"Delay and Pray" won't work for commercial real estate (Washington Post)

Steven Pearlstein
The Washington Post
10/1/10

Some of the biggest names in commercial real estate came to Georgetown University's McDonough School of Business this week to give their assessment of where their industry stands after the worst bust since the Great Depression.

The conversation among Michael Fascitelli of Vornado Realty Trust, Thomas Flexner of Citigroup, Scot Sellers of Archstone-Smith and Chris Nassetta of Hilton Worldwide was remarkably candid, good-natured and jocular. But I came away with the distinct impression that conditions in the industry will have to get worse before they can get better.

It's been two years since the credit bubble burst, and commercial real estate prices have fallen by an average of 40 percent. The problem now is that the industry remains paralyzed. Because financing has dried up, deals aren't getting done, and because there are no deals, nobody knows what anything is worth. That makes financing even more difficult.

In the last several months, a trickle of deals and a flicker of life in the market for securitized loans have led some in the industry to declare that a rebound has begun. But the members of the Georgetown panel were not so sure. Those deals largely involved trophy properties in strong markets such as Washington and New York that were fully leased and generating a steady stream of income. The attractive prices at which the properties were sold - and the attractive interest rates at which they were financed - was mostly a reflection of how much money is sitting on the sidelines and how few opportunities there are to put it to use.

Outside the best properties in the best markets, the panelists report, there are almost no deals, no refinancings, no restructuring, no foreclosures. Everyone is just waiting and hoping for a magical rebound that is unlikely to materialize.

Many owners of office buildings and shopping centers are owners in name only - their 20 percent equity stake, or down payment, has long since been wiped out by the decline in value. While some continue to make monthly loan payments from rents and reserve funds, it is unlikely they will ever be able to repay or refinance the original loan. Over the next six years, $1.3 trillion in commercial real estate loans will come due.

Take the example of a $100 million office building that was originally purchased with a $80 million loan. Today that building may be worth only $60 million, which in today's lending environment can support only a $40 million loan. To refinance the property, the owner would have to come up with $20 million to pay off the balance of the old loan plus another $20 million as a down payment on the new loan - and that is on top of the original $20 million down payment that is already lost. That $60 million in equity will only be recouped when the value of the property tops $100 million again, which by most estimates won't be anytime soon. So most owners are unwilling to throw good money after bad.

Lenders, meanwhile, are reluctant to take control of that distressed property, because doing so would require them to take a $20 million loss - the difference between the original loan and the property's current market value. Their preference has been to extend loans when they come due, often on more favorable terms, in the hope that prices will rebound. In the industry, this is only half-jokingly referred to as "extend, amend and pretend."

The lenders' patience derives not from any sympathy for borrowers but from a cold calculation of self-interest. They understand that if they foreclose on a large number of properties and put them on the market, the increased supply will push down prices even further. Under mark-to-market accounting rules, that would require them to write down the value of all the other non-performing loans still on their balance sheets.

Up to now, regulators have been willing to turn a blind eye to bank balance sheets that do not fully reflect the likely loan losses and declines in loan values. Even with this forbearance, 279 banks have already slipped into insolvency, and there are more than 800 on the still-growing list of problem banks kept by the Federal Deposit Insurance Corp. Citigroup's Flexner said that if regulators were to force banks to fess up to all of their losses, hundreds more regional and community banks would likely fail, forcing the government insurance fund to borrow as much as $300 billion from the Treasury to meet its obligations.

Despite those risks, it's time to get on with it. Only when owners and lenders acknowledge their losses and distressed property and loans are put up for sale can credible pricing return and new capital equity and debt flow back into the market.

My old friend Arthur Segel, who ran a successful real estate fund and teaches at Harvard Business School, figures that when the market finally stabilizes, the accumulated losses for owners and lenders will easily exceed $1 trillion, and it will take another $1 trillion in fresh equity to adequately recapitalize the industry.

To jump-start the process, Segel suggests that regulators require lenders to sell or restructure 20 percent of their problem loans each year for the next five years. And to ease the impact, he suggests relaxing the mark-to-market rules and giving banks a grace period of 12 to 18 months before having to adjust the value of the loans and properties that remain on their books.

This reckoning will be painful and disruptive, politically as well as economically. But at this point, even those who know the industry best acknowledge that "delay and pray" is no longer a viable strategy. Dragging it out will only make things worse.