The Real Estate Crises: Challenges and Opportunities

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There is no doubt about it: these are challenging economic times. This is especially true with respect to real estate.

Like our May magazine cover? See the implosion in action…

Last summer, from within the eye of the storm, Craig and his partner, Alan Ramos, facilitated a presentation to the Real Estate and Litigation Sections titled, “What Really Happened in the Real Estate Mortgage Industry: How did we get here and where are we going?” By the end of the presentation, all in attendance recognized two things. First, the residential real estate adjustment probably wasn’t close to being over. Second, challenges were already facing the commercial real estate (CRE) sector.

The causes of the residential real estate adjustment included questionable (defenders would say “novel”) lending innovations, namely the advent of “Mortgage Backed Securities”. These transactions caused a break-down of the traditional lending model: Risk was no longer tied to reward in the same way because lenders had securitized the loans. While there is no end in sight for the residential real estate melt-down, it may seem overly pessimistic to also look at the challenges facing CRE. On the other hand, what good ever comes from not discussing something? Maybe (much like “Y2K”) the recession’s effect on the CRE sector will be a non-event. But on the other hand, maybe not.

As many readers may already know, the same “innovation” was used in commercial real estate lending where these derivative products are referred to as Commercial Mortgage Backed Securities (CMBS’s). The effects of CMBS’s have already been seen in CRE transactions, bankruptcies and litigation. Many continue to predict the likelihood of an even larger problem hitting the commercial real estate sector, and point to statistics like the following:

“Issuance of commercial mortgage-backed securities, or CMBS, peaked in 2007 at $230 billion, having more than doubled from a total of less than $100 billion in 2004.” Statement of Sandra Thompson, Director, Division of Supervision and Consumer Protection, FDIC, before the Congressional Oversight Panel, Washington, DC, February 4, 2011

As the recession continues, additional businesses may close resulting in increases in commercial vacancy rates.  Of course, higher vacancy rates will drive down CRE rental rates further. This will not only impair the owner’s ability to make payments to the lender, but it may also make it impossible to refinance the properties when loans become due.

“Over the next five years, about $1.4 trillion in commercial real estate loans will reach the end of their terms and require new financing. Nearly half are ‘underwater,’ meaning the borrower owes more than the property is worth. Commercial property values have fallen more than 40 percent nationally since their 2007 peak. Vacancy rates are up and rents are down, further driving down the value of these properties.” Nasiripour, S. (2011, February 11). Elizabeth Warren Warns About Commercial Real Estate Crisis, ‘Downward Spiral’ For Small Businesses, Local Banks. The Huffington Post.

Some predict that widespread foreclosures of commercial property will occur. In a recent speech, Dennis Lockhart, president of the Federal Reserve Bank of Atlanta pointed to the, “…potential of a self-reinforcing negative feedback loop…” which will affect commercial lending, small business employment, and commercial real estate values. Some analysts state that CRE values have already declined 42% from their peak in early 2007 to their lowest point in early 2010. (Sources: Real Capital Analytics; Moody’s/REAL CPPI National Aggregate Index.) Many predict that local and community banks will be the hardest hit. Unfortunately, loans from local and community banks are often more closely associated with the creation of new jobs. As a result, some predict that we are likely to see an even greater impact on the overall economy caused by an adjustment in the CRE sector than from the residential market adjustment.

However, there are some who disagree. To be sure, there are signs that with respect to CRE perhaps the worst may be behind us. Deals of all types are getting done and some studies give a picture of CRE prices on the upswing. Some point to factors that may buffer a CRE downward spiral and some point to activity in the CRE market and upcoming events (such as preparations for the America’s Cup) that could result in a rapid CRE recovery.

One buffer is the liquidity that exists in the national equity market. There are trillions of dollars which will be invested in CRE in 2011. Unfortunately, the specific figure is a fraction of the trillions of equity dollars which were
invested in CRE in previous years. Additionally, there are signs that lenders may approach defaulting CRE loans in a different way than how lenders approached defaults on residential property. Residential loan modifications that reduce the principal balance, though often talked about, occur very rarely. On the other hand, CRE lenders may be more likely to see a rationale for this type of loan modification. This may occur so that a lender can comply with banking regulations. This may also occur because the commercial lender recognizes that cash flow will be maximized by allowing the current owner to continue operating the commercial property- especially when compared to incurring the costs and delay in payments during a foreclosure and/or a bankruptcy. Regardless of why loan modifications could be more palatable to lenders in the CRE sector, it may be one of the factors that slows a downward spiral. The hopeful say that we have already seen the bottoming out of values and that there is sufficient equity in the CRE investment pool to stop values from declining any further.

In order to deal with these and other issues, we bring you this year’s Real Estate Issue, “The Real Estate Crises: Challenges and Opportunities”. In our first article, Tom Nagle attempts to predict how the recession may affect California’s Redevelopment Agencies. Jerry Hunt and Chris Hunter discuss the potential role of a Receiver, appointed by the Court, to assist working through the many issues that arise when a project has only been partially completed. Scott Haislet’s article delves into tax implications, and strategies, for moving through this down-market, while Michael Durkee and Thomas Tunny’s article addresses the need for land use due diligence when buying real estate in a volatile market. Lastly, perhaps the nature of these times is best exemplified by our final article by Amanda Bevins which discusses what happens before and during the foreclosure auctions held on the steps of the courthouse. There is no doubt that these are challenging times. It is our hope that this issue will assist you in navigating some of the challenges and pointing to some opportunities. We look forward to seeing you–after the storm has passed.

(Parts of the above were originally published in the Spring 2011 NRS Law eNews Electronic Newsletter.)

Craig Nevin

- Craig Nevin is a partner at Nevin, Ramos & Steele. He has provided litigation and transactional counsel to property owners and developers, financial institutions and governmental agencies, and to contractors and subcontractors for almost 25 years. Mr. Nevin is currently on the Board of Senior Legal Services of Contra Costa County and The Law Center – two of the county’s major providers of pro-bono legal services. He is a Past President of the CCCBA Real Estate Law Section, former Adjunct Professor of Real Estate at JFK University school of Law, and from 2002 to 2009 served as Special Master to the Courts of San Francisco, Alameda and Contra Costa Counties.

Gil Berkeley

- Gil Berkeley is “of counsel” at Morgan Miller Blair, where he previously served as Chair of the firm. His practice includes general business counseling and a broad spectrum of real estate matters. Gil was instrumental in founding the Real Estate Section of the CCCBA and served as its initial president.

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