. (FDIC), 21 commercial banks failed in the first three months of 2009 compared with 25 for all of 2008.
The second trigger is the continued sluggish U.S. economy, which is putting more pressure on borrowers to keep up with their mortgage payments. Because commercial real estate tends to lag the broader economy, the pain has yet to be felt to a large degree.
Workout window open — for now
Facing a potential flood of foreclosures, most banks are ill prepared for the tide that may wash over them. Most are understaffed and many are already overwhelmed with other problems, like how to keep their doors open.
Rather than take back properties from struggling borrowers and place the assets on their balance sheets at an unknown value, a growing number of banks today are opting to extend existing loan terms in the hopes that the market turns around. Loan extensions also buy the borrower time to realize more net operating income and pay back their debts.
“Lenders have been more willing to extend loans for six or 12 months and try to get a better lay of the land as to what the future holds for the asset,” says Jerry Cataldo, executive vice president with Hostmark Hospitality Group, a leading hotel management firm in Schaumburg, Ill.
“Right now it appears there is almost reluctance to move all the way through to foreclosure,” says Jon Barry, president of retail brokerage and property management for Colliers Spectrum Cauble in Atlanta, who leads the asset resolution services group.
One major reason is that lending institutions don't have the manpower due to layoffs and leaner operational staffs to handle troubled loans. “It's relatively quiet. We're seeing a trickle of assets moving back to the lenders, but it is just the beginning,” says Barry.
In lieu of foreclosure, many banks are selling their distressed mortgages to investors. “For a lot of these banks that gives them greater accounting flexibility,” says Brian Olasov, a managing director of law firm McKenna Long & Aldridge LLP in Atlanta.
“When you have an REO property, you can't play any accounting games with that. You get an appraisal, and that's the value of the REO,” continues Olasov. “Most bank analysts would agree that most banks have been slow to write down the value of the underlying collateral securing that loan. This is all about preserving capital that the bank needs from a regulatory perspective. That's one reason you haven't seen aggressive foreclosures,” adds Olasov.
Given the banking industry's woes, many borrowers could have the upper hand when it comes to negotiating with their lenders, according to Ted Hunter, head of the real estate group at law firm Lowenstein Sandler in New York.
While many loans may fall into technical default when the value of the property falls below certain pre-set loan covenants, the borrower is still making its mortgage payments. In these cases, Hunter says lenders will be more inclined to restructure the loan to give the borrower time to come up with additional equity rather than foreclose.
Mezz gets aggressive
Many mezzanine lenders are still sitting on the fence when it comes to taking drastic steps. “A lot of the mezzanine debt holders know that their debt is worthless, so they don't want to foreclose because that would mean they would have to recognize a loss on their investment,” says Peter Miller, a partner in the real estate law practice of Akin Gump in New York. “They're perfectly content to let the world drift the way it is.”
Some mezzanine lenders, however, are aggressively seeking more drastic steps to recoup their investments, particularly when it appears that the primary lender is ready to foreclose on a property.
In the case of the Hancock Tower sale, two mezzanine lenders, Normandy Real Estate Partners and Five Mile Capital Partners, bought enough debt from other lenders on the tower to gain a senior position. They also wanted to hold onto the trophy to recognize the potential upside of a market recovery, even if it proved to be years away.
“The deal structures are much more complex than in the 1990s because they're so highly structured and so highly leveraged that you're going to have these battles between the different capital providers in a way that you've never seen before,” says Olasov.
Troubling fundamentals
While there is a general proclivity among lenders to modify loan terms and work out distressed loans, many analysts fear that the continued weakening of real estate fundamentals will ultimately lead to more REO properties across all major sectors in the months and years ahead.
“There will be a point in time where fundamentals will get so weak that it's possible that some assets will go into foreclosure because the fundamentals have fallen apart,” says Spencer Levy, senior director of capital markets with CB Richard Ellis.
This dynamic is creating a bubble of potential trouble. “The volume of negotiations taking place between landlords and tenants is staggering, which leads me to believe there is going to be a much steadier stream later this year of properties being at risk from a cash flow perspective,” says Hunter.
“We are seeing a lot more tenants coming to us saying they need to get out of their lease or need to lower their rent burden because they can't afford it anymore.” Landlords, too, are much more willing to renegotiate lease terms today since they need cash flow to pay debt service.
Hostmark's Cataldo agrees. “There are going to be owners who hand in the keys because they're going to get to the point where they don't want to throw more money at an asset to keep it going. It may not be the lender pursuing it, but the other way around.”
In the meantime, banks are slowly starting to get a handle on how to best manage their troubled loans, according to Cataldo. “Lenders are putting their loans in buckets and will then attack the buckets in turn. Toward the second half of this year they are going to have a better feeling about what they can do with their assets, if they do take control of them.”
Ben Johnson is a Dallas-based writer.
MOUNTING PROBLEMS FOR COMMERCIAL REAL ESTATE
Commercial and multifamily assets in foreclosure, bankruptcy or whose mortgages are being modified or restructured are considered to be troubled properties.
| (As of March 31, 2009) | Troubled Properties | Lender REO Properties* |
|---|---|---|
| Dollar Volume | $63.9 billion | $7.3 billion |
| Number of Properties | 3,232 | 470 |
| *properties lenders have take back through foreclosure | Source: Real Capital Analytics | |
Is the Fed's new investment plan a deal with the devil?
One of the wildcards that could stem the flow of commercial real estate foreclosures and auctions is the U.S. government. In early April, the U.S. Treasury, in conjunction with the FDIC and the Federal Reserve, announced a new derivation of the Troubled Asset Relief Program (TARP), the Public-Private Investment Program or PPIP.
The aim is to use $75 billion to $100 billion in TARP funds to entice private investors to partner with the government in buying toxic assets that are clogging many lenders' balance sheets. The assets could include properties and commercial mortgage-backed securities.
Many commercial real estate analysts see pros and cons in the plan. “It seems like a great opportunity, but many of the larger institutions we've talked to are scratching their heads,” says R. John Wilcox, senior vice president with Savills, a New York-based real estate investment banking firm.
“Lenders are wondering if they're making a deal with the devil, if they partner with the government. Three months down the road, what if the lenders become a political hot potato?” asks Wilcox. “Do the rules get changed and do their fees get reduced? And who are you going to use to replace the government financing, which is not clear.”
With so much public outcry over executive compensation and perks, many lenders are a bit gun shy. “Many of them are asking if the federal government is their partner, are they going to have to take the bus to the airport? Really, people are thinking like that,” says Robert White, president of Real Capital Analytics. “The government has been a little capricious about things lately, so it's rightly so.”
Others wonder what incentives are in place for lenders in the private sector to participate. “Does the private guy really step up when he's not sure we've hit bottom yet?” asks Joe Franzetti, a 30-year industry veteran hired by Chicago-based Cohen Financial to lead its debt advisory services business. “Going back to the RTC (Resolution Trust Corp.) days, no one knew how to price real estate until the RTC effectively set a floor. This time, where's the floor?”
Banks also face the prospect of creating more problems than solutions. Selling off so many assets at a market-clearing price could be devastating.
“You're going to blow a hole in the capital base of the bank, rendering them either insolvent or not so well capitalized,” says Brian Olasov, a managing director of law firm McKenna Long & Aldridge LLP in Atlanta. “If that happens, would a bank in that situation be in a position to attract new capital?”