USC Real Estate Conference Experts Assess Realities of Battered Commercial Marketplace

Glenn Sonnenberg, president, Latitude Management Real Estate Investors, Inc.: Commercial real estate appreciated 60 percent from 2004 to 2008-easy, cheap credit, and a surge in transactions. The housing cycle peaked a year before the commercial property. The troughs nearly coincide-34 percent down for housing and about 40 percent for commercial. There is a hope that the bottom of the economy should start kick-starting transactions. Prices seem to have leveled off. With financing, originations are down. In the latter part of 2008, virtually no transactions were getting financed. The commercial market has fallen 80 percent since its peak. There are clearly fewer lenders and a reluctance to lend. Traditional lenders have been slow to come to market. In the last couple of months there has been a tick upward in the number of loan applications and in loans that have closed. Finally, it is a highly impish market-illiquid for a number of reasons.

Unemployment falls relatively in line with how real estate has been performing. We tend to look at the numbers and forget that real estate is about who people are, where they live, what they do, and what they do with their disposable income. Tracking over the last 20 years indicates that unemployment drives a lot of what is going on in real estate.

What happens going forward? The upper markets are where job growth is expected to be most significant, and the bottom markets, not surprisingly, with Detroit in the lead, is where we can expect employment losses. That will drive real estate value and will also drive liquidity to and from these markets. Real estate is still local.

It appears businesses are finally starting to hire up again. One of the leading indicators of that is the number of part-time hours being billed. That is up markedly across the country, which would seem to indicate that hiring is not far behind.

Raymond W. Lowe, senior vice president, Wells Fargo Real Estate Banking Group: Before the bubble we had lots of liquidity sloshing around at every level. Everything I need for life I learned in Econ 101: a lot of everything results in too much competition and degrading quality and prices. Commercial real estate is no different than all the rest of America and most of the rest of the world: too much debt in the years leading up to the bubble. We hear subprime lenders vilified as the evil guys in this, but to generate a little sympathy, this happens in every market. For issuance of sub prime mortgages versus profitability for sub prime lenders, is it any surprise that you see too many people doing the same thing? They compete against each other, and destroy each other's profitability and credit quality. You can say that of almost any market and almost any product.

Commercial banks loaded up on commercial real estate leading up to the boom. As a class, lending has really fallen off the cliff because commercial real estate loans are a threat to most banks. Some have said we have excess reserves, the problem is, I don't think anyone today really knows. But the old rules probably don't apply anymore-what is adequate capital? What is, therefore, excess capital? We do know that if you are the chief credit officer at a mid-sized or smaller bank, if you have a lot of troubled loans compared to the amount of capital you have, you have a loss.

Most real estate exposure is in commercial real estate; if you are a small bank of about $1 billion and under, you have over half of your assets in real estate and over a third of that in commercial real estate. That is the issue. The hundred largest banks hold about $1 trillion in commercial real estate exposure. The 7,500 banks on the other end of the barbell hold $800 billion-not even as much as the 100 largest. Those 7,500 banks are generally in the small category. Individually they have huge exposure in percentage of assets in commercial real estate. There were 140 bank failures last year; I think there is a lot more coming, but it won't be the 100 largest. It will be large portions of the 7,500 small banks-those that have 50 percent of their assets in real estate.

Glenn: How big is the bubble? How does it work its way through the system? Who is going to be lending to people to be able to exit from special service loans?

Brian F. Olasov, managing director, McKenna Long & Aldridge LLP, Atlanta, GA: Taking a look at debt against GDP, I look at various forms of mortgage debt to GDP, which is probably of greater relevance to this audience. If you take a look at the relationship between residential debt outstanding and gross domestic product, for a couple of decades it was very stable at around 48 or 49 percent. It started spiking in 2001 for all the reasons that we know now, including the Fed keeping its rates very low and foreign capital flooding into the mortgage markets. That 48 or 49 percent of residential debt to GDP hit 79 percent. At its high water mark, there was $11.2 trillion in residential mortgage debt outstanding-that was a year and a half ago. And oh joy-how we have worked down that excess. We are now down to $10.9 trillion. If you believe in a reversion to the mean-like I do-than we have $4 trillion too much residential debt outstanding. Among all the modification programs coming out of HUD and the Fed and the FDIC, it's been one disappointment after another. The recidivism rate for modified mortgages has been 60 percent higher. If you translate that into commercial debt, I figure we have about $1 trillion too much debt outstanding. As far as I am concerned, we can't get back to economic vitality until we figure out what we are going to do with what might be $5 trillion too much debt. These are public policy questions that go way beyond what any single institution can decide to do.

Glenn: We have a bunch of assets, sitting with a bunch of servicers, in a bunch of CMBS transactions, that need to go somewhere at some point once these extensions run there course. How does that work its way up?

Brian: This cycle is different than those previous. We don't really have a commercial real estate problem; we have a commercial real estate debt problem. We're talking about losses that haven't been realized yet. It is not that we have excess properties that need to be bulldozed, which was true in the last downturn; we have indebted losses that haven't been allocated. And now we have to go to, on some level, the public policy question about who is going to take those losses.

Raymond: If I were to mentally survey our own capital available to lend, which is effectively limitless, and our customers' capacity to buy, the reason why more isn't happening isn't because they don't have the money to buy or we have the money or willingness to lend-it's because they cannot find sellers to sell. Whether that means property owners who can't sell because the market value is less than their debt or because lending and holding institutions were willing to sell their loans on sale at market clearing prices to get rid of them, many of those institutions know that if they did that their capital levels would go to zero and they would be out of business.

Glenn: Can we talk a little bit about the level of delinquencies in the market today and anticipate an increase in delinquency? How that is being dealt with?

Brian: If you look at Trepp, which is one of the preferred sources for looking at the CMBS industry, it follows the old maxim that residential markets lead commercial markets by six quarters. I started testing that a couple of years ago. I have been working with Trepp, and they have asked me to update this information. You can actually predict going out a year and a half where delinquencies are going to end up. If this relationship holds, then you can see delinquencies from CMBS move up from today's 7.61 percent across the whole industry to about 14 percent. That varies significantly from one type of property from another.

The other axiom is that shorter-term leased properties are going to lead the industry going in and coming out. Sure enough, hotels are the worst asset class because they have a series of one-day leases. They are at about 17 percent delinquency. For multi-family-the huge transaction that happened just a few weeks ago for the Bedford side of Peter Cooper Village was a $5.4 billion deal buying from Met Life that got reappraised at $1.8 billion. That's a two-thirds value decline. That is attributed to multi-family. Multi-family delinquency (30-plus) is up to 13 percent. You go down the food chain and the best property type is office, which is just a shade under 5 percent and industrial, just under 4 percent.

Glenn: Isn't that partially due to the fact that there is a long lag time on leases?

Brian: That's absolutely right. The longer the leases, the more stable revenue.

Glenn: How about apartments?

Guy K. Johnson, president, Johnson Capital: Those are moving very quickly too because of month-to-month leases. The apartment business is rebounding. There is not enough product nationally. The bloom is off the for-sale housing for those who should never have owned. The most efficient next place is multi-family. That gets to be a cornerstone now, along with health and education. For office, if there were employment growth, it would be better. Retail is very confusing. It is almost too tough. There is some concern with neighborhood grocery/drug retail. There is some concern that for the very high-end luxury retail, people will walk around, look, enjoy the ambience, and then go home and shop online.

Glenn: Let's talk a little bit more about the basic food groups and where lenders will shakeup. There was an article recently in the (Wall Street) Journal that surveyed 79 multi-family markets and found that 60 of them are bouncing off the bottom. Let's talk about what lenders are doing.

Guy: In all the food groups-industrial, office, retail, and multi-family-we see that government sponsored entities (GSEs), like Freddie Mac, Fannie Mae, and FHA, are roughly 90 percent of the multi-family market today. They have accomplished the mission of providing liquidity when others weren't there. They are extremely competitive and extremely active. Probably because of that liquidity, prices in multi-family didn't really drop as much as some of the other product types. There is no shortage of money there. The challenge might be for less attractive properties. Freddie and Fannie won't do those; FHA will, but only if appropriately underwritten. FHA is completely overwhelmed now; their volume has gone five or ten fold.

Glenn: If you look through multi-family loan production, even in 2009, $36.4 billion from Fannie and Freddie. They guarantee over 50 percent of the residential, 40 percent of the multi-family, as you say, 90 percent of the multi-family today. Doesn't that have to be 90 percent leased for 90 days? Aren't there limitations on what Freddie and Fannie can do?

Guy: They are a great source construction financing if you can show the demand or the need for the marketplace. Typically they are stabilized, so you have companies like Glenn's and others that would perhaps bring you're the stabilization for transitional storing. There is a lot of capital out there for that.

Raymond: Just to anecdotally confirm that: Although we are not doing this because we know there are GSE takeouts available, but because multi-family fundamentals being ahead of the other food groups in terms of their distress and recovery, we are processing three multi-family deals through closing. They are all construction loans-ground up, two for-sale, and one for-rent because the land value is low enough that they can be acquired at prices that make sense and construction costs are low enough that the whole thing pencils. It gives everyone the confidence that in today's market those projects will absorb. They happen to be fantastic markets. The fact is that we don't have any office building construction loans in process.

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Glenn: I'd like to ask Brian: It seems to me that there are a lot of banks that are "too small to fail." What's is happening with these banks? What happens if they really do if they write their values down? What does that do to the banking industry?

Brian: Certainly there were a lot more failed banks during the RTC (Resolution Trust Corporation) days, but to put this into context, the cost of the RTC crisis and the S&L crisis, as measured by the official history of the RTC in 1995 dollars, was $140 billion. We, as a country, are $182.5 billion into AIG. That is just one institution. The other thing that is interesting, and this certainly isn't going to be a ban regulatory reform discussion, but it is important to see that in background discussions, one of the emerging challenges on Capital Hill and among the state bank trade associations is establishing the right level of capital. You see various initiatives inspired by a Harvard economist who set the leverage ratios-which is the inverse of the capital ratios-at 15 to 1. It really begs the question about what we are measuring. An assessment is unfortunately part of the large cap worry, where Capital Hill and the people who are going to be writing the legislation for banks just don't have the facts at their disposal. If you take a look at the 140 failures last year, the average cost of resolving each of those 140 institutions according to the FDIC was 25 percent of total assets. According to the FDIC, their equity to total assets was negative 25 percent. Prior to their closing, those institutions were playing between four and five positive capital. Be really careful when you start talking about setting out these very mechanized capital rations because you have to understand how you measure the underlying assets.

That gets back to the larger issue. If you look at that gap between stated capital and where institutions pencil out in terms of market value, it's about 30 points. That is a huge spread when you represent a lot of entrepreneurial investors and they go into bank and they are bidding 40 cents on the dollar and the bank is carrying that number on their books for 80 cents on the dollar and 70 cents on the dollar. And people are wondering why the market isn't clearing. These community banks don't have the capital necessary to take the loss, even if they were willing to admit what the market clearing values are. Unfortunately, this all has the context of an absolute capital freeze. We are at a very awkward point in providing liquidity into real estate. The RBS deal that happened a couple of weeks ago was a $300 million deal. I am glad it happened-terrific. In 2007, CMBS issues were $230 billion. A $300 million deal every quarter is not going to get us back to where we need to be. Imposing capital requirements has not achieved the intended consequences of the ability of commercial banks to lend. That, again, is a dynamic that has been lost on Capital Hill.

Raymond: In the S&L crisis, when we had 589 failures, these were all under-capitalized institutions that were closed for that reason. The RTC implemented the write-down on the assets, the tax payers split the bill on the write-down, and the assets cleared. A lot of us in the room are waiting to see that happen again. For instance, in my office we do a lot of that kind of distress acquisition financing, but without the distressed acquisitions, there isn't going to be any financing. Why isn't that happening now?

Brian: It gets back to capital inadequacy. There is a lot of very strange revisionism going on. I watched the hearings of the financial crisis inquiry commission, and you don't really see a lot of the witnesses who would be candidates for Profiles in Courage. Essentially what they are saying is, "It was everyone's fault but mine." You can start with Greenspan and Reuben and work you way down, where the former CEO of WaMu says his $308 billion bank was not big enough to be a part of the deal that cut to save these institutions. There were regulations in place, going all the way back to 2006 and even prior, restricting commercial real estate concentrations. They were routinely violated; there was no enforcement mechanism. The result of that is that there is a complete mismatch between a lot of those market clearing values and the ability of the banks to withstand that kind of market loss. In aggregate, there is only $1.2 trillion in the entire banking system and there is about $5 trillion in real estate debt-residential, multi-family land, and core commercial. If you start getting any kind of haircut-10 percent, 20 percent-against that $5 trillion portfolio, you are going to start knocking out 2,000 banks.