It's Deja Vu All Over Again, Only Different

By: William (Chip) T. Cavanaugh, Jr.
Real Estate in the Changing World: Confronting the Crisis
April 28, 2009

This is a movie that none of us wanted to see again. In the late 1980s, Texas was the epicenter of the collapse of the nation's real estate market. An overabundance of easy credit from banks and savings and loan associations, coupled with underwriting criteria that in hindsight seemed incredibly naïve (at best) or criminal (at worst), led to massive overbuilding of most all commercial real estate property types. The resulting (and inevitable) collapse of this bubble devastated Texas real estate market and financial institutions for a decade.

Now, it is everyone else's turn. Once again, a real estate bubble formed — this time caused by an overabundance of credit, hyper competition among lenders to push money out the door and resulting lax underwriting standards — and once again the bubble burst. Cap rates are headed up, property values are headed down, investors are facing the loss of their equity in projects, developers fear liability for loans they can't repay and financial institutions are failing. All this seems eerily familiar to most Texas real estate professionals over the age of 45 or so. Ironically, however, Texas is in better shape than most of the nation this time around. For example, employment actually grew in Texas in 2008 and home values in most major Texas cities declined by less than five percent in 2008 (as contrasted with declines of over 25 percent in some other major markets). But, the world economy is inextricably interconnected today, so while the Texas real estate market may feel a bit less pain than those in other parts the nation, they are by no means immune to the effects of the sickness that has infected the global capital markets.

Looking forward, it appears obvious that history will to some degree repeat itself and many of the events that occurred in the late 1980s will occur again. Tenants will default, workouts will commence, and foreclosures will occur, borrowers will file bankruptcy, distressed assets will be sold, fortunes will be lost and, eventually, fortunes will be made. Terms such as "REO property" and "cancellation of indebtedness income" will again populate the everyday discussions of Texas real estate investors and developers.

So, in many ways, as the great Yogi Berra said, "It's déjà vu all over again." But, as the current crisis plays itself out, it looks like some key elements are going to unfold very differently than they did in the late 1980s.

The Scale of Today's Crisis is Much Larger.  In the late 1980s, the real estate industry in Texas and the Southwest was devastated, and as a result, a significant percentage of the banks and savings and loan associations in the region failed; however, the real estate market and financial institutions in the rest of the country (and in the rest of the world) held up fairly well. Indeed, while capital was hard to come by in Texas, on a global basis capital remained fairly abundant. So once the market perceived that the price of real estate assets had hit the bottom, such capital was readily deployed to fill the financing gap caused by the demise of Texas banks and savings and loans (S&Ls). The size of the problem was also considerably less. Although almost 3,000 banks and S&Ls with aggregate assets of approximately $900 billion failed in the late 1980s, the Resolution Trust Corporation (RTC) was able to resolve the S&L crisis at an eventual cost to the taxpayers of "only" $124 billion. By contrast, some estimates of the ultimate amount needed to recapitalize the nation's banks today range as high as $3-$4 trillion with a net cost to taxpayers of $1-2 trillion. Moreover, the commercial mortgage-backed securities (CMBS) market is shut down (with no short-term, and perhaps no long-term, prospect of revival) and it is not at all clear where the funds will come from to refinance the almost $600 billion in United States (US) commercial mortgage debt that will mature during the next three years. Given the fact that commercial real estate values may have fallen by 35 percent or more, one expert has predicted that 70 percent of the nation's outstanding CMBS debt will not be refinanceable absent large capital infusions. The source of that equity capital is also unclear, given the strain that pension funds, endowments, insurance companies and other traditional providers of equity are experiencing. In short, this crisis is lot larger than the S&L crisis of the 1980s and it will be a lot harder to solve.

The Problem Today is Scarce Capital, Not Oversupply of Product.  In the late 1980s, the skylines of cities such as Dallas, Texas quickly changed from featuring cranes (fondly referred to in those days as the "State Bird of Texas") to featuring "see-through buildings" built on a spec basis and mostly devoid of tenants. Texas developers and lenders learned their lesson, however, and the development of most product types in Texas during the last 15 years was driven by demand. As a result, most well-located properties today are reasonably well leased and, at least so far, tenants have for the most part been staying in possession and paying their rent. That is beginning to change, especially in the retail sector, as the deteriorating economy puts tenants' businesses under increasing pressure and they react by seeking to reduce their space requirements and/or rental rates. But so far, the primary driver of today's real estate crisis has been the lack and/or cost of capital, not an oversupply of commercial real estate product.

Workouts won't be Straightforward Anymore.  Despite the financial and emotional hardship caused by the failure of a real estate project in the 1980s, the workout process was fairly straightforward for borrowers and lenders back in the day. The borrower's loan was generally held by a bank, S&L or other portfolio lender. The borrower often had a personal relationship with the lender's loan officer. On larger transactions where loan risk was shared between several lenders, such sharing was often accomplished by using a participation agreement rather than forming a syndicate of co-lenders, so the borrower retained its primary relationship with the originating lender. Even when a workout officer, "bad bank" or government entity assumed responsibility for the loan, the borrower was still dealing with a single lending party whose agenda and financial motivation were fairly simple to understand.

Today, approximately 28 percent ($900 billion) of the $3.3 trillion in outstanding commercial real estate mortgage debt in the US has been securitized. In fact, CMBS loans constituted more than 50 percent of all US real estate debt in the last few years prior to 2008, with $230 billion of US real estate debt having been securitized in 2007 alone. Much of that securitized debt (and non-securitized debt as well) also featured a layer of mezzanine financing (i.e., debt that is secured by the equity in the borrower and is subordinate to the mortgage debt).

In the workout context, such securitization and/or mezzanine financing changes everything. A large loan might feature a bewildering array of parties in interest on the lender side, such as, depending on the size of the loan and the complexity of the financing and the securitization: the lender that originated the loan, the depositor entity of the investment bank that sold the bonds backed by the mortgage (and likely dozens or hundreds of other mortgages), CMBS trustee, master servicer, subservicer, special servicer, senior (A piece) bondholders, junior (subordinated piece) bondholders, holder(s) of any B note, operating advisor for the B note holder(s), rating agencies, senior mezzanine lenders, junior mezzanine lenders and lastly, but importantly, the warehouse or repo line lenders who provided financing to the various lenders. Each of these players has a different agenda and motivation regarding the credit and the resolution thereof (and many have one or more conflicts of interest). Moreover, rather than decisions being based on purely economic criteria, decisions are now regulated by the "servicing standard," the Real Estate Mortgage Investment Conduit (REMIC) rules contained in the Internal Revenue Code (IRC), and the consent rights, consultation rights and other provisions of documents such as pooling and servicing agreements, co-lender agreements, participation agreements, inter-creditor agreements and mortgage loan purchase agreements. For lenders and borrowers, such factors can create an incredibly complicated gauntlet that impedes an efficient resolution of the loan. Just to take one example, in may cases a borrower doesn't really have anyone on the lender side to talk to until some time after the loan goes into monetary default (when the loan is transferred to special servicing). As a result, stories have begun to circulate of borrowers of performing loans who have withheld loan payments for the sole purpose of getting their loan transferred to a special servicer who would be able to discuss how to handle their upcoming maturity.

There will be Fewer Real Estate Bankruptcies this Time.  Perhaps the only professionals that enjoyed the late 80s were bankruptcy lawyers. In those days, filing bankruptcy was a quite effective way for a real estate borrower to avoid foreclosure, buy time and re-negotiate debt on more favorable terms (often as a result of the lender's fear of the dreaded "cram down" risk). While of course borrowers worried about the impact a bankruptcy filing would have on their ability to obtain credit in the future, they assumed (often correctly) that the market would have a short memory in this regard. As a result, thousands of bankruptcy cases were filed, many of them by entities that owned single assets. Indeed, several real estate companies filed hundreds of bankruptcy petitions on behalf of their affiliated single asset entities.

That won't happen this time for a couple of reasons. First, in 2005 the Bankruptcy Code was amended to add Section 362(d)(3), which makes "single asset real estate" bankruptcies much less attractive to debtors by, among other things, limiting the length of the automatic stay applicable to such cases in the absence of the filing of a confirmable plan of reorganization or the making of monthly payments at the non-default contract rate.

Second, and just as important, since the early days of the development of the CMBS market out of the residential loan securitization market and the RTC's pioneering commercial loan securitization transactions in the early 1990s, the nation's smartest finance attorneys sought to devise as many methods as possible to prevent real estate borrowers from using the bankruptcy process to hinder the lenders' realization on their collateral. The so-called "single purpose entity (SPE) provisions" were one result of these efforts. While these provisions were originally designed for securitizations, they were quickly adopted by balance sheet lenders as well. As a result, a large percentage of today's outstanding real estate loans include "SPE provisions" that are designed to inhibit the borrower from filing bankruptcy or, if a bankruptcy is filed, to ensure that borrower's stay in bankruptcy is short. For example, in addition to requiring that the borrower's only asset be the collateral property and that the borrower conduct business as a separate and distinct entity (with a legal opinion confirming that the borrower will not be "substantively consolidated" with the sponsor or its affiliates in a bankruptcy), the SPE provisions often required that the borrower have an independent director or member who's vote is required as a prerequisite for a bankruptcy filing (and who presumably will worry that if the entity is insolvent then his fiduciary duty runs to lender and therefore he will be more reluctant to authorize such a bankruptcy filing).

The SPE provision that is most likely to inhibit a bankruptcy filing is the so-called "springing recourse guaranty," which became increasingly common the last few years. All across the nation, sponsors are calling their lawyers and saying "I thought I had a non-recourse loan and was only liable for "bad boy" acts, but I just looked at the limited guaranty that I signed and it says that if the special purpose entity that I formed to buy the property files bankruptcy then I will become personally liable to repay the full amount of the loan — is that enforceable?" The answer, at least at the current time, is "yes." The prospect of warm-blooded human assuming personal liability for repayment of the loan a voluntary bankruptcy filing (or collusion in an involuntary filing) is likely to significantly reduce the number of real estate bankruptcies filed this time around.

None of this means that there will not be any real estate bankruptcies; to the contrary, I expect bankruptcy attorneys to be plenty busy during the next few years (and in fact, they already are). Moreover, in many situations, a bankruptcy filing will be a sound strategy for a real estate borrower. But, a flood of real estate bankruptcies of the magnitude seen in Texas the late 1980s seems unlikely.

CMBS Provisions will be Tested.  The architects of the modern day CMBS protections must have some sympathy for the geniuses who worked in the Manhattan Project to create the atomic bomb: these were the nation's smartest scientists, but until the bomb was tested, all they could do was hope that it would work as their theories predicted. As it turned out, it did. Perhaps the result will be the same for all the structures and protections that were developed by the nation's smartest investment bankers and lawyers to support the CMBS market; however, to date, most of such structures and protections have never really been stressed or tested. The issues are two-fold. First, as a practical matter, can all the various parties in a complicated CMBS structure function as designed, reach decisions and act? Or, will disputes, self-interest and fear of liability doom most creditor groups? Second, will any of such protections (such as the above described springing recourse guaranty and the SPE provisions) be declared unenforceable by a bankruptcy or other court protective of its jurisdiction? If all such protections are upheld, it will not be because of a lack of effort to the contrary by borrowers' counsel across the nation during the next few years. The General Growth bankruptcy will provide an interesting test case: its filing included its affiliated SPE borrowers on 158 retail properties. That's not supposed to happen. As a result, Fitch recently revised its rating outlook from "stable" to "negative" on 96 CMBS classes across 20 transactions, saying that the "inclusion of the SPE borrowers within GGP's bankruptcy filing creates a level of uncertainty for CMBS investors." Stay tuned for how this one turns out.

Loan Extensions will be the Order of the Day, for Awhile.  Given the increased complexity involved in loan workouts and enforcement as well as most lenders' desire to avoid classification of a loan as "distressed" (due to the impact on their capital requirements) and the fact that many properties are performing fine but simply can't be sold or refinanced at maturity, both balance sheet lenders and CMBS special servicers are routinely putting the problem off for another day by extending loans that have matured.  On CMBS loans, depending on the vintage and terms of the securitization there may be some significant restrictions and/or consent requirements applicable to the ability of the special servicer to extend the loan. Moreover, such extensions are not without controversy, since on an individual loan level senior bondholders are increasingly concerned that such extensions are putting their principal at risk solely to avoid a loss by (or maintain interest payments to) junior bondholders, and on a macro level there is a sentiment that such extensions are simply delaying the painful, but necessary and unavoidable, re-pricing of commercial real estate that must occur in order for the transaction market to function again. Indeed, quite a battle is shaping up between the American Special Servicers Association (the trade group for the special servicers, who is lobbying to obtain greater flexibility for loan extensions and assumptions under the Remic rules) and the CMBS Investors Roundtable (the trade group for the large life insurance companies and other senior bondholders, who is seeking to recover as much principal as possible as quickly as possible by forcing the special servicers to foreclose on the property and sell it). But, for now, most decision makers still have a "let's put it off and hope things get better tomorrow" approach. So although lenders have typically been rattling the sword just enough to induce the borrower to make a pay-down on the loan, increase the interest rate and/or provide a guaranty or other credit enhancement, loan extensions remain commonplace.

Loan Sales will be Back, Sort Of.  Even early on in the 1980s' real estate crisis, it was fairly easy to see how the government would deal with the assets it inherited. Banks and S&Ls were balance sheet lenders. As they failed, the Federal Deposit Insurance Corporation (FDIC) and Federal Savings and Loan Insurance Corporation (FSLIC) (and ultimately the RTC) inherited real estate owned (REO) properties and whole loans. Prior to the RTC's portfolio sales offerings there had not been an active market for the trading of non-performing real estate loans, so a fair amount of innovation was required to engineer a process whereby the RTC and other agencies could sell such paper. Still, since the RTC owned 100 percent of these loans, it was fairly easy for the RTC to sell, and for a buyer to underwrite and price such loans.

There will certainly be plenty of whole loan sales in the current down cycle as lenders are being pressured to get these assets off their books, but buyers should not expect a repeat of large scale sales of portfolios of non-performing loans of the type pioneered by the RTC. Many of the assets that the government is poised to inherit (either by purchase from distressed banks in the still sketchy Public-Private Investment Program (PPIP) or via inheritance following the insolvency of banks) are not whole loans, but rather, are securities that were issued in a CMBS transaction. The CMBS structure (and its inherent multi-tranche capital stack) makes it much more difficult for a buyer to underwrite and price such securities. This is especially true in the case of unrated or subordinated securities, B notes, collateralized debt obligation (CDOs) and other so-called "toxic assets." Even in the case of whole CMBS loans, for a number of reasons it is not at all clear that special servicers will utilize loan sales as a way to deal with defaulted CMBS loans. Further, in the short-term, although loan sale volumes are up significantly and many more whole loan portfolio sales will be coming to market in 2009, the bid-ask spread remains too large for many loan portfolios to trade — many lenders simply remain unwilling or unable to recognize the significant losses that would result from selling their loans for large discounts and many prospective loan buyers are conserving dry powder in the hope that prices will continue to fall in the future (i.e., they are waiting for "blood in the streets"). Finally, non-governmental loan sellers aren't in the same position as the RTC was to support a higher price in consideration of undertaking an obligation to purchase "defective loans" if the representations and warranties in the loan sale agreement prove untrue. As a result, although there has been a lot of talk about loan sales, there has not been a lot of trading yet and several portfolios have been pulled form the market after generating less than desired bids. Perhaps this will change as the PPIP gets underway, and certainly there are a lot of funds being raised with the goal of acquiring subperforming and nonperforming loans, but to date the market has been slow to develop.

Some Local and Regional Banks will Fail (Again).  While the CMBS market (or lack thereof) gets most of the attention, the nation's approximately 3,000 community and regional banks hold over $2 trillion in commercial mortgages. Such loans make up approximately 20 percent of the loan portfolio of most such banks. In many (and perhaps most) cases, these loans were of the type that were deemed too risky for CMBS issuances, such as land acquisition loans and construction loans. Many of such loans aren't yet listed as troubled because interest carry is built into the loan, but it is only a matter of time. The FDIC and other government agencies have been fixated on the large national banks to date, but eventually they will begin to focus on the smaller community and regional banks. Marketplace rumors abound that Treasury's impending "stress tests" are biased against community and regional banks in favor of the nation's largest banks. As the community and regional banks are forced to mark their assets to market (even under the new, more forgiving standards), some of them will fail, just like last time.

And Now for the Good News.  In the end, if there is one thing that we Texans learned from our pain and suffering in the S&L crisis, it was that all real estate crises come to an end eventually, just like the real estate bubbles that created them. They are often more severe and longer lasting than originally anticipated, but they all come to an end. This one will too. Someday.