Capitalist Fools

Commercial real estate is dominated by financial professionals, not hustlers looking for a quick flip. So why is the market about to melt down?

Few places in New York are less likely to inspire grand dreams than Stuyvesant Town and Peter Cooper Village, the twin housing projects that sprawl across 80 acres of the Lower East Side. Built by MetLife in the 1940s, the project encompasses block after block of boxy brick apartment buildings and stolid public spaces, entirely barren of inviting corners or eye-catching detail. The critic Lewis Mumford dubbed it “the architecture of the Police State”; a slightly kinder motto might have been “What do you expect for $68.50 a month?”

Yet when MetLife spruced up the complex and put it on the market in 2006, real-estate moguls jetted in for the sale. A joint venture put together by Tishman Speyer and BlackRock carried the day through its willingness to, as The New York Times noted, “pay up—way up—to unlock future profits in the sprawling Manhattan properties.” At $5.4billion, their winning bid made the sale the most expensive real-estate deal of all time.

Three years later, however, those profits were still securely locked inside the property’s 11,232 apartments—many of which remained rent-controlled, despite strenuous efforts to convert them to upscale market-rate rentals. With net income well under projections, the partnership started spending down its reserves. Then, in October 2009, a court ruled that the partnership had improperly decontrolled the rent for thousands of apartments, and would have to return them to their original status. As of this writing, analysts are predicting default in a matter of months unless the partnership’s debt of $4.4billion can be restructured—a shaky prospect, given that the owners may owe tenants of formerly rent-stabilized apartments as much as $200million in rent overcharges and damages. Stuyvesant Town might soon set another record: the biggest real-estate default in history.

That default would be one of the first tremors of an earthquake about to roil financial markets: a commercial real-estate crisis mirroring the catastrophe in the residential market. October brought both the Stuy Town deal’s first death rattle and the bankruptcy of the real-estate financier Capmark. As annual bank failures topped 100 for the first time in almost two decades, Federal Deposit Insurance Corporation Chair Sheila Bair fretted over the threat posed to lenders by losses linked to hotels, malls, and condominiums. But even as this new impending crisis unsettles commercial lenders and borrowers, the story of its origins can shed new light on how we got into this larger financial mess in the first place.

Commercial mortgage lenders basically have to worry about two kinds of default risk: cash-flow risk, and asset-price risk. Cash-flow risk is what happens to homeowners when the primary breadwinner becomes unemployed, and to landlords or hotel owners when rental prices plummet. Since commercial tenants typically sign relatively long leases, this problem tends to grow slowly except in hotels—and, apparently, in rent-controlled properties with litigious tenants.

But the risk posed by falling asset prices is a big problem for commercial landlords, and for their bankers. The value of much commercial real estate is tightly linked to employment—if employers don’t have bodies to put at desks, they don’t need more rooms to put the desks in. With unemployment north of 10percent, and retail suffering, the nation’s stock of commercial real estate is suddenly less valuable than it used to be.

In some ways, price declines are a bigger problem for landlords than for homeowners. Unless forced to move, homeowners with long-term mortgages who make enough to cover their payments can sit tight and hope the market recovers. Landlords, however, typically take out commercial loans for shorter terms of three to 10 years. In normal times, landlords coming to the end of a mortgage simply roll the debt over into a new loan. But collapsing asset values have wreaked havoc on this process.

Now, as loans come up for renewal, lenders have to reassess how much credit they’re willing to extend. Take a property that was worth $100million in 2007, when it was financed with a four-year, $70million mortgage. That’s a reasonably conservative 70percent loan-to-value (LTV) ratio. But if the building is worth only $70million when it’s time to roll the loan over, keeping the LTV at 70percent means that the owners can now borrow only $49million, and have to come up with tens of millions to pay off the original loan. Worse, as the markets tighten, lenders tend to want to see a lower LTV in the deals they finance.

That suggests that a lot of commercial loans are going to go bad. According to Joseph Gyourko, a Wharton real-estate professor, at least $250billion worth of commercial loans are going to roll over in each of the next few years. When they do, many landlords will probably be caught short—and so will their bankers. Although most U.S. residential mortgages were bundled into mortgage-backed securities, only a fraction of commercial mortgages were securitized. Some bank or finance company still carries the rest on its books and will have to write them down if they can’t be rolled over; some of those banks will ultimately have to be taken over by the FDIC. As the banks’ loan portfolios are sold off, the write-downs of the underlying collateral will give bank examiners a new, lower reference price for the collateral held by other banks, possibly tipping those banks into insolvency as well. You get the picture.

That said, the repercussions from the commercial collapse will not be as great as those from the housing sector. The commercial market is considerably smaller than the residential market. The existing FDIC system can handle the decline, which will likely hit smaller banks harder than those in the “too big to fail” bracket. Moreover, fraud was probably much more prevalent in the residential than the commercial market, where even the newbie investors tend to be financial professionals or established businesspeople, not hustlers looking for a quick flip.

But given how experienced those investors were, why are our problems now as bad as they are? Fraud aside, Gyourko notes that at the height of its bubble, the commercial real-estate market displayed most of the pathologies that characterized the residential side. Only 50percent of the increase in prices between 2003 and 2008 resulted from rising rents, he says; the rest was just inflated optimism about the rents landlords would be able to charge sometime in the future. And just as in housing, banks joined the folly, increasing the LTVs and requiring less amortization over the life of the loan.

Take the Stuyvesant Town deal. The investors aren’t shady subprime lenders or naive kids. Tishman Speyer has been in the real-estate business for decades, and the investors who trusted the firm with their money are sober institutions like the Hartford Financial Services Group and the California Public Employees’ Retirement System. Yet according to TheWall Street Journal, when Stuyvesant Town was sold, lenders were projecting that the Tishman Speyer–BlackRock partnership would be able to triple its net income in five years through building upgrades and decontrol. That’s why the principals paid a premium for the property, and financed the purchase with loans totaling more than 80percent of the price.

Even before the financial crisis sapped demand in the rental market, this plan was questionable. The buildings simply weren’t built as deluxe rentals—the mosaic tile in the public areas has been replaced by marble, but in the cramped vestibules and narrow hallways, the effect isn’t luxurious; the buildings just look like they’re dressed up for Halloween. With mostly tiny kitchens, and no room in the lobbies for a doorman, these apartments were never going to command the kind of rents that would justify the partnership’s bid. Even though many of the apartments have been decontrolled, net income has barely risen.

Besides, anyone who’s been in New York long enough to find Zabar’s without a map knows that rent-controlled tenants like to sue, and New York’s housing law is notoriously tenant-friendly. Even if the new owners had found tenants willing to pay top dollar, there was a good chance they would never have been allowed to charge it. Game theorists often speak of the “winner’s curse”: the tendency of auctions to be won by the people who are the most delusionally overoptimistic. It’s an apt description of what seems to have happened. Not just to the Tishman group, but to America.

One of the most persistent narratives of the recent crisis portrays a nation of unsophisticated home buyers led astray by greedy bankers. Supposedly those bankers were willing to write risky loans because they intended to pass them on to some unwary investor. But this explanation falters in the face of a legion of failing commercial deals. Prospective landlords had all the expertise they should have needed to put a fair price on properties—and the majority of lenders who were originating loans for their own portfolios had ample incentive to perform careful due diligence.

The best explanation for the calamity that has overtaken us may simply be that cheap money makes us all stupid. The massive inflows of international capital, which Ben Bernanke has called the “global savings glut,” poured into our loan markets, driving interest rates lower—and, since most real estate is purchased with borrowed funds, pushing up the price of property in both the commercial and residential sectors. Rising prices, in turn, disguised any potential problems with the borrowers, because if they ran into cash-flow problems, they could always refinance, or sell. Everyone was getting bad signals from the market, and outlandish purchases looked almost rational.

That answer isn’t quite satisfying, especially in the face of another financial meltdown. We don’t want ambiguity and complex systems; we want heroes, villains, and a happy ending. But by now we should all know that real-estate markets are rarely the stuff of fairy tales.