Why This Real Estate Bust is Different
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  1. The Commercial Real Estate Bust 2.0
  2. Why This Real Estate Bust Is Different
  3. Who Will Refinance $3.5 Trillion in CRE?
  4. REITs & ETFs to the Rescue?
  5. Conclusions: Look Before You Leap


In my September 29 E-Letter, I wrote extensively about the looming crisis in the commercial real estate sector. Things have not improved since my late September letter, and in fact have gotten even worse, despite the pick-up in the economy in the 3Q. Commercial real estate prices have continued to fall, and foreclosures continue to rise.

This week, we will revisit the commercial real estate ("CRE") bust. When I wrote about it in September, we had questions from readers as to how the CRE crisis came to be and why this current slump seems to be worse than other real estate slumps in the past. I have friends and business associates that ask the same thing.

I recently ran across a very good article in BusinessWeek that explains why this commercial real estate bust is unlike any in the past. It is written in an easy-to-understand style with lots of examples. So, for those of you with questions about the CRE bust and the implications for the financial markets, I have reprinted excerpts from the article below. I think you'll find it informative.

The core problem with the commercial real estate market is the $3.5 trillion in outstanding mortgage debt. Of that amount, an estimated $1.3-$1.5 trillion of outstanding loans will have to be refinanced in the next 3-4 years alone. In the past, banks were generally willing to extend these loans, for years in many cases, until the economy and the CRE markets recovered. But they may not be so obliging this time around.

Complicating matters in the current slump is the fact that millions of investors have become CRE lenders over the last decade in the form of Collateralized Mortgage Backed Securities ("CMBS"). Most of these investors just want out; they have no desire to extend these loans. This is another reason the current CRE slump is like no other.

So, it is a real possibility that we will have yet another credit crisis on our hands over the next few years, which supports my view that this could well be a double-dip recession, with the second downturn sparked by widespread defaults and foreclosures in commercial real estate. It's a lot to cover in one letter, so let's get going.

The Commercial Real Estate Bust 2.0

Cyclical swings in the commercial real estate market are hardly new. In the good times, developers overbuild, leaving themselves open to losses whenever the economy slows down. In the past, it was usually banks that ended up with foreclosed properties. In today's mess, in addition to the banks, there are millions of investors who bought collateralized debt securities on commercial real estate who are left holding the bag. And it's a very big bag.

The entire US commercial real estate market is valued at apprx. $6.4 trillion. Of that, apprx. $3.5 trillion of properties have outstanding mortgages. Nationwide, commercial real estate prices have already plunged 39% on average from the peak in late 2007, according to the MIT Real Estate Center. Estimates vary but it is widely believed that nearly half of all commercial real estate mortgage loans in the US - $1.3 to $1.5 trillion - will come due in the next 3-4 years alone.

MIT also reports that most commercial properties bought or refinanced in the last five years are now upside down on their loans, with current property values having fallen below the finance or purchase price. Real Capital Analytics reports that owners have lost their entire down payments on about $1.3 trillion worth of property. Deutsche Bank recently estimated that 65% or more of these loans will fail to qualify for refinancing when they come due.

The Fed's latest "Beige Book" analysis on the economy on October 21 underscores the fact that the commercial real estate market is still worsening:

Commercial real estate was reported to be one of the weakest sectors… Commercial real estate continued to weaken across the 12 Districts… Each District indicated that demand for private commercial real estate was weak, with New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco all characterizing activity as declining further since the last report. An inability to obtain credit was often cited as a problem for businesses that wanted to purchase or build space. High vacancy rates were noted as a key concern especially for landlords who were not offering concessions.

Each year, PricewaterhouseCoopers and the Urban Land Institute issue a detailed report entitled "Emerging Trends in Real Estate." This annual report, in its 31st year, is based on interviews with about 1,000 developers, investors, real estate service firms, banks and others.

The latest report for 2010 predicts that commercial real estate prices will continue to decline well into 2010, falling 40%-50% from the peak in 2007. According to the report, this will be the worst commercial real estate decline since the Great Depression, eclipsing the 1990s savings-and-loan crisis. It goes on to say:

"Not surprisingly, the overwhelming sentiment of interviewees remains decidedly negative, colored by impending doom and distress over prospects for an extended period of anemic demand and costly deleveraging. Hardest-hit will be retail and office properties, reflecting a weak job market and cautious consumers."

With the above as a general backdrop to the current commercial real estate dilemma, let's now turn to excerpts from the November 16 BusinessWeek article that I mentioned in the Introduction. Hopefully, this will answer questions about how we got in this mess. Following that, I will further explain how this CRE slump is like no other.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.


Why This Real Estate Bust Is Different

Unrealistic assumptions, layers of investors, sky-high prices, and possible fraud will make it hard to clean up the mess in commercial real estate

When Goldman Sachs sold complex bonds backed by the Arizona Grand Resort and other commercial properties in 2006, it suggested the returns would be strong. The 164-acre luxury Arizona Grand, set against the Sonoran Desert in Phoenix, boasted an award-winning golf course, deluxe spa, and several swank restaurants. The on-site water park was named one of the best in the country by the Travel Channel. With the resort's new owners planning to refurbish hotel rooms and common areas, Goldman told investors that the renovations would help boost cash flow.

As was so often the case during the real estate boom, the lofty projections didn't pan out. When the economy softened and business travel slumped, Arizona Grand's bookings slipped to 67%, from 80%. The resort defaulted on the $190 million underlying loan in 2009—a hit that alone could largely wipe out investors who bought the riskier pieces of the Goldman mortgage-backed securities deal.

"It's one of the largest losses we have forecasted for an individual loan," says Steve Kuritz, a senior vice-president at Realpoint, an independent credit-rating agency. The property, once valued at $246 million, is now worth just $93 million. A spokesman for Goldman says the pricing on the bonds was in line with market levels at the time and not above what investors could get on similar securities. Grossman Co. Properties, which owns Arizona Grand, didn't return calls for comment.

It would be easy to write off this blowup as just another casualty in the regular boom-and-bust cycle of the $6.4 trillion commercial real estate market. But the Goldman deal, with its unrealistic assumptions, multiple layers of investors, and stratospheric prices, helps illustrate why this downturn is more complicated than previous ones—and will turn out to be far costlier. Already, prices have plunged 41% from the peak in 2007, according to Moody's/REAL Commercial Property Price Index—worse than the 30.5% fall in the housing market from its 2006 apex. "We've never seen this extreme a correction as far back as the data go, which is the late 1960s," says Neal Elkin, president of Real Estate Analytics, the research firm that created the index. Adds billionaire investor Wilbur Ross: "Commercial real estate has gone from being highly liquid at sky-high prices to being extremely illiquid at distressed prices."

To appreciate why this bust is like no other, first consider the typical commercial real estate downturns that used to crop up every 5 or 10 years. The pattern was predictable: When prices for apartment complexes, office buildings, shopping malls, and other properties began to rise, developers sped up their projects to cash in on the bull market. Eventually, some of those developers, unable to fill all the new space, began to default on their loans, and lenders were stuck with the buildings they'd financed. The slump lasted no longer than the time it took for the property glut to be worked down.


But overbuilding isn't the culprit in this bust. An oversupply of money is what pushed commercial real estate over the edge. [Emphasis added]

It turns out the same excesses that drove the housing market's crazy rise and fall were present in commercial real estate, too—but they have largely gone unnoticed until now. Bankers, in their haste to make more and bigger loans, blindly accepted borrowers' wildest growth assumptions and readily overlooked other shortcomings on loan applications. They did so in part because they could easily sell their dubious loans to investors in the form of commercial mortgage-backed securities [CMBS]. As the market overheated, it became a breeding ground for fraud: A flurry of new court cases reveals the disturbing extent to which commercial mortgage borrowers may have doctored loan documents. [Emphasis added]

While the housing crisis seems to be easing, the commercial storm is still gathering strength. Between now and 2012, more than $1.4 trillion worth of commercial real estate loans will come due, according to real estate investment firm ING Clarion Partners. Analysts at Deutsche Bank estimate that borrowers will have trouble rolling over as many as three-quarters of the loans they took out in 2007, the most toxic vintage. [Emphasis added.]

For the banks and investors whose money fuels the economy, this presents major problems. Their losses will likely cast a shadow over lending—and, by extension, the overall economy—for years. The market won't fully recover until 2020, says Kenneth P. Riggs Jr., CEO of Real Estate Research, and in cases where "values were over the top...maybe never."

In the short term, toxic securities are creating a new problem weighing on the market: a tangle of interconnected investors fighting over the remains of the properties they own. In the past the damage was limited to a handful of lenders who invested directly in any given project. Now there can be dozens of groups of investors, each with its own agenda. The April bankruptcy of shopping mall owner General Growth, one of the largest real-estate-related bankruptcies ever, affected hundreds of parties—an unprecedented slicing and dicing of assets. These investors won't soon forget the bust and aren't likely to dive back into the market as aggressively as they once did. [Emphasis added]

And yet the securities are only a secondary problem. The main driver of the commercial real estate bust is the underlying loans. How frothy did the market get? In one notable example, New York investment fund Sterling American Property and real estate company Hines paid $281 million in 2007 for the 42-floor office building at 333 Bush St. in San Francisco. That worked out to $518 a square foot, far higher than today's price, according to Real Capital Analytics, a research firm. Less than two years later, the building's primary tenant, law firm Heller Ehrman, filed for bankruptcy and stopped making rent payments. According to Real Capital Analytics, the building's owners did not make a recent loan payment, and the lender is expected to begin foreclosure proceedings…

What's striking is how quickly some big commercial deals have gone south. In April 2007, Charney FPG, a New York real estate partnership, paid about $180 million to buy a 22-story office building in Manhattan's Times Square district. It borrowed $202 million to pay for the purchase, renovations, and incidentals—111% financing. Because the rental income didn't cover the debt payments, Comfort's lenders, Wachovia and RBS Greenwich Capital, required the firm to set aside $10 million in reserves to keep the project afloat until it got more paying tenants. Those occupants never materialized, and by July the owners had exhausted 95% of their reserves. The building is now in jeopardy of being seized by the bankers, says Real Capital Analytics' head of research, Dan Fasulo. "Everyone knows Judgment Day is coming." Says a Charney spokesman: "The owners are in the midst of restructuring the debt." Wachovia and RBS declined to comment.

Commercial lending mirrored mortgage lending in another way: Loans were made based on an unshakable belief that the market would never go down. An analysis by research firm REIS of mortgage securities created between 2005 and 2008 found that income projections for properties exceeded their historical performances by an average of 15%. "It was all based on assumption of cash flow," says Howard S. Landsberg of New York-based consultant Weiser Realty Advisors. "If you couldn't afford to pay the bank back now, in three years you could count on another $20 a square foot" in rent. When the numbers didn't add up, some lenders got imaginative. Says a banker at a large Wall Street firm: "If the cash flow wasn't there, you had to ignore it or find ways to create it."

Some lenders may have drummed up business for themselves, enticing borrowers with more money than they needed. Consider Credit Suisse's $375 million loan to the Yellowstone Club in Big Sky, Mont., one of the starkest examples of poor underwriting in recent memory. Opened in 1999 by Timothy L. Blixseth, a welfare kid turned timber magnate, the private ski and golf club catered to the ultra-wealthy crowd. Microsoft founder Bill Gates and Tour de France champion Greg LeMond built multimillion-dollar vacation homes there.

In 2005 a Credit Suisse banker approached Blixseth about a loan, which the banker compared to "a home equity loan," according to bankruptcy court documents. Blixseth initially turned down the offer. But after several calls and a personal visit to Blixseth's home near Palm Springs, Calif., the banker persuaded Blixseth to borrow $375 million in the name of the club. According to court papers, the two decided the transaction fee by coin flip; Blixseth won, agreeing to pay 2%.


But not all of the funds were earmarked for the club. The deal allowed Blixseth to use up to $209 million of the proceeds "for his own personal benefit," according to the bankruptcy court papers. In a civil lawsuit filed by Yellowstone investors and homeowners, the plaintiffs say Blixseth used some of that money to fund a lavish lifestyle, including the purchases of a 20-seat Gulfstream corporate jet, two Rolls-Royce Phantoms, and three Land Rovers.

While Blixseth was busy spending the money, Yellowstone was struggling under the weight of its debt. Vendors often went unpaid for three months or longer, according to bankruptcy court testimony. In November 2008, Yellowstone filed for bankruptcy protection. "The only plausible explanation for Credit Suisse's action is that it was simply driven by the fees it was extracting from the loans it was selling and letting the chips fall where they may," said Ralph B. Kirscher, a federal bankruptcy judge in Helena, in a May court decision.


The banks were hardly the only freewheeling players during the credit boom. The fast-and-easy lending environment was fertile territory for alleged fraudsters. In 2007 Prudential Financial lent $13.9 million to Namir A. Faidi, a Houston developer who planned to use the money to pay off construction loans on Piazza Blanca, a Mediterranean-themed shopping complex in Galveston, Tex. Faidi dipped into the project's reserve fund to make the first loan payment but failed to make any more. After that, Prudential concluded that some of the leases he'd submitted weren't legitimate. According to a civil suit filed in federal court by Prudential, Faidi's loan papers included a signed lease from time-share giant Bluegreen, a purported tenant that would occupy 26% of the space. But when Prudential contacted Bluegreen after the default, it learned it had backed out of talks and never signed a rental agreement…


Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Who Will Refinance $3.5 Trillion in CRE?

As noted earlier, it is widely agreed that there is apprx. $3.5 trillion in outstanding commercial real estate debt. It is also widely agreed that some $1.3 to $1.5 trillion of that debt will have to be refinanced over the next 3-4 years. The question is, who will step up to the plate? The chart below illustrates who the main players are.

Who Will Finance American Real Estate Tomorrow?

Looking at the left panel above, we see that banks and S&Ls hold 51% of outstanding CRE debt. Investors in Collateralized Mortgage Backed Securities (CMBS) own apprx. 21%. Together, these represent 72% of outstanding CRE debt. The slice noted as "Other 15%" is mainly made up of REITs. Much of the financing since 2002 has been in the CMBS (individual investors for the most part).

Virtually all of the players have seen the values of their CRE investments plunge since the peak in 2007. As noted earlier, CRE values are down 39%-41% on average depending on which estimate you believe, and they are still falling for the most part.

The National Association of Realtors projects that retail vacancy rates will increase from 11.7% in the 2Q of 2009 to at least 12.9% in the same period of 2010, the highest vacancy rates since 1991. Likewise, NAR projects that office building vacancy rates will rise from 15.5% to at least 18.8% by this time next year.

While the economy seemed to turn around in the 3Q, most forecasters agree that the unemployment rate will remain near 10% for all of 2010. Given that, it is likely that CRE vacancy rates will remain high. For all these reasons, Deutsche Bank predicts that over 65% of the loans coming due in the next few years will fail to qualify for refinancing.

So, we are back to the question of how does this $1.3 to $1.5 trillion in CRE get refinanced over the next several years? The answer is, much of it won't. Defaults will continue to rise. This will put banks increasingly in the sublease business, assuming that willing tenants can be found. Unfortunately, sublease rental rates typically are only 60%-80% of the original rates.

Commercial real estate loans are not just concentrated among the nation's largest banks; these loans are widely made by regional banks and even smaller banks. These banks are even more at risk because they will likely have a harder time accessing the crucial capital to offset rising defaults on commercial real estate loans. The FDIC reports that 120 small and regional banks have failed so far this year (as of Nov. 6), compared to only 24 failures in all of 2008.

Obviously, banks will not be refinancing much of the $1.3-$1.5 trillion that comes due over the next 3-4 years. Banks are still trying to reduce their exposure and deleverage. Likewise, the CMBS market has practically dried up. So who is left to refinance these maturing CRE loans?

As we might expect, there are those in the CRE industry that are calling for a government bailout – what else is new? You may recall that about this time last year, the Fed created what is called the "Troubled Asset Loan Facility" (TALF) which is scheduled to end soon. Now there are calls from the CRE industry to extend that facility.

Others are calling for changes such as:

  1. Stop forcing banks to reclassify loans that have had minor modifications to assist borrowers (and continue the so-called "pretend and extend" practice);
  2. Reject any new taxes on real estate such as capital-gains-tax hikes; changes to IRS Section 1031, which allows tax deferral; and
  3. Amend the IRS Tax Reform Act of 1986 to allow modification of loans within Real Estate Mortgage Investment Conduits (REMICSs). Some 25% of US commercial real estate is financed with these securities.

It remains to be seen if the Obama administration will entertain any of these requests. If I were a real estate developer, I wouldn't count on it.

REITs & ETFs to the Rescue?

REIT is the acronym for Real Estate Investment Trust. REITs are similar to mutual funds except that their shares trade as stocks on the major exchanges. ETF is the acronym for Exchange Traded Funds, which also trade as stocks throughout the day. REITs generally only invest in real estate.

Like real estate, REITS were hammered by the recession, on average losing 70% from the peak in 2007 to the bottom in March. Since then, average REIT prices have rebounded strongly, up apprx. 80%, but are still far below the highs in 2008. Dozens of new IPOs in the form of REITs have been launched since March, reportedly raising over $20 billion in new assets, by fund managers who seek to acquire bargain basement commercial real estate properties. I'm told there have also been dozens of new ETFs that have been formed this year for the very same purpose.

Most estimates suggest that there will be around $500 billion in commercial real estate loans that will need to be refinanced in 2010 alone. So while REITs and ETFs will help, they are not the magic bullet.

Conclusions – Look Before You Leap

There is currently $3.5 trillion in outstanding commercial real estate debt, with much of it related to properties purchased at exorbitant prices during the real estate boom that ended in 2007. Many private equity players and hedge funds used heavy leverage, borrowing up to 80% of the purchase price, to acquire the properties that are now struggling to generate the cash-flow needed to service the debt and meet debt calls.

An estimated $1.3- $1.5 trillion in commercial real estate debt will need to be refinanced over the next 3-4 years, with apprx. $500 billion of that coming due in 2010. The question is, who will be there to refinance these CRE loans? Banks are trying to reduce their exposure to CRE. REITs and ETFs will take on some of these properties, but certainly not all or even most. Is there another massive government bailout on the horizon? Don't rule it out.

It is not unusual for the real estate market to worsen even after the economy comes out of recession. In the 1991 recession, it took the industry 14 months to rebound after the recession's end; in the 2001 downturn, it took 29 months for the sector to fully recover. Even if the current recession ended in the summer as many seem to believe, it could easily take a couple of years for commercial real estate to bounce back, and that assumes we are not looking at a double-dip recession which I believe is entirely possible.

Put differently, the commercial real estate dilemma is likely to get worse before it gets better. As discussed above, vacancy rates continue to rise; loan default rates continue to rise; foreclosures continue to rise; and all of this will continue to worsen as long as unemployment remains above 10%.

As discussed above, a lot of money is being raised publicly and privately with the goal of cashing in on the commercial real estate debacle. Promoters are touting "once in a lifetime" profit potential as they look to scoop up distressed properties for pennies on the dollar.

Yet the amount of money being raised is only a fraction of the size of the $1.3+ trillion in commercial real estate debt that needs refinancing over the next 3-4 years. So the CRE market could be far from a bottom. As the old saying goes, look before you leap.

Very best regards,

Gary D. Halbert


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Wrong time to be pushing massive health reform


"Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend any product or service advertised herein, unless otherwise specifically noted."

Forecasts & Trends is published by ProFutures, Inc., and Gary D. Halbert is the editor of this publication. Information contained herein is taken from sources believed to be reliable, but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgment of Gary D. Halbert and may change at any time without written notice, and ProFutures assumes no duty to update you regarding any changes. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Any references to products offered by Halbert Wealth Management are not a solicitation for any investment. Such offer or solicitation can only be made by way of Halbert Wealth Management’s Form ADV Part II, complete disclosures regarding the product and otherwise in accordance with applicable securities laws. Readers are urged to check with their investment counselors and review all disclosures before making a decision to invest. This electronic newsletter does not constitute an offer of sales of any securities. Gary D. Halbert, ProFutures, Inc. and all affiliated companies, InvestorsInsight, their officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Securities trading is speculative and involves the potential loss of investment. Past results are not necessarily indicative of future results.

Posted 11-17-2009 3:54 PM by Gary D. Halbert