The Other Real Estate Crisis — Commercial Property

This article was originally published by the Fiscal Times on Saturday, Sept. 18, 2010 and the Washington Post on Sunday, Sept. 19, 2010.

The landmark Mayflower Hotel in Washington, D.C. has been a watering hole for presidents and pundits alike. But like other commercial real estate properties throughout the country affected by the mortgage crisis, the Mayflower is under water.

By Katherine Reynolds Lewis and Jonathan O'Connell

It was dubbed Washington's second best address by Harry S. Truman, and it has hosted events for every presidential inauguration since Calvin Coolidge. Franklin Roosevelt used it as a retreat to work on his 1933 inaugural address. And FBI Director J. Edgar Hoover was a lunchtime regular.

The elegant Renaissance Mayflower Hotel, a Washington landmark since 1925, was considered a hot property when Rockwood Capital of San Francisco acquired it for $260 million in March 2007. Then, practically overnight, the real estate market collapsed and credit evaporated in a historic global financial meltdown. The new hotel owners, saddled with $200 million in debt, watched as the value of the property tumbled. By August, credit agency Realpoint estimated its value at $128 million.

The Mayflower loan was underwater, the plight of hundreds of billions of dollars' worth of commercial properties across the nation that are worth less than their mortgages. If the hotel's owner couldn't find a way to restructure the debt, it could lose the property.

A staggering $1.4 trillion of commercial real estate loans will come due nationwide in the next four years, forcing borrowers such as Rockwood to refinance or default on their obligations. Trouble lingers even at doorsteps in Washington, one of the strongest markets in the country thanks to a broad employment base, a sound infrastructure and a massive government presence.

This is happening at a time when the capacity to absorb such debt has been slashed, following the bankruptcies of financial firms such as Lehman Brothers and the collapse of the commercial mortgage-backed securities issuance down to a tenth of its peak size. The thought of a string of commercial real estate defaults walloping the barely recovering economy and jeopardizing the stability of still-tottering banks is enough to keep analysts up at night.

"It's a very tricky time right now," said Geoffrey DiMeglio, director of consulting at Market Outlook, a consulting firm. "Even in a weak recovery, I don't see employment improving the fundamentals in real estate fast enough to get these properties out of default."

Property owners and lenders may well ride out this storm with lessons from the last major slump in the commercial real estate market. During the collapse of the early 1990s, banks were under pressure to secure a speedy fix for troubled properties. So instead of working with borrowers, they were quicker to process foreclosures and then sell off properties at auction. Lenders ended up losing billions on real estate portfolios that they didn't want to hold and weren't equipped to manage. The fallout rattled through the economy. In time, the glut of cheap property on the market created a fast and vast run-up in wealth once the market took off again, fueling those heady days of consumer largesse.

"Banks and other lenders were forcing things onto the market when there was no real market, so that things were going really cheap," said Douglas J. Donatelli, chairman and chief executive of First Potomac Realty Trust in Bethesda. "And the losses that banks were taking were much, much greater than they should have been or could have been."

In those days, the Mayflower may well have been foreclosed upon and sold at auction alongside luxury townhouses and exurban housing developments funded by speculators. This time, another scenario played out. Rockwood Capital signaled in November that it might not be able to make its next mortgage payment, according to Realpoint. Bank of America, the primary lender, and investors in the Mayflower didn't hit the panic button. Instead they were willing to overlook a missed payment or two and wait out the downturn, absorbing some short-term losses, according to sources with knowledge of the deal who were not authorized to discuss it.

In late July, a special servicer, a company that manages distressed loans for lenders, agreed to extend the due date on the loan. In return, Rockwood Capital would put up $11 million of additional cash, according to Standard & Poor's analysts.

The servicer, Midland Loan Services, a division of PNC Real Estate, extended the due date for the balance of the loan by a year, to 2013, in exchange for the capital infusion. The deadline could be pushed out to 2014 if Rockwood meets specific performance benchmarks. Rockwood and Bank of America declined to comment.

Changes in thinking

The wait-and-see attitude of the Mayflower's creditors signals a shift in thinking.

While stretching out the payments on a loan may well save it, it could also delay the pain. "Even though it was a bloody situation in the early '90s, at least it was mercifully quick," Donatelli said. "A lot of people lost a lot of money and a lot of jobs and a lot of projects changed hands that might not have had to change hands, but it was fast, reasonably fast. This is going to be prolonged."

Where refinancing doesn't pan out, cash can save the day. Some investors have upped the ante when debt comes due, even on purchases made near the peak of the market. New York-based Tishman Speyer and a half-dozen partners defaulted on a $600 million note for a portfolio of 28 Washington-area office buildings that they'd agreed to buy for $2.8 billion in late 2006. In June, five days before Barclays had reportedly scheduled an auction on the debt, Tishman and its equity partners threw another $700 million into the deal, erasing the debt and hanging onto the properties.

Even Lehman Brothers, still embroiled in bankruptcy proceedings, has managed to scrape together money to save a deal. In 2007, Monday Properties of New York partnered with Lehman to buy 10 Rosslyn office buildings for $1.1 billion - only to see Lehman go bankrupt 16 months later. This spring, Monday had $239 million of debt coming due on the properties, a situation that seemed ripe for distress.

In June, Lehman secured bankruptcy court approval to join Monday in making an additional $263 million equity investment to erase the debt. Anthony Westreich, chief executive of Monday Properties, said the strength of Rosslyn's office market, considered a top market internationally, was a major factor in persuading Lehman to increase its equity stake. He said that he does not expect to see many other Washington property owners with debt coming due lose their portfolios, either.

"A lot of loans that matured today or tomorrow are being extended out, sort of pushing the problem down the road," Westreich said.

While "lending and extending" is keeping some properties out of foreclosure, he said, other borrowers are surviving on savings or loans that are still locked into low interest rates. All that could change if interest rates rise, making loan payments more pricey, he said, which could push more properties onto the market and create opportunities for buyers.

A large equity stake, Donatelli said, is strong incentive for a borrower to salvage a deal.

"There's a lot more equity in the real estate market as a whole than there was in the early '90s," he said. "Back in the early '90s, there was very very little equity. Most projects were built with 100 percent debt. Today, it's really rare to see a project built with 100 percent debt."

High stakes

Without question, the stakes are high. Commercial real estate accounts for 6 percent of gross domestic product and property values have fallen more than 40 percent since reaching a high in 2007. The default rate for commercial mortgages held by banks has yet to peak; it hit 4.28 percent in the second quarter and is expected to climb to 5.4 percent by the end of next year. Fitch Ratings predicts "significant increases in delinquencies on commercial property loans." Overall, the U.S. economy is balanced between a return to healthy lending and economic growth and continuation of the recession amid anemic capital markets.

"The real flood of these maturing loans hasn't happened yet," said Ben Thypin, senior market analyst at research firm Real Capital Analytics.

With banks still reeling from the financial crisis and stingy with their lending, borrowers could fail to find lenders willing to refinance when their mortgages come due.

Developers that have the money to pay the debt coming due on an underwater property face the same decision that many homeowners do: Is it better to just walk away? In recent months, major commercial-property owners have defaulted on debts and surrendered buildings worth less than their loans.

Companies such as Macerich, Vornado Realty Trust and Simon Property Group stopped making mortgage payments to put pressure on lenders to restructure debts, according to a report in the Wall Street Journal. In some cases they have simply walked away, notifying the lender of their decision with "jingle mail" - sending back the keys. These companies may have piles of cash to make the payments, but a default ends up being a better business decision.

Even so, the Mayflower experience offers a ray of hope that, despite the "wall" of maturities coming due before 2014, many commercial real estate markets will persevere. After all, a powerful collection of actors have a stake in buoying the sector: investors hunting for bargains, federal regulators who have papered over trouble in the past and lenders who would rather have some income than amass a collection of nonperforming real estate.

"To foreclose or liquidate many of these distressed assets in this market does not make sense," said Frank A. Innaurato, managing director at Realpoint. "There is a lot of optimism that. . . things might be turning around. We're looking at some point in 2011 where we may hit a turning point, but it's very much dependent on a willingness to lend."

Weathering the storm

Standard & Poor's ranks the Washington area as one of the healthiest commercial mortgage-backed securities markets in the country, second only to Massachusetts, largely because of the federal government's growing demand for office space. States that suffered the most in the housing bust and manufacturing downturn are at the top of the list for delinquencies: Nevada, Arizona, Michigan, Florida and Ohio, said Larry Kay, a Standard & Poor's director. But major cities in other states and, to some degree, the regions around them have weathered the storm.

Other properties - even the iconic - have been pushed onto the market by untenable financing and less patient lenders. Case in point: the Watergate Hotel, a portion of the complex made infamous by the Nixon-era break-in. The hotel was purchased by developer Monument Realty in 2004 for $45 million. Monument planned to transform the 251-room hotel into high-end condominiums called Belles Rives at the Watergate.

But last year, Monument began missing payments on a $40 million loan from PB Capital, a German bank, which foreclosed in July 2009. Monument principal Michael J. Darby said that he offered to replace the debt using $25 million in new equity and $25 million in subsidies that he hoped to receive from the District of Columbia, but PB Capital declined. After PB Capital failed to find a buyer at auction, a holding company of Euro Capital Properties bought the property for $45 million in May. PB Capital did not respond to requests for comment.

"You would think that the lender would be willing to work with us," said Darby, who doesn't think many properties will go the way of the Watergate. "That happened in the recessionary part of the market because the lenders didn't have anything else that they knew they could do with the property."

Unlike the residential mortgage market collapse, malaise in the commercial real estate sector is more a symptom of a sluggish economy than a looming threat to recovery. When housing prices plummet, household wealth evaporates and consumers cut spending, leading to economic contraction. But trouble in commercial real estate merely reflects the health of the economy, whether slower retail sales, decreased tourism or corporate downsizings. While the sector affects state and local tax revenues and economic growth - thereby touching every taxpayer and resident in the country - it's unlikely to single-handedly trigger a repeat of the 2008 financial crisis.

Still, interest rates and the overall economy are wild cards. A jump in interest rates would worsen the difficulties borrowers are currently experiencing and increase defaults. Similarly, if the U.S. economy moves into a deflationary cycle, all assets would lose value, including real estate.

As Donatelli put it: "There's an inevitable day of reckoning coming. It might not be as bloody, it might not be as severe, but it's gonna come, it just might be kicked down the road a couple years."