FCIC on CRE: "You've Got to Get Up and Dance."

The Financial Crisis Inquiry Commission's report is out.

There are a couple sections specifically about commercial real estate. The first is, "LEVERAGED LOANS AND COMMERCIAL REAL ESTATE: 'YOU'VE GOT TO GET UP AND DANCE'" and the second is "COMMERCIAL REAL ESTATE: 'NOTHING'S MOVING'"

The first section documents the explosive rise of the CMBS industry and how that coincided with spikes in property values. The second section from later in the document is about the standstill that eventually emerged in the commercial real estate investment sales market after the financial crisis.

I've cut and pasted those two sections after the jump:


The credit bubble was not confined to the residential mortgage market. The markets for commercial real estate and leveraged loans (typically loans to below-investment grade companies to aid their business or to finance buyouts) also experienced similar bubble-and-bust dynamics, although the effects were not as large and damaging as in residential real estate. From 2000 to 2007, these other two markets grew tremendously, spurred by structured finance products—commercial mortgage–backed securities and collateralized loan obligations (CLOs), respectively—which were in many ways similar to residential mortgage-backed securities and CDOs. And just as in the residential mortgage market, underwriting standards loosened, even as the cost of borrowing decreased, and trading in these securities was bolstered by the development of new credit derivatives products.

Historically, leveraged loans had been made by commercial banks; but a market for institutional investors developed and grew in the mid- to late 1990s. An “agent” bank would originate a package of loans to only one company and then sell or syndicate the loans in the package to other banks and large nonbank investors. The package generally included loans with different maturities. Some were short-term lines of credit, which would be syndicated to banks; the rest were longer-term loans syndicated to nonbank, institutional investors. Leveraged loan issuance more than doubled from 2000 to 2007, but the rapid growth was in the longer-term institutional loans rather than in short-term lending. By 2007, the longer-term leveraged loans rose to $387 billion, up from $46 billion in 2000.

Starting in 1998, the longer-term leveraged loans were packaged in CLOs, which were rated according to methodologies similar to those the rating agencies used for CDOs. Like CDOs, CLOs had tranches, underwriters, and collateral managers. The market was less than $5 billion annually from 1998 to 2002, but then it started growing dramatically. Annual issuance exceeded $40 billion in 2005 and peaked above $80 billion in 2007. From 2000 through the third quarter of 2007, more than 60% of leveraged loans were packaged into CLOs.

As the market for leveraged loans grew, credit became looser and leverage increased as well. The deals became larger and costs of borrowing declined. Loans that in 2003 had paid interest of 4 percentage points over an interbank lending rate were refinanced in early 2007 into loans paying just 2 percentage points over that same rate. During the peak of the recent leveraged buyout boom, leveraged loans were frequently issued with interest-only, “payment-in-kind,” and “covenant-lite” terms. Payment-in-kind loans allowed borrowers to defer paying interest by issuing new debt to cover accrued interest. Covenant-lite loans exempted borrowers from standard loan covenants that usually require corporate firms to limit their other debts and to maintain minimum levels of cash. Private equity firms, those that specialized in investing directly in companies, found it easier and cheaper to finance their leveraged buyouts. Just as home prices rose, so too did the prices of the target companies.


Commercial real estate—multifamily apartment buildings, office buildings, hotels, retail establishments, and industrial properties—went through a bubble similar to that in the housing market. Investment banks created commercial mortgage–backed securities and even CDOs out of commercial real estate loans, just as they did with residential mortgages. And, just as houses appreciated from 2000 on, so too did commercial real estate values. Office prices rose by nearly 60% between 2003 and 2008 in the central business districts of the 32 markets for which data are available. The increase was 193% in Phoenix, 153% in Tampa, 147% in Manhattan, and 146% in Los Angeles.

Issuance of commercial mortgage–backed securities rose from $47 billion in 2000 to $169 billion in 2005, reaching $230 billion in 2007. When securitization markets contracted, issuance fell to $12 billion in 2008 and $3 billion in 2009. When about financing came from the top five investment banks and large commercial banks such as Bank of America and Deutsche Bank.

Bear Stearns was increasingly active in these markets. While Bear topped the 2006 market in residential securitizations, it ranked in the bottom half in commercial securitizations. But it was racing to catch up, and in a 2007 presentation boasted: “In 2006, we firmly established Bear Stearns as a global presence in commercial real estate finance.” The firm's commercial real estate mortgage originations more than doubled between 2004 and 2006.

And then the market came crashing to a halt. Although the commercial real estate mortgage market was much smaller than the residential real estate market—in 2008, commercial real estate debt was less than $4 trillion, compared to $12 trillion for residential mortgages—it declined even more steeply. From its peak, commercial real estate fell roughly 45% in value, and prices have remained close to their lows. Losses on commercial real estate would be an issue across Wall Street, particularly for Lehman and Bear. And potentially for the taxpayer. When the Federal Reserve would assume $30 billion of Bear's illiquid assets in 2008, that would include roughly $4 billion in loans from the unsold portion of the Hilton financing package. And the commercial real estate market would continue to decline long after the housing market had begun to stabilize.



Commercial real estate—offices, stores, warehouses—also took a pounding, an indicator both of the sector's reliance on the lending markets, which were impaired by the crisis, and of its role as a barometer of business activity. Companies do not need more space if they go out of business, lay off workers, or decide not to expand. Weak demand, in turn, lowers rents and forces landlords to give their big tenants incentives to stay put. One example: two huge real estate brokerages with headquarters in New York City received nine months' free rent for signing leases in 2008 and 2009.

In fall 2010, commercial vacancy rates were still sky-high, with 20% of all office space unoccupied. And the actual rate is probably much higher because layoffs create “shadow vacancies”—a couple of desks here, part of a floor there—that tenants must fill before demand picks back up. In the absence of demand, banks remain unwilling to lend to all but the safest projects involving the most creditworthy developers that have precommitted tenants. “Banks are neither financing, nor are they dumping their bad properties, creating a log jam,” one developer told a National Association of Realtors survey. “Nothing's moving."

In Nevada, where tourism and construction once fed the labor force, commercial property took a huge hit. Office vacancies in Las Vegas are now hovering around 24%, compared with their low of 8% midway through 2005. Vacancies in retail commercial space in Las Vegas top 10%, compared with historical vacancy rates of 3% to 4%. The economic downturn tugged national-brand retailers into bankruptcy, emptying out the anchor retail space in Nevada's malls and shopping centers. As demand for vacant property fell, land values in and around Las Vegas plummeted.

Because lenders were still reluctant, few developers nationally could afford to build or buy, right into the fall of 2010. Lehman's bankruptcy meant that Monday Properties came up short in its efforts to build a $300 million, 35-story glass office tower in Arlington, Virginia, across the river from Washington, D.C. Potential tenants wanted to know if the developer had financing; potential lenders wanted to know if it had tenants. “It's a bit of a cart-and-horse situation,” said CEO Anthony Westreich, who in October 2010 took the big risk of starting construction on the building without signed tenants or permanent financing. The collapse of teetering financial institutions put commercial real estate developers and commercial landlords in binds when overextended banks suddenly pulled out of commercial construction loans. And when banks failed and were taken over by the Federal Deposit Insurance Commission, the commercial landlords overnight lost major bank tenants and the long-term leases that went with them. In California, at least 35 banks have failed since 2003.

Almost half of commercial real estate loans were underwater as of February 2010, meaning the loans were larger than the market value of the property. Commercial real estate loans are especially concentrated among the holdings of community and regional banks. Some commercial mortgages were also securitized, and by August 2010, the delinquency rate on these packaged mortgages neared 9%—the highest in the history of the industry and an ominous sign for real estate a full two years after the height of the financial storm. At the end of 2008, the default rate had been 1.6%

Near the end of 2010, it was not at all clear when or even if the commercial real estate market had hit bottom. Green Street Advisors of Newport Beach, California, which tracks real estate investment trusts, believed that it reached its nadir in mid-2009. About half of the decline between 2007 and 2009 has been recovered, according to Mike Kirby, Green Street's director of research. “Nevertheless,” Kirby added, “values remain roughly 20% shy of their peak.” That's one perspective. On the other side, Moody's Investors Service, whose REAL Commercial Property Price Index tracks sales of commercial buildings, says it is too early to make a call. Moody's detected some signs of a pickup in the spring and fall of 2010, and Managing Director Nick Levidy said, “We expect commercial real estate prices to remain choppy until transaction volumes pick up.” The largest commercial real estate loan losses are projected for 2011 and beyond, according to a report issued by the Congressional Oversight Panel. And, looking forward, nearly $700 billion in commercial real estate debt will come due from 2011 through 2013.

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