Archive for the 'CRE Economics' Category

Is the Slow-covery in Trouble?

Last week, the Fed’s Open Market Committee said the pace of the economic recovery had “slowed” and that growth “is likely to be more modest in the near term than had been anticipated.  The Fed announced it was going to take some of the payments it has received from CMBS bonds and other assets it purchased as part of the stimulus, and reinvest them in Treasuries – effectively holding down mid-term interest rates –  in an attempt to stimulate the economy further. The Fed noted that high unemployment, modest income growth, lower housing wealth and tight credit were holding back household spending.

Sudeep Reddy of the Wall Street Journal explained succinctly how the Fed’s plan is supposed to work:

“After cutting short-term interest rates nearly to zero in December 2008, the Fed essentially printed money to expand its portfolio of securities and loans to above $2 trillion, from $800 billion before the global financial crisis. Its purchases of mortgage-backed securities and U.S. Treasury debt, aimed at keeping long-term interest rates down, were discontinued in March. The Fed began talking about an “exit strategy” from the unprecedented steps it took to prevent an even deeper recession.

But on Tuesday, the Fed shifted its stance. It said it would act to keep its securities holdings constant at around $2.054 trillion, the level on Aug. 4. Had the Fed not acted, its mortgage portfolio was set to shrink by $10 billion to $20 billion a month, as mortgages matured or were paid off early. Now, the Fed will reinvest those proceeds in U.S. Treasury securities of between two- and 10-year maturities.

Some Fed officials have been uncomfortable with the size of the Fed’s position in the mortgage market. To assuage their concerns, the Fed won’t be enlarging its mortgage holdings.”

Will this further stimulus work? No one knows. But this move is generally not being seen as a good sign for an economy we’ve been repeatedly told is recovering.

The idea that the “recovery” isn’t going so well has been common for months across the bleaker reaches of the economic blogosphere (such as the comments sections of the Calculated Risk blog, or the ZeroHedge blog, or David Rosenberg’s well considered newletters for Gluskin Scheff — where he suggests today that we may not be headed for a double dip because the recession may not, in fact, have ever ended).

However, concern about the pace of the recovery has recently been cropping up more frequently in the mainstream media – especially since the Fed’s announcement. For example, in Saturday’s New York Times, Jeff Sommer questioned whether a double dip recession is likely, asking, “Will the economy pick up momentum or slip back into recession?”

 After noting that Ben Bernanke had recently called the current economic outlook “unusually uncertain”, that Lakshman Achuthan, Managing Director for the Economic Cycle Research Institute agreed that “growth has definitely slowed” and that Bill Gross of bond manager Pimco said, in essence, that the momentum of the economy from the first to the second quarter was downhill, and that it’s possible we’re close to a double-dip recession, Sommer stated:

“Still, the economic signs are ambiguous. . . . What’s been lacking is broad consumer demand, a revival of the housing market and sufficient business confidence in large-scale hiring.  And, of course, there are deep structural economic problems — the highest ratio of public debt to gross domestic product since World War II, for example — that will need to be dealt with over many years.”

At the risk of stating the obvious, with so many folks worried about their jobs, or underemployed, or paying down debt, and so many companies sitting on money but not hiring, it’s simply not clear what new business developments are likely to spur sufficient “consumer demand, a revival of the housing market and sufficient business confidence” to lead to large scale hiring.  I have a sneaking suspicion that we ultimately will regret greatly allowing so many jobs to be outsourced, especially manufacturing jobs – ultimately our economic viability as a country boils down to whether we can produce things that others want to buy — and in doing so, whether we can keep our own citizens employed.

Keeping interest rates down to stimulate the economy seems to work in smaller economic downturns, where there’s pent-up demand and ordinary folks can afford to buy things.  But, where so many households are wildly overleveraged and worried about their futures, the Fed may simply be “pushing on a string” – trying to create demand that simply won’t be there until the overhang of debt is paid off by borrowers, or written off by creditors (who of course then have to recognize their losses), or both.  (Maybe there’s another way to create demand and deal with that debt, but if so I don’t see it.)

And until the huge amounts of debt are somehow cleared or something else makes businesspeople more confident about hiring (and employees more confident about getting and keeping jobs), the current levels of distress in the commercial real estate market seem likely to continue and perhaps increase.  According to Costar’s Commercial Repeat-Sales Indices, the largest metro commercial real estate markets have been “attracting significant institutional capital and forcing prices upward over the first two quarters of 2010 . . . while the broader market has continued to soften. . . . This divergence of the two worlds may soon change as we are now witnessing a pause and softening even within the investment or institutional grade primary markets.”

Doesn’t sound much like a CRE recovery.

CoStar goes on:

Many of the opportunity funds continue to seek out distressed properties, which are affecting the prices shown here, but the expectations of a tsunami of opportunities have not materialized and overall transaction volumes remain below normal.

Distress is also a factor in the mix of properties being traded. Since 2007, the ratio of distressed sales to overall sales has gone from around 1% to above 23% currently. Hospitality properties are seeing the highest ratio, with 35% of all sales occurring being distressed. Multifamily properties are seeing the next highest level of distress at 28%, followed by office properties at 21%, retail properties at 18%, and industrial properties at 17%.

Since current governmental policies seem to be encouraging a “delay and pray” approach to resolving bad real estate loans, this approach (which I don’t think can really be called a strategy) seems to be to hope for a broad economic upturn.   It seems likely that the distress in commercial real estate won’t improve significantly unless hiring picks up, and the trend seems to be going the wrong way.  PRI’s The Takeaway reported that, according to Newsweek and Slate columnist Dan Gross :

“An unemployment rate of 9.6 percent in America may sound bad, but it doesn’t include millions of discouraged American workers. . . The real unemployment rate is closer to 16.5 percent . . . . That’s the Bureau of Labor’s U6 number, which takes into consideration so called “discouraged workers” who have given up looking for work, as well as people who are working part time but would like to be working full time. Overall, according to Gross, the number means that there is ‘one out of six adults in this country whose talents and time and skills are not being utilized anywhere near to the extent of their abilities.’ ”

I hope I’m wrong, or missing something about the economy, but it seems to me that the “Slow-covery” is getting even slower. Instead of a long hot summer, we may be looking at a long cold winter of discontent.


Fire or Ice in 2010?

Fire and Ice

Some say the world will end in fire,
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire. . . .

— Robert Frost

Happy New Year, everyone!  Over the holidays, I spent some time  reading economic news, trying to figure out what’s happening,  and how it will affect the commercial real estate industry this year.  (As have you, probably.)

A lot of folks think that the federal government’s actions in 2009 and 2010  to “print money” to support the economy ultimately will result in inflation, or even hyperinflation.  Another group predicts deflation, as fewer buyers of various goods and servicers mean less demand, and more competition to make sales.  What if they’re both right?

It’s pretty clear from publicly available statistics that in real terms we did not grow the economy in 2009:   almost all of the GDP growth last year was triggered by the government stimulus, and not by private demand.  At least, that’s the view of a lot of economic pundits, including for example Stephen Pearlstein of the Washington Post, and’s own Robert Knakal.

I’m not an economist, but for what it’s worth, it looks like we might be heading into a period of both inflation and deflation:  inflation in necessities, commodities, interest rates and any supply constrained goods or services(which always seems to include anything I want to buy!); and deflation in the areas where there is an oversupply or room to lower costs.  

And we don’t have much growth coming from the private sector, so “stagflation”, an economic condition of slow growth and high unemployment  prevalent in the 1970’s,  may revisit us.  It was not fun the first time, and, like the color combination of harvest orange and avocado green so beloved then,  probably won’t have improved with age.

Unfortunately, commercial real estate looks like one of the deflationary sectors.  The 2010 prognosis looks poor, even though I expect more deals will get done than in 2009.   It looks like we’re heading into a time of price discovery as CMBS and other loans come due  or default, and owners can no longer fund the expenses of properties whose actual cash flow is coming short of their earlier projections.  (CMBS loans are reportedly at their highest default rate ever, over 6%, as reported by Jon Prior at Housing Wire.)

The last few years of construction may not have looked like overbuilding at the time because consumer sales were driving the economy, burning easy credit (including HELOCs).  But the growing number of hotel, broken condo and retail foreclosures suggests an overvaluation pattern more like the late 1980’s.  Virtually every business’ forecast of the demand for its own goods or services — and the space it would need to sell them — was too high.  These forecasts were based on faulty assumptions about continuing consumer purchasing power and easy credit.   Technology shifts like telecommuting, office sharing, internet shopping, videoconferencing and the like will continue to make more efficient use of commercial real estate, diminishing the need for offices, retail and hotels.

CRE values have sunk — no one knows exactly how far, but 40 – 55% off the peak is mentioned frequently.  Owners and lenders are generally, and understandably, reluctant to do deals at corrected low prices which would cost them money (or in the case of lenders force recognition of losses).  Still, eventually owners get tired of carrying properties, and loans come due.  Barring massive additional government stimulus directed at CRE,  circumstances will slowly forcibly close the bid-asked gap, at least on some deals.  That’s when price discovery will occur, and buyers and investors will become more likely to act. 

For players in the industry, the slow freeze of 2009, where so few deals were done, should thaw somewhat in 2010.    As time forces sellers’ hands, we’re starting to see more deals:  smart sellers with multiple properties are making triage decisions about which ones to hold on to, and which to sell to generate cash (or staunch the bleeding cash flow) so that they can survive this great recession.  Buyers are starting to buy properties and notes — though with significant discounts to face value, and at prices where a return is virtually guaranteed (even factoring in the cost of foreclosing in note sales).  Careful underwriting is back, and unlikely to change for some time.

On the legal side, this shift from a seller’s to a buyer’s market is leading to more careful  negotiation of deal terms, more attention to completing careful diligence, longer time periods for diligence and stronger representations, warranties and indemnities from sellers.  Perhaps as an industry we’re all shutting the barn door after the horse already ran away, but it’s an understandable reaction to the excesses of the last few years.

So, freely acknowledging my lack of an economics degree, I will put on my mystical “Deal Doer” turban instead, and predict that 2010 will be  a lot like 1992 was in California.  We’ll see  some deals, mostly heavily distressed/discounted, and the deal volume gradually will increase as the new reality of lower prices sinks into everyone’s consciousness.   The big unknown is what steps the government might take, if the downturn in CRE values appears to threaten the stability of the banking system or starts to cause a second downturn.  Fundamentally, and unfortunately, governmental intervention in real estate generally seems to be designed to keep real estate prices inflated even if that means rewarding folks who took inordinate risks.  The argument is that such support provides a slower and arguably softer landing, but it risks serious stasis, as in Japan and our own 1970’s stagflation, and I think is misguided.  Ultimately, just like the sun comes out after the rain, the CRE industry will eventually bounce back after price discovery.  Assets will find new prices, and new uses — people and businesses still need roofs over their heads.  Many owners and lenders will realize their losses.  Some sharp buyers will snap up deals.   But all of that can’t happen until the market is allowed to work to reset prices down to rational levels, and the overall business climate improves.

UPDATE:  Thursday January 7, 2010:

I just attended the Jones Lang LaSalle Forecast 2010 event in downtown LA this morning.  JLL fielded a strong array of speakers who have a considerably  more optimistic view of current economic conditions than I do. 

Notably, JLL’s Global CEO, Colin Dyer, informed the gathered real estate luminaries that JLL’s worldwide offices are seeing (1) a strong recovery in most Asian CRE markets driven by the economic expansion there; (2) a slower recovery in Europe, led by the historically strong commercial areas in London and Paris; and (3) the US CRE markets generally lagging, but picking up in coastal markets first.  Bob Hertzberg, former speaker of the California State Assembly, pointed out that 7 of the worst markets in the US are in California.

Richard Weiss, EVP and Chief Investment Officer of City National Bank was also generally positive, opining that the US economy is in recovery mode, and predicting that the recovery would be strong enough that the Fed would allow interest rates to start rising in April. 

Generally, the consensus view from the speakers at the JLL 2010 Forecast was that perhaps the lack of pressure on banks to recognize losses and foreclose, coupled with massive governmental stimulus, might in fact be creating a relatively soft landing — with CRE prices falling 35 – 55% from peak, but without an overcorrection.  Time will tell.

Happy Holidays, 2009: CRE is Scrooged

I’ve thought the market was overvalued, and that a wave of foreclosures was coming, for several years.  I was wrong in 2005 and 2006; by 2007 a fair number of folks thought the CRE market was overvalued, but we did not see many defaults, at least here in Southern California.  In 2008, the CRE  market seemed to be generally stuck.  This felt very similar to 1991 — everyone knew values of CRE had fallen, but no one wanted to take action — as if denying reality might make it go away. 

But many of us, including me, have been surprised by how long it has taken for the weakness in the overall economy to affect the CRE market this time, and how long it has taken before an uptick in defaults, workouts and foreclosures.   In some parts of the country, like Michigan and Florida, the wave of foreclosures brought on by falling values has already hit.   But in California, where we have generally seen only limited CRE foreclosures in 2009 (but a lot of modifications), it looks like we’re in the trough of activity looking up at the crest of the wave now.

Just today, in connection with a discussion of a consensual workout of some prominent San Francisco real estate, Bloomberg reports

“Commercial mortgage defaults more than doubled in the third quarter from a year earlier as occupancies fell, according to Real Estate Econometrics LLC.  .  . Property sales financed with commercial mortgage-backed securities plunged 95 percent from a record $237 billion in 2007, according to JPMorgan Chase & Co. “

Bloomberg goes on to quote Moodys, as saying that values “may fall 55 percent from their peak” due to a lack of securitized debt.

 Third quarter 2008 was bad enough:  double that default rate is ugly. 

A drop of CRE values anything like 55% obviously will be even worse news for highly leveraged projects — and could gouge the LTV ratios for even the most conservative lenders.

Probably we’ll see a greater number of underwater owners giving back their properties to lenders, either by deeds in lieu, agreements to not fight foreclosure, or the like.  Often these graceful surrenders are made in  exchange for limiting guaranty exposures.   In the case of CMBS loans, we’re starting to see lots of resales of the property made consensually through a receiver to a willing buyer/new borrower who is willing and able to assume the existing loan, as modified.    These can be fairly simple and effective workout deals, if documented correctly to avoid the traps presented by California law.  We’re also seeing some lenders who don’t want to battle through foreclosures quietly moving to sell their loans to buyers willing to undertake those legal fights in exchange for a discount on the note price.

True to 1991 form, we don’t seem see borrowers or lenders completely capitulating to reality yet:  there’s still a persistent gap (though a diminishing one) between what lenders are willing to sell distressed debt or foreclosed property for, and what buyers are willing to pay.

That’s what we seem to be seeing now, as we go into the holidays.  I’d be interested in hearing whether you are seeing that too — or seeing something different.  Please let us know by posting a comment.

Beware of green shoots: there may be snakes in the grass

There’s good economic news breaking out all over,  it seems.  The Fed’s Beige Book report, released July 29, suggests that the pace of economic decline has started to slow.  The stock market liked this news, responding with gains per Bloomberg. But does a little bit of economic improvement mean that the worst is over for commercial real estate?  or that we’ll have a fast recovery in CRE?  I don’t think so.

Despite all the talk of “green shoots” and economic improvement,  it is likely that CRE will suffer for a significant amount of time.

Why?  There is simply not enough growth to increase demand for commercial space.   Consumer demand, which for better or worse drives our economy, is way down, for a number of reasons:

  • The continuing high rate of unemployment (14.5 million Americans were out of work in July per the Boston Globe) scares even those consumers who have jobs.  So they spend less.
  • So many people overleveraged themselves through home equity extraction (and must either repay that money or have their houses foreclosed upon) that they don’t have much money to spend.  (Bloomberg reports that banks held a record $674 billion of HELOCs and $211 billion of closed- end home-equity debt as of March 31, according to FDIC data.)
  • So many people overleveraged themselves through credit card and other debt that they don’t have much money to spend.  And instead of buying more, they are apparently paying down their debts — probably good for them personally, but collectively not great for increasing demand and growth in the economy.  CNNMoney reported that since last August, the amount of outstanding consumer credit has declined, according to the Federal Reserve, with total consumer borrowing sinking a seasonally adjusted $10.3 billion, or 4.9%, to $2.503 trillion, and revolving credit, which includes credit card debt, fell $5.3 billion, or 6.8%, to $917 billion. 

Until consumer demand increases for goods and services, companies have no reason to increase their use of commercial real estate by taking on new leases or purchases of retail, office or industrial space.   In fact, since demand is down, many users of CRE will continue to look for ways to cut their expenses for CRE as a way to reduce their expenses overall — and to survive the downturn.   Obviously, if enough tenants default on their leases, this creates problems for landlords, who in turn may default on their mortgages.  This is happening now; for example, prominent Southern California developer Maguire Properties recently announced it will sell or return to lenders seven buildings in Southern California per Business Week.

In addition, the death (or serious incapacity) of the CMBS market has wiped out about 40% of the total financing capacity that was available to finance CRE.   That means that, over the next few years, unless an alternative source of funding is found, many CRE projects will have trouble finding refinancing at maturity.   Since CRE prices have fallen significantly, it is very difficult for many CRE owners to get financing.  For that reason, we should expect to see a lot more defaults (including maturity defaults), workouts and foreclosures. 

Many banks have been quick to extend loans and slow to foreclose, because they could not afford to recognize losses as doing so would increase their capital requirements and perhaps push them into insolvency — and the undesired embrace of the FDIC.  However, as banks move toward recovery, assisted by the massive federal bailout, their capital reserves should improve.  This should allow them to move forward to recognize their losses and foreclose on their troubled CRE loans over time.

So instead of thinking that CRE will recover soon, based on what I’m seeing,  CRE has not yet absorbed the brunt of the recession, and will likely continue to get worse over the next couple of years, until much of the CRE market has been significantly repriced downward.

Of course, the wild card in this is government intervention:  if the federal government decides that massive CRE failures would destabilize the financial system, it might well retool existing governmental bailout programs, invent new ones or change tax policies to cause the injection of more liquidity into the CRE market.   It is hard to guess at the government’s likely intervention, but this Fed and this administration have been very willing to use taxpayer money to stabilize the financial markets, and so might do the same for CRE. 

What do you think?  Share your views by replying below.

The approaching tidal wave: Maturity defaults in CRE loans


Bloomberg has reported this week that “almost $165 billion in U.S. commercial real estate loans will mature this year and need to be sold or refinanced as rents and occupancies fall, according to First American CoreLogic.  The U.S. South has the most maturing loans with 60,893 mortgages valued at $96 billion coming due on shops, offices, hotels, apartment buildings and land . . . .The West is second with 20,549 mortgages maturing for a value of $35 billion.  Commercial property owners are struggling to pay debt as the recession reduces demand and forces landlords to cut rent. . . . Properties worth more than $108 billion were in default, foreclosure or bankruptcy as of July 8, according to data firm Real Capital Analytics Inc.  .  .  .  U.S. commercial property prices fell 7.6 percent in May from a month earlier, bringing the total decline to 35 percent since the market’s peak, Moody’s Investors Service said last week.  .  .  . More than 5,000 commercial properties in the 10 biggest U.S. metropolitan areas got at least one default notice in March, marking the first time that’s happened in First American records going back to January 2003. ”

This looks like an approaching tsunami to me for banks, special servicers and other CRE lenders. 

Now we’re seeing lenders generally extending their loans when possible to avoid having to sell properties at current low prices and into a market where potential buyers are having difficulty arranging new financing.   (The smart lenders are using this as an opportunity to review their loan documents and fix anything that could block or hamper later enforcement through foreclosure.) 

These extensions are, essentially,  bets that the economy will recover soon enough that these lenders won’t have to foreclose or do larger scale workouts.  Extensions are also protective measures for each individual institution —  by postponing any writedown, the lender preserves its own capital and protects its short term solvency.  And it is possible that the massive governmental stimulus will reinflate the economy and the demand for CRE (though I am skeptical about this).

But I can’t figure out where the needed replacement financing is going to come from, especially since the CMBS market appears to be dead, leaving a huge gap (perhaps 40%) in the financing available for CRE.  (Few banks have an appetite for more real estate loans.  Haven’t heard a lot about life insurance companies wanting more  CRE loans either.  One of my partners has done one of the two covered bond deals completed to date, and thinks that structure is unlikely to replace the missing CMBS financing.)   Do any of you have any ideas about what will replace this missing financing?


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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.