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How Bad Is This?

After 47 years as a consultant to the commercial real estate industry, Stan Ross is incredulous about what he sees unfolding in today's global financial markets and the troubled U.S. economy. “I've never seen anything like this.”

Considering that in his professional career the 71-year-old Ross has witnessed real estate cycles dating back to 1961, that's saying something. Ross, based in Los Angeles, started as a partner in the consultancy of Kenneth Leventhal & Co., which merged with accounting firm Ernst & Young in 1995. He is now chairman of the University of Southern California's Lusk Center for Real Estate.

Ross notes that while previous cycles included relatively high unemployment and interest rates, today's recession is characterized by low interest rates and very limited liquidity in the marketplace brought on by a near collapse in the financial sector.

“In prior cycles we were able to refinance and even get new loans at a high cost,” says Ross. “This time around if you have a loan that's coming due, if you're lucky you might get some interest by lenders in refinancing. But you also will be challenged by tighter underwriting criteria.”

That is, if there are any lenders left. Fannie Mae and Freddie Mac have fallen into conservatorship, Bear Stearns and Lehman Brothers have collapsed, and Bank of America is buying Merrill Lynch. Meanwhile, Citigroup is on the ropes. In mid-November, The Dow Jones Industrial Average was down 43.6% from its record high in October 2007. Worries about rising loan defaults in the commercial mortgage-backed securities (CMBS) market have also escalated.

Shades of the RTC?

Some analysts compare today's crisis and government-backed recovery programs to the savings and loan (S&L) crisis of the late 1980s. But the parallel doesn't quite fit, says Ross. “With the savings and loan debacle we wiped out a lot of the S&Ls, but at least we still had our banks.”

Ross served on the task force that helped create the Resolution Trust Corp. (RTC), a government-owned asset management company tasked with working through the troubled residential and commercial real estate loans generated by overzealous S&Ls.

In March 1990, NREI recapped details of the bold move: “The Resolution Trust Corp. has released its first inventory of assets from failed thrifts that are available for sale, including about 30,000 real estate properties.” Ultimately the RTC disposed of some $300 billion in assets.

By January of the following year, NREI reported that the RTC had held its single largest auction in terms of dollars recovered, in which 14 properties attracted 130 registered bidders in a sale that brought in $112 million.

Replicating an RTC-like program in today's environment would be difficult, Ross notes. “They [the RTC] had a lot of similar assets that you could put into buckets quite easily. And the market had a lot of liquidity, so on the buy side you had a lot of buyers showing up.”

System failure

Hugh Kelly, principal of Hugh Kelly Real Estate Economics in Brooklyn, spent more than 20 years as the chief economist with Landauer Real Estate Counselors, an international real estate counseling firm. There he oversaw the market studies that helped finance the World Trade Center and General Motors buildings in New York.

Kelly believes the recent financial crisis points to a deeper problem with the very foundation of the financial system. In the fall of 2007, the financial markets were going to take one of two roads. Either the products themselves were failing, which would have necessitated a relatively short recovery period, or the system's structure was critically flawed, which experts now know to be the case.

“This is an industry failure as the S&L crisis was, so there's that as a similarity,” says Kelly. “But this is different in magnitude — it's far larger. It's different in its international ramifications, and it's different in that it has affected not just one area of the financial markets the way the S&Ls did.

“It's affected every end of the financial market. It is similar to the 1930s in that it will require a structural solution rather than ad hoc fixes.”

The United States' economy has experienced five major systemic crises over the past 18 years, notes Kelly. “That's a sign that the system is unraveling. With all of these crises we tried to solve one thing at a time, when we might have seen this was a system that needed to be restructured,” Kelly believes.

“The speed of capital flows, the volume of capital flows and the ingenuity of the financial instruments had burst the bounds of the system that we have in place,” continues Kelly. “A restructuring that could have been done over a period of five or six years without excessive dislocation now needs to be compressed into a year or two.”

Victims, not instigators

For once, the commercial real estate industry appears to be less to blame than macroeconomic circumstances, according to Leanne Lachman, president of Lachman Associates, a New York-based consulting firm. Lachman started her career in commercial real estate in 1960 at the Los Angeles office of Chicago-based Real Estate Research Corp., where she began working for the market research firm as a college freshman at the University of Southern California.

Later, she spent 13 years at Schroder Real Estate Associates in New York, a pension fund manager, and she has been an executive in residence at Columbia Business School in career counseling.

“The key difference from other cycles is there really was not commercial overbuilding this time,” says Lachman. Heading into the economic downturn, significant examples of serious overdevelopment on the commercial side were spotty, she adds.

Still, the cascading effect of the global financial market meltdown has affected every sector of the commercial real estate industry. And many industry professionals have felt broadsided.

Lachman saw this reaction at the Urban Land Institute's meeting in October in Miami Beach. “You could really tell the difference. People sort of felt they'd been victimized this time,” she says.

Specifically, Lachman cites the travails of several developers in Manhattan who were forced to stop work on construction projects because they had relied on construction loans from Lehman Brothers.

“All of a sudden you can't draw down the construction loan that you thought you had. That's pretty dramatic. Some small developers are going bankrupt quickly. That's true victimization,” says Lachman.

Back to the '70s

Bad economic news has come in waves in recent months, but many people who were stunned by the severity of the current economic turmoil have been surprised to find that this recession ranks as only the fourth worst in the past 40 years, says Peter Linneman, founder of the real estate department at the Wharton School of Business at the University of Pennsylvania. He is also a long-time industry consultant.

“Every cycle is the worst as you're going through it, but 1973-1975 was much worse,” says Linneman. “The unemployment rate was higher, the number of job losses was higher, the industrial output collapsed, the housing starts collapsed, the stock market was a disaster, and the real estate market was dead,” the economist adds.

“There was a war still going on, and during it you had a Constitutional crisis [Watergate] with a sitting president, and a sitting vice president resigning and being replaced by the Speaker of the House. That had never happened before. It was horrible,” he adds.

Given that context, Linneman downplays the present crisis. “Is this economy in good shape? Of course not. On the other hand, with hindsight, 2006 wasn't as good as we thought it was,” he says.

“A lot of that money we thought we made in 2006 we really didn't make. It was all paper. Mid-2008 through mid-2009 won't be as bad as we think it is. The world is not coming to an end.”

The 1970s recession was prolonged by government intervention in the form of price controls on oil, beginning in November of 1973. NREI wrote in December 1975 that “most building owners and managers have instituted some energy conservation measures since the energy crisis.”

In that issue, building technology columnist Joseph H. Newman offered readers a way to calculate the “building energy ratio,” which took into account electricity, natural gas, steam and oil.

Linneman doesn't want to see the federal government repeat the mistakes of the past. “In the '70s we looked to the government for answers, and the government gave us answers that over the next few years turned out not to be very good answers. We're at a similar challenge point right now. Relying on government to save us is a dangerous situation.”

Wall Street R.I.P?

Many industry pundits believe that the current financial crisis has led to the death of Wall Street. Other seasoned professionals with long memories disagree. “Wall Street has had numerous eras in which products have disappeared and business has consolidated. The firms that got redefined have been redefined many times in their history,” says Kelly, the economist.

Kelly points to the small bond houses in New York City in the 1970s that were consolidated into larger firms and into pure investment banks when fixed commissions were abolished.

Despite the appearance that New York is quickly losing its status as the financial capital of America, if not the world, Kelly disagrees with that assessment. “When all of this is said and done, you don't have greater power than JPMorgan Chase, and even Bank of America (based in Charlotte, N.C.) now has its center of power in Manhattan.”

Kelly predicts that many of the laid-off investment bankers in New York will wind up as the new breed of industry regulators. “You certainly need people with expertise to monitor these products. You can't instantly invent experts in credit default swaps.”

Consolidated financial power may ultimately rest with the New York Federal Reserve Bank. “One reason is that it's on the scene. Also, now that all of these institutions are bank holding companies it falls under the Fed, not under the Securities and Exchange Commission,” says Kelly.

Nearly all observers agree that the CMBS market will live to fight another day, perhaps in a different model. “Securitization has not suddenly become obsolete,” says Kelly. “It needs to get itself off the mat.”

Digging out now

For several years, industry experts have espoused the role of greater transparency and its ability to mitigate the boom- and-bust cycles inherent in the real estate industry. Is it really working?

“There is so much information available on what's going on everywhere across the globe now,” says Ray Torto, global chief economist at CB Richard Ellis. “My argument is that because of transparency, once the market does find out what the new price is for commercial real estate, people are going to jump into the market fast.”

Given the complexity of the latest financial instruments, including credit default obligations, transparency alone is not enough. “The rating of the various tranches of commercial and residential securitizations was not understood, and investors thought they were getting a more quality senior piece of paper than they were getting,” says Ross. “They thought they could rely on the due diligence and the collateral, and they found out they couldn't.”

Ultimately, this recession will end only if the subprime residential contagion is cleaned up. “Until you stop this downward spiral on housing, you can't effectively deal with the rest,” says Kelly.

What other forward-thinking strategies are advisors giving their clients? “I told people to go on a trip around the world, go fishing, do anything to restrain yourself from jumping in,” says Lachman. “There is not a first-mover advantage. Patience is going to be very important this time around.”

Ben Johnson is a Dallas-based writer.

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