NorthBay biz Marin correspondent Bill Meagher takes a look at the county’s struggling commercial real estate market and explains why it could further delay Northern California’s economic recovery.
Three little words: commercial real estate.
Typically, commercial real estate is a lagging economic indicator, so it’s no great surprise the stench arising from the sector is only now becoming evident to the general public. Those in the business of buying, selling, financing or leasing properties began suffering two years ago. The credit markets evaporated. Lenders, despite public reassurances, ceased lending. Property values tanked like Tiger Woods’ public image. The jobless recovery hammered office and multifamily properties. The economy slapped hotels and retail silly. The Marin office vacancy rate ran 20 percent last year, while Sonoma County’s climbed to almost 30 percent at the end of the third quarter. And while that’s brutal, it’s positively stellar compared to Petaluma’s 41 percent.
Case in point
Marin Commons illustrates the emerging crisis. It’s a stone’s throw from Highway 101, perhaps five minutes from the San Rafael-Richmond Bridge exit (less as the crow flies). The 455,000-square-foot office complex is Class A space, though not considered trophy property. Still, it’s among the better office buildings in Marin. At one time, it was the only complex hardwired for high-speed Internet in the county. It boasted high-profile tenants such as Lucas subsidiary THX, Kaiser Permanente and Genworth Life Insurance Company. So when international real estate giant Hines Real Estate and financing behemoth GE Capital purchased the buildings in 2005, nobody batted an eye. Sure, the property was only half-occupied, but this was Hines, a real estate investment trust that had holdings all over the globe and real estate expertise in a big way. There was talk of converting some of the property to housing—not an easy thing to pull off in Marin, but worth pursuing if for no other reason than new housing in the county was a rare commodity indeed, and the margin on new construction wouldn’t do anything but pump up the joint venture’s (JV) returns.
The JV put a $56.3 million mortgage on the property from Connecticut General Life Company as well as an $8.5 million construction loan from Connecticut General’s subsidiary CIGNA to cover capital improvements. That was a lot of debt for a building that was just half leased, but again, this was Marin, and surely Hines knew what it was doing.
But the plans to build housing never took off, the property lost tenants and value, the economy began going south and soon, two of the largest real estate players in the United States were upside down on Marin Commons—and the cash flow wasn’t covering the debt. Complicating matters was the fact that Wall Street was battering GE Capital, with analysts pointing to GE’s top-heavy real estate portfolio of property and debt. GE valued it at $84 billion, but Wall Street claimed the value was less.
Ugly numbers
The Marin Commons story is anything but uncommon across the country. Real Estate Econometrics, a real estate research firm, says unpaid commercial real estate debt will reach 5.3 percent on a national basis by 2011. That figure may not sound like much, but add in a little more information and it gets plenty scary. Consider that, of the $247 billion in global distressed real estate debt, Real Capital Analytics says $180 billion is in the United States. Moody’s Investor Services reports that prices for commercial real estate may drop by 55 percent off price peaks from October 2007. Never mind prices were artificially inflated in the red hot market and investors overpaid. What’s important to remember is those properties carry debt, especially when you look at this next number.
Banks carry 31 percent of distressed loans in the United States, according to the PricewaterhouseCoopers Korpacz Real Estate Survey. Real Capital Analytics says that 48 percent of commercial real estate loans of $5 million or less are held by local or regional banks. Banks with less than $10 billion in assets are considered small banks, and they make up just 20 percent of the total commercial banking assets in the United States. But they hold almost half of the total commercial real estate loans, according to Bank Call Report data.
ING Real Estate Investment Management estimates that, between last year and 2012, $1.4 trillion worth of commercial real estate debt will require refinancing. That’s trillion with a “T.” And of that total, $700 billion may be under water now (property that’s no longer worth the debt owed on it).
Downplaying the problem
Welcome to the other shoe. The question of whether it will drop depends on whom you speak with. In a January speech, Federal Reserve Governor Elizabeth Duke said credit conditions in commercial real estate were “particularly strained.”
Morgan Stanley analysts say troubles in commercial real estate should “only be a moderate headwind for the economy.” This from the Wall Street bank that invested $61 billion in real estate from 2005 to 2008, and last year turned back five San Francisco buildings it purchased for $279 million. Bob Bach, chief economist for commercial real estate broker Grubb & Ellis, told the Los Angeles Times that calling commercial real estate the next shoe to drop is “really an exaggeration. It implies that commercial real estate could cause damage to the financial system equivalent to the subprime residential mortgage losses, which is highly unlikely because the value of commercial mortgages is a fraction of the value of outstanding residential mortgages.”
If you’re like me, the fact that Grubb & Ellis makes its money brokering deals has you reading Bach’s remarks while holding a shaker of salt. Bach also demonstrates a gymnast’s flexibility when he adds, “If banks aren’t lending because they’re coping with losses in their real estate portfolios, this could impede the economic recovery.”
Educated guesses
Robert Eyler, director for the Center for Regional Economic Analysis and a professor of economics at Sonoma State University, is somewhat non-plused by the threat of commercial real estate being a drag on the economy. “The amount of loanable funds at banks right now is large and swelling. Much of this is from the special programs the Federal Reserve, the Treasury and Congress put together as ‘bailout’ money, and has yet to hit the street. Now, if $1.4 trillion in commercial real estate needs to be refinanced, and $1.1 trillion is in reserve, and the long-term trend of excess reserves is about $2 to $4 billion, I think it’s an indicator that commercial banking and commercial real estate are talking and preparing.”
He continues, “The one beauty of that is the money now waiting to be used may become assistance for commercial real estate and avoid another bailout package, an idea that’s been bandied about. The one curse is, it doesn’t solve the fundamental problem of commercial real estate, which is how to slow down vacancies and simultaneously experience positive cash flow. Until the economy picks up in earnest and firms start to occupy those vacant spaces, there will be some lack of temerity on the part of banks to refinance those loans and, thus, foreclosures will rise.”
Richard Parkus, head of commercial real estate debt research for Deutsche Bank Securities, predicts that banks across the country will lose someplace between $200 billion and $300 billion on bum commercial real estate loans. He also says less than 1 percent of commercial real estate loans have so far been written off, but before all the shouting stops, he expects losses to be north of 8 percent. In January, JP Morgan Chase CEO James Dimon referred to the state of commercial real estate as a “train wreck.”
Matthew Anderson of Foresight Analytics in Oakland says as many as 650 banks could fail in the next few years, the majority of those failures directly linked to too much exposure to commercial real estate. To put that number in focus, consider that, as of this writing, with my New Year’s resolutions freshly fractured, 140 banks failed last year (and the FDIC’s in-house list of troubled banks—those that may require help or closing—sat at 552).
Eyler weighs in, “Concerning bank failures, it’s possible that another reason for the mass of excess reserves in banking is to prepare for major consolidation by the larger banks, for better or worse, subsidized by the government to further reduce competition in banking. Credit unions may also move into the consolidation cycle as financial regulations become more widespread and cover all lending institutions in a similar way. Bank failures usually follow major financial market volatility, and the commercial real estate issue does expose a lot of teetering institutions to more write-offs, charge-offs and, ultimately, failure.”
Close to home
Locally, Bank of Marin and Tamalpais Bank have been affected by their exposure to commercial real estate. Sterling Financial, which owns Sonoma Bank, has been told to raise $300 million in capital or find somebody who wants to purchase the parent company, largely due to commercial real estate woes. North Valley Bancorp, which lends in the North Bay, signed an agreement with the Federal Reserve in January to put a new business plan in place as well as maintain sufficient capital and steer clear of “substandard” or “doubtful” borrowers. Five Star Bank, Summit State Bank, North Coast Bank, Wells Fargo, Bank of America, Westamerica Bank and Exchange Bank all have exposure to commercial real estate, not the least of which involves the bankruptcy of Sonoma real estate investor and financier Clem Carinalli.
Carinalli amassed a substantial commercial real estate portfolio before declaring bankruptcy, leaving many of the lenders in limbo as the rat’s nest of interdependent investment vehicles and properties are unwound by the courts. Among those lenders is the aforementioned North Valley Bank, which is carrying a reported $19.2 million in loans to the beleaguered financier.
Some banks have sought to push off their losses attached to souring or maturing loans by extending the loan terms, a technique that has earned the monikers “extend and pretend,” and “delay and pray.” While this lets property owners hold onto their investment and keeps the bank from having to take back property it doesn’t want in the first place, it doesn’t solve the problem; it only pushes off a solution to a future date.
Lenders are required to set aside funds to cover anticipated losses on commercial real estate loans. And that’s money not being loaned out or put to work turning a profit for the banks. And should the bank actually suffer losses, there’ll be pressure to raise new capital to not only satisfy federal regulators, but investors as well.
As some bank loans fail—and they will fail—those losses make it more difficult for the banks to lend to undercapitalized local businesses that need cash to either maintain their business in a precarious economy or to create new jobs and grow. In turn, as businesses stagnate or, worse, fail, the number of jobless grows and more businesses are impacted as local spending is cut.
Why it’s different
Commercial real estate debt is different than residential debt. People pay off their homes and continue to live in them debt free. Commercial property is often simply refinanced as the debt becomes due. Also, commercial loans are often for a term of 10 years, with some portion of that term paid as interest only by the property owner. That means that at the end of the loan term, a balloon payment is due that can be substantial.
In recent years, commercial real estate finance has been dominated by larger players on Wall Street and by insurance companies. The companies invest a portion of their profits and premium payments by making property loans. The loans that Wall Street firms like Goldman Sachs and Morgan Stanley make are grouped into bunches or securitized, with as many as 100 or more ending up in packages worth billions of dollars. The loans are then sliced up into bonds to be sold off to investors. The loans and bonds created from them are known as Commercial Mortgage Backed Securities (CMBS).
The bonds are sold to investors and are priced according to risk, with the safest paying less of a return and riskier bonds carrying a higher return. The bonds are evaluated by investment rating companies such as Moody’s Investor Services. The bond investors are paid off by property owners paying their mortgages. The Wall Street investment banks carry no risk from the loans and generate fees from the sale of the bonds in addition to realizing all funds that were loaned out on the mortgages.
If everything goes right, the CMBS loans work well for everybody in the investment progression. The property owner gets a loan at a very competitive interest rate that costs nothing up front. The investment bank underwrites the loan using sound principals and generates income by selling the bonds. The ratings agency generates income from rating the bonds, and the bond investor realizes returns as the loan is paid off.
But in the summer of 2007, things happened to systematically shut the entire system down and begin the meltdown of commercial real estate. To begin with, lenders got greedy, looking to generate volume in loans to feed the CMBS market and increase fee income, no longer underwriting loans in a fashion that honestly weighed risk. Instead, some loans were being written so that the borrower paid interest only for a longer period of time, sometimes for the entire term of the loan. This means on a $100 million, 10-year loan with 10 years of interest-only payments, at the end of a decade, the borrower would still owe the entire $100 million. This type of underwriting certainly helped the borrower’s cash flow, but it left a hefty balloon to be paid off. Some loans were being written so that instead of covering 80 percent of the value of the property (an industry standard), borrowers received 85, 90 and—in some cases—95 percent of the property value, making the loan riskier as the borrower was contributing less equity and thus had less skin in the game. Lenders were also underwriting loans based not on in-place cash flows, but rather on projected cash flows. This let borrowers receive larger loans based on blue sky hopes.
The ratings agencies had a built-in conflict, as they were being paid by the investment banks that were creating the bonds. While Moody’s, Fitch and the rest claim they were not swayed by the fact that their business was driven by the creation of CMBS, those claims seem to be spurious on their face, especially since the delinquency rate of CMBS loans has multiplied by 29 since July 2007, according to Moody’s own numbers. Even more daunting is the fact that 42 percent of the distressed loans now held by lenders were originated by investment banks. Compare that number to the 31 percent originated by banks, and you begin to see the looming finance mess.
Regulatory breakdown (again)
Bond investors bear some responsibility for the meltdown as well. Too often, they simply relied on the ratings coming from the agencies rather than doing their own independent research. The bond investors, hungry for what they were told were AAA-rated bonds, created an amplified demand for more bonds, pushing investment banks to do even more volume—underwriting and risk be damned. When CMBS began to look a little off, investor demand fell off a cliff. With bond demand dropping to almost nothing, lenders no longer knew what to price their loans at as their resale market disappeared almost overnight.
As Wall Street banks stopped lending, other lenders did one of two things: Life insurance companies, which traditionally kept their loans on their books to maturity, scaled back their lending a bit, cherry picked the best properties and borrowers to lend to, increased their interest rates and became more conservative in their underwriting. On the other hand, regional and community banks increased their lending for a while, enjoying the fact that the commercial real estate market had come to them. But unlike life insurance companies, which became more prudent and jumped interest rates, for a time, banks continued to loan at volumes that would prove to be dangerous.
They also continued to make construction loans, the most risky of commercial real estate loans, since the projects don’t generate any income until they’re finished and purchased or begin leasing up. In fairness, banks have always done construction loans; it’s their bread and butter. And while lenders look carefully at income projections for finished developments, if the unforeseen happens, it can be difficult indeed. It’s even more troubling when the economy begins to slip, and lenders continue to make construction loans.
Local troubles
Look no further than downtown Novato for an extra large example of what happens when income projections go sideways. When the $80 million Millworks project launched downtown, the developers dreamed of a 421,000-square-foot property that would join a 50,000-square-foot Whole Foods supermarket with 125 condos and townhomes. With its location adjacent to what will eventually become the downtown SMART train stop, the project was a taste of the kind of transit-friendly development gaining favor in emerging urban areas across the country.
But the supermarket won’t be open until later this year, and the condos sit empty, an expensive reminder of the tumbling housing market. The owner has tried to salvage some cash flow by renting the condos until a sales market returns, but that’s a far cry from the profits anticipated by the developers and the loan repayments due their lenders.
Sometimes projects never make it to the “vertical” stage. In Windsor, Shiloh Sustainable Village was an innovative $50 million project bringing together retail and office space as well as senior and market rate housing all wrapped up in an environmentally sustainable package. But the ambitious project is now in the hands of Equity Bancorp, a San Rafael private lender. It took the property back from North Street Partners LLC, part of the development group that planned on bringing 10,000 square feet of retail grocery space, 20,000 square feet of office, 80 low-income senior apartments and 60 market rate row houses.
But the project struggled under $8 million in debt, of which Equity owed better than $3 million. The land won’t do Equity any good, and the project’s future value is somewhat tied to the approved uses, so the future of the green project is very much in doubt.
Not everything on the local commercial real estate scene is bleak, however. Bridger Commercial Funding in Mill Valley, a company that works with more than 2,000 banks and lenders across the country, is reviving its CMBS lending program with a bit of tweaking. In the past, Bridger had twin platforms in which it took loans made by other lenders and packed them for inclusion in CMBS packages in New York as well as originating loans on its own. Bridger helped banks shed the loans, regaining the capital and limiting the risk to the lenders by clearing the loans from their portfolios.
The new program takes advantage of the Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF. The government program is designed to restart the securitization market and get credit flowing once again. In 2007, $246 billion worth of loans were securitized as cash flowed to the commercial real estate industry like wine in local tasting rooms. And like those sampling buttery Chardonnays and robust Cabernets, there was a definite buzz and a feeling that the good times wouldn’t end. But 2008 saw just $12 billion in CMBS and 2009 closed with only $2 billion originated, and like imbibers spending too much time in tasting rooms, pain followed.
Bridger looks to assemble packages of loans that are diversified both in the property niche represented as well as by location, with loans ranging from $2 million to $20 million.
While the reentry of Bridger into the CMBS market is a net positive, there’s still plenty of bad news waiting as loans bounce back to banks that were caught up in a market awash in cash and blue skies. Alas, the heavens today are chock full of black clouds and thunderheads, while bankers who should have known better scramble to buy umbrellas. The forecast calls for pain, with intermittent failures and plenty of showers dampening the recovery.
