The other real estate bubble

August 5, 2009

Petrino DiLeo analyzes the pleas of the not-so-suffering victims of another real estate crisis--and explains why they shouldn't get a bailout.

DURING A special hearing of Congress' Joint Economic Committee in mid-July, Rep. Carolyn Maloney, a Democrat, talked about the growing volume of bad mortgages and said, "Doing nothing is not an option."

Right-wing Republican Sen. Sam Brownback chimed in, too. "Now it's on us," he said, "and I think we need to look at what it is that's taking place, and what policy issues we can address to try to make it better, or at least not as bad as it possibly could get."

What's this? After years of mounting losses, foreclosures and evictions, is Congress finally getting serious and coming up with a real plan to help homeowners in danger of default?

With more than 3.2 million foreclosures expected to take place in 2009 (on top of 3.1 million in 2008), and 15 million homeowners owing more on their mortgages than their homes are worth, such legislation would be grossly overdue.

The help on offer from the federal government has been paltry compared to the need. For example, according to the Treasury Department, only 270,000 homeowners have been offered loan modifications under Barack Obama's Making Home Affordable program as of early July--and only 131,030 loans had actually been modified.

New office towers under construction in Charlotte, N.C.
New office towers under construction in Charlotte, N.C. (James Williamor)

So is something about to change? Sadly, no.

Instead, Maloney and Brownback were voicing their concern about the crisis of commercial real estate--that is, office buildings, shopping centers, apartment complexes, light industrial warehouses, hotels and so on.

Instead of finally doing more to help ordinary people, Congress seems poised to jump to the aid of another group of millionaires and billionaires--and throw federal dollars at exactly the people who don't really need it.


THE JOINT Economic Committee hearing was farcical. Those testifying consisted entirely of representatives from major commercial real estate trade groups, a commercial real estate analyst and an official from the Federal Reserve Bank. The bipartisan panel of lawmakers lofted softball questions at these "experts," who took the opportunity to plead poverty and ask for a laundry list of government handouts and new legislation.

At one point, Maloney declared her sympathy for their plight. "I find it shocking," she said, "that some of the most respected and successful businessmen and women from the district that I am honored to represent tell me they can't get loans."

Missing from the hearing was any discussion of whether the owners and developers of commercial real estate actually need a bailout.

By definition, you have to be wealthy to invest in commercial real estate. But the assumption in Corporate America now is that no one has to take a loss on their investments--because the government will step in with a handout. That's why a group as odious as real estate developers feels emboldened to ask for help.

This isn't a question of preserving jobs. If commercial property owners default on loans, this doesn't mean their buildings--and the businesses operating in them--will shut down. Office towers don't close down if the owners' mortgage goes bad, only if they lose their tenants.

Thus, General Growth Properties--the second-largest owner of shopping malls in the country--filed for bankruptcy earlier this year, and all of its properties are still operating while the firm tries to restructure its debt. In other cases, commercial buildings will pass into the control of the lending banks, which will continue to operate them.

These looming handouts to commercial property owners can't be justified as helping the economy as a whole--only the wealthy few who can use them to avoid investment losses.

The other issue missing from the congressional hearing on commercial real estate was the industry's own responsibility for the mess it's in. None of the lawmakers pointed out how realtors and developers profited off the inflating financial bubble in commercial real estate prices. Instead, investors and developers got to portray themselves as victims of the credit crunch.

Compare this to the discussion when the housing bubble deflated. Whenever the question of aid to homeowners was broached in Congress, conservatives complained that those facing foreclosure had been "irresponsible," and the rest of us "shouldn't have to pay for their bad debts."

The crisis in residential real estate was attributed to speculation and home "flippers"--and homeowners who got stuck with predatory sub-prime mortgages were portrayed not as victims, but as culprits, who gamed those poor mortgage lenders and brokers by lying on their applications in order to get homes they couldn't afford. Some financial executives and political figures even tried to pin the blame for sub-prime mortgages on laws to promote minority home ownership.

None of these kinds of accusations are heard about commercial real estate development--even though "speculation," with the aim of making bigger profits, is the sole purpose of these investments.

Instead, at the congressional hearing, Brownback invited "you, or any of your industry associations, to come up with specific proposals to put forward, because certainly in my office, we'd be interested in putting them forward, whether we get them through or not... That's what I see our role as trying to do is to--to help you get money back in the marketplace."


THE WIDER purpose of the hearing in Congress and similar public relations exercises outside it is to build up the case that the commercial real estate crisis represents a "systemic threat" to the financial system--and lawmakers need to act quickly and on the same massive scale as the Bush-Obama Wall Street bailout to head off financial catastrophe.

It is true that there will likely be hundreds of billions of dollars in losses in commercial real estate in the coming years. But commercial real estate sector is much smaller than residential real estate. Overall, there's about $12 trillion in outstanding residential mortgage debt compared to $3.5 trillion for commercial real estate. Similarly, the total value of commercial real estate is one-third to one-fourth the size of the residential sector.

The difference, of course, is that homeowners don't have massive lobbying operation to plead their case, nor have they been able to line politicians' pockets with contributions over the years.

This isn't to say that commercial real estate isn't facing a crisis. As with the residential sector, low interest rates and abundant opportunities for borrowing caused property values to balloon. Those values are now plummeting precipitously.

Moreover, the sector is being affected by the downturn in the economy. As layoffs continue and businesses close, office vacancy rates rise--and consumer spending falls, hammering the retail sector. Business and recreational travel are both down, which is hurting tourism.

Thus, vacancy rates are rising in every part of the commercial real estate market. Since the market's peak, the number of commercial real estate deals have dropped by 95 percent, and property values are down by as much as 40 percent, with further to fall, according to analysts. The decline is already worse than the 27 percent in the commercial property downturn of the late 1980s and early 1990s, and is also outpacing the drop in home prices, which have fallen by about 30 percent.

Another recent report showed that $2.2 trillion worth of U.S. commercial properties bought or refinanced since 2004 are now worth less than the original price. All told, more than 5,000 commercial properties worth $108 billion are now in default, foreclosure or bankruptcy.

The pain is showing up at banks. In their recent earnings reports, Morgan Stanley and Wells Fargo reported large losses associated with commercial real estate holdings. Colm Kelleher, Morgan Stanley's chief financial officer, said he didn't see the light "at the end of the commercial real estate tunnel yet"--after the bank reported a $700 million write-down on its $17 billion commercial property portfolio in the second quarter. Wells Fargo saw non-performing loans in commercial real estate jump 69 percent in the second quarter.

There will continue to be defaults, delinquencies and foreclosures in the commercial real estate sector as long as the economy remains weak, and that will show up at the banks--and not just the large banks where the residential mortgage crisis ended up being concentrated, but at hundreds of regional and local banks exposed to losses from commercial properties. Already in 2009, close to 70 banks have failed--triple the total for 2008.


THE QUESTION remains, however, whether our money should be spent to bail out this sector--especially since, contrary to the claims of industry trade groups that they are innocent bystanders of the ongoing credit crunch, commercial real estate owners and developers clearly acted irresponsibly in recent years.

At the peak of the market, low-interest loans covering 100 percent or more of a building's value were widely available, and the same sort of loan conditions that caused problems in the residential market--for example, loans with low-interest teaser periods, before ballooning in later years--existed on the commercial side.

In fact, unlike residential mortgages, most commercial real estate loans aren't designed to be paid off at all. Instead, the idea is for borrowers to make small payments at low interest rates for years, and when bigger payments kick in, the borrower either refinances or sells the property, thereby avoiding the larger payments entirely.

But when the whole party stops, there's a problem. Right now, borrowers can neither refinance nor sell--which is a major reason why defaults, delinquencies and foreclosures are on the rise.

Another huge problem is that banks were overly generous in evaluating assets when they made loans. They assumed prices and rents would continue to rise, and therefore the income stream from the property would continue to grow. In reality, the opposite has transpired--values are falling and properties aren't generating the cash flow necessary for borrowers to pay back debts.

In addition, at the peak of the market, somewhere between a quarter and a third of commercial mortgages were tied to Wall Street's securitization machine--that is, the loans were packaged together into huge bonds, which were then sold off in pieces to the biggest investors. In the peak year of 2007, these loans accounted for $230 billion of total commercial mortgages--last year, the number was $12 billion, and so far in 2009, it has been almost zero. In other words, the credit crunch hitting commercial real estate is the result of Wall Street's crisis, not "irresponsible" homeowners.

Real estate owners and developers are using this as an excuse to agitate against new financial regulations. At the congressional hearings, Richard Paruks, head analyst of commercial mortgages for Deutsche Bank, said: "I think many of the panelists here today believe, along with I, that securitization is critically important to play a role in helping to improve the situation as we go forward, and that there are today quite a number of proposed regulations which pose a significant threat to securitization...I think that we need to think very carefully about those proposed new regulations."

The question that needs asking is whether commercial mortgage-backed securities machine should be restarted again--and whether it would be a good thing to return to the times when owners and developers could get a commercial mortgage loan with inflated assumptions about rent and property value increases for the full value of the property.

Another galling feature of the congressional hearings was the fact that the federal government and the Federal Reserve Bank have already initiated programs to aid the commercial real estate sector. The problem is that the industry isn't happy enough with what the government did.

If there was a deeper crash in commercial real estate, it could wreak havoc with pensions. Many pension funds are heavily invested in commercial property and have already lost a lot of money. Further declines would be a problem.

But the bailout being talked about won't go to workers' pensions. It will end up in the bank accounts of a few wealthy owners and developers--the same group of people who have benefited from every measure the government has carried out since the financial crisis began to unfold.

Isn't it time that our side got a bailout instead?

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