Commercial property values still have more room to fall. But they’re firming. We are seeing a meaningful transaction volume. But there really are not very many transactions. Each one is a special situation. Now is a great time to invest – if you haven’t already missed the bottom, which is still to come.
Fundamentals of commercial real estate still suggest major problems ahead. Rents continue to drop, pushing down values. But some values are rising. There is a lot of money on the sidelines, ready to pounce. But the deals are not there. And the money is getting ready to go home. Lenders are lending, except they aren’t. Sellers want to sell but there’s nothing on the market. Anything on the market attracts a bidding war, at least among those who are interested. History repeats itself. Except this time it’s different. And so it goes on.
Anyone who tries to take a snapshot of the current moment in commercial real estate history gives up, confused. It’s bad but maybe it’s also good, or getting ready to get good, all at the same time.
Looking back, the market in some ways feels like 1993, when commercial real estate had just suffered a particularly pronounced cyclical downturn and was entering the early stages of recovery. No one felt much enthusiasm or confidence, but within a few years the enthusiasm and confidence returned. For ten years after that, the industry rode high, propelled by securitisation and low interest rates. Those who bought in the early 1990s made fortunes.
Is it different this time? Probably not. Smart buyers remember the history and want to buy. But the distressed properties that everyone expected to see aren’t materialising, at least not in major urban markets. That’s because most lenders are laying low and giving borrowers time, partly because bank regulators aren’t applying much pressure on lenders. That could change, of course, but will it change before the market moves upwards again of its own accord? No one really knows. We will all find out at some point, too late for most market participants.
Commercial real estate does see signs of the return of securitisation – early toes in the water. Securitisation represents a perfectly reasonable means of financing real estate, drawing in vast pools of capital that otherwise might not be available for that purpose. And that, of course, drives down the cost of money and drives up property values. It can all happen again and probably will, until it collapses again under its own weight and ever-growing creativity and complexity.
During the boom period that just ended, great financial minds took some good ideas and pushed them to extremes. Loan-to-value ratios approached 100 per cent. Appraisals became optimistic predictions of the future, instead of just trying to attach a value to what was already there. Tranching of debt became more and more complicated, including at the asset level. Intercreditor negotiations assumed that smart minds could identify every possible problem or issue that might arise between multiple lenders, and come up with words to handle that problem or issue correctly and appropriately. This was all supposed to eliminate the issues and tensions of having second or third or fourth mortgages, but it turned out to create a new agenda of issues and tensions ultimately not very different, or perhaps worse.
We all now know – or have learned again – that real estate can go wrong in ways that even very smart people can’t even imagine. The facts often play out in whatever way discloses the one imperfection, gap, undefined term, or unstated assumption in the governing legal documents. The deal structures of 2005 through to 2007 left very little room for surprises and hiccups.
Take, for example, the travails of the most famous commercial real estate debacle in history – Stuyvesant Town and Peter Cooper Village in downtown Manhattan – an investment structure that included a US$3 billion senior mortgage, eleven layers of mezzanine (junior) financing secured by pledges of equity interests in various ownership entities, and an intercreditor agreement that was 141 pages long, including 13 exhibits.
That agreement allowed the mezzanine lenders to acquire their collateral at a foreclosure sale, but could proceed without the risk of certain impediments only if “all defaults under [. . . ]the Senior Loan [. . . ]shall be cured by the junior lender” within a short time. The language sounds perfectly ordinary.
The holders of the US$3 billion senior mortgage persuaded a trial court that the quoted language means the mezzanine lenders can’t foreclose and take their collateral unless they also pay off the US$3 billion mortgage (just a minor detail). The junior lenders disagree, of course, saying that the language really means something else or only applies in some other context.
It’s all just one example of the many surprises, known and still unknown, that lurk in the tremendously complex loan documents and intercreditor relationships of the late commercial real estate financing boom.
Thus, when commercial real estate financing and values revive, look for simplicity and old-fashioned underwriting principles: low loan to value ratios, just one lender, conservative valuations, demonstrated cash flow in place, creditworthy tenants, simple deals, simple documents. Deals like these already attract plenty of lenders.
It’s the overleveraged stacks of debt of the last few years of the boom that will have the most trouble finding new buyers or lenders, at least at the valuations that drove those deals. A foreclosure or other resolution may need to occur first.
Fortunately, the federal government seems to have restrained its natural urge to solve every problem and “do something” about “market failure” in the commercial real estate markets. For the most part, markets have been allowed to do their magic, responding to excesses and resetting prices to a more appropriate level.
Of course, at least one important area of the commercial real estate market multifamily does depend for financing on branches of the federal government that even now still pretend to be private companies but really turn out to be just bottomless pits for federal money. So far, though, the federal treasury has resisted pressure to “save” other parts of the commercial real estate market.
The markets won’t really recover until they have worked through the consequences of the boom, through massive repricing – a process already underway.
The process of “working through” will also inevitably involve litigation. At this point, though, the courts remain somewhat unpredictable in their reactions to the deal structures of the last boom.
One line of judicial thought tends to enforce documents as written and enforce whatever allocation of risks the parties agreed upon. Another line of judicial thought tends to look at courts as all-purpose vehicles for improving the commercial real estate world by deciding who was “good” and who was “bad” and who deserves to be punished. It is a mindset that comes to commercial real estate litigation from the world of residential foreclosures, where judges often seem to want, above all, to “keep people in their homes.” (The author expresses no opinion on how best to classify the Stuyvesant Town intercreditor dispute and how it should ultimately turn out. The author is not involved in that dispute.)
If the judicial improvers-of-the-world triumph, their unintended consequences may include a reduced willingness of real estate lenders to make loans. Some might argue that if that change of heart among lenders means lower leverage and simpler deals, so much the better.
In the meantime, the fundamentals of real estate remain uncertain at least as long as the economy remains uncertain. Businesses aren’t expanding, and that’s particularly true of the service businesses that populate office buildings. But because office developers generally didn’t overbuild, the overhang of vacant office space, at least in major cities, is not horrible. It’s a different story in retail and residential, of course, and to a lesser degree in hotels where the markets still suffer from the consequences of overdevelopment.
Looking ahead, it’s reasonable to expect the crowd of frustrated buyers with bags of cash on the sidelines to reduce their expectations. And it’s reasonable to expect sellers, who so far mostly aren’t selling, to reduce their expectations, too, and perhaps feel some pressure to act. As those forces build, we can reasonably expect to see more transactions, maybe even a deluge, and eventually some confidence in price-based valuations.
The next few years will probably offer great opportunity for long-term real estate investors and for lenders willing and able to make conservative loans to back those investors.
Those investors and lenders will continue to look to their legal counsel for solid documents and careful due diligence, but they may ask for more from their counsel. In keeping with the general push toward simplification, real estate business people may push their lawyers to keep transactions simple and straightforward with less paper, and fewer words, to document whatever it is the parties want to do. This may in part reflect a recognition that much of the complexity perpetrated during the late boom resulted in interesting litigation.
The market may expect more practical business sense from counsel. Instead of dispassionately raising an issue, awaiting instructions from the client, taking notes, and then proceeding as instructed, counsel may more than ever be asked to make a recommendation and support it, and help lend the parties toward closing of issues and ultimately a closing of the transaction.
Lawyers who can do this – and help their clients understand what matters and what doesn’t – may see their role expand beyond creators (and endless revisers) of paper into a broader, and more mutually satisfying, relationship with their clients.
Times of economic stress always put pressure on legal fees. If lawyers do less, then they might charge less. Thus, if clients push toward simplicity and brevity they may find the same concepts ripple into lower legal fees. At a minimum, clients may be able to push their lawyers for greater certainty in the pricing of their work.