1. Friday, September 18, 2009
Facing the next real-estate collapse
By SCOTT S POWELL & DAVID LOWRY
THE next wave of the credit crisis is about to hit -- a collapse in commercial real estate
and potential explosion of bank failures. With its resources tapped out by the first wave,
what should Washington do?
Over the last year, the Federal Reserve doubled the size of its balance sheet, and took
unprecedented action in monetizing government debt and extending credit to financial
institutions. Now it must head off inflation and extricate itself from $5 trillion-plus in credit
exposure from various bailouts. The Treasury, meanwhile, is issuing debt at the fastest
pace in peacetime history.
Now comes the next crisis. The same factors that caused the residential bubble -- easy
credit, lax lending standards and booming mortgage-backed-securities underwriting --
also drove commercial real-estate overvaluation. But the commercial market lags the
residential one by about a year, so this bubble is still popping.
Already, commercial-real-estate prices nationwide are 39 percent off their peak of two
years ago, reports the MIT Center for Real Estate. The 18 percent price decline in this
year's second quarter was the largest quarterly drop in 25 years.
Prices fell just 27 percent during the late-'80s/early-'90s savings-and-loan crisis -- a
collapse that prompted the then-largest federal intervention ever -- $125 billion in the
form of Resolution Trust Corp. seizures and auctions. Last year's crisis saw Congress
providing nearly six times more to bail out the US financial sector. And that was only the
start.
Most commercial properties bought or refinanced in the last five years are now upside-
down on their loans -- that is, the property can't be sold for its finance value or purchase
price. Real Capital Analytics reports that owners have lost their entire down payments
on about $1.3 trillion worth of property.
Nearly half of all US commercial-real-estate-mortgage loans come due within the next
five years. Deutsche Bank believes that 65 percent or more will fail to qualify for
refinancing.
Absent new job creation -- and whatever nascent recovery is underway seems unlikely
to produce net new jobs for several years -- vacancy rates will remain high. The action
in commercial real estate will be largely subleasing -- at rents of 50 percent to 85
percent of scheduled lease rates. These lower sublease rates will eventually become
the real market rates, putting further downward pressure on property values.

2. As things stand, this next wave of the crisis will sabotage the recovery -- driving up bank
failures, FDIC bailouts and problems for some large insurance companies. Indeed,
Congress will surely wind up having to bail out the FDIC itself.
What to do? For once, act before the bottom falls out.
1) Stop forcing banks to reclassify loans that have had minor modifications to assist
borrowers. Such rules contribute to failure rather than averting it.
In some cases, it would be appropriate for regulators to permit the renewal of current
loans at higher loan-to-value ratios, thus reducing unnecessary foreclosures. So long as
loans are performing, and no actual losses have been incurred, banks shouldn't have to
take charges against earnings and capital. We need to stop forcing the seizure of banks
that aren't in genuine danger of failing.
2) Reject any new taxes on real estate -- such as capital-gains-tax hikes; changes to
IRS Section 1031, which allows tax deferral; and efforts to change the tax status of
"carried interest." Plus, modernize the Foreign Investment in Real Property Tax Act of
1980 to encourage foreign investment in US real estate.
3) Amend the IRS Tax Reform Act of 1986 to allow modification of loans within Real
Estate Mortgage Investment Conduits (REMICSs). Some 25 percent of US commercial
real estate is financed with these securities.
The tax code permits REMICs to pool commercial-mortgage loans into trust-like
instruments commonly known as CMBS, which issue interest-bearing securities based
on their value. Tens of thousands of commercial mortgages are now locked into
structured CMBS, just as with residential mortgages.
The Treasury recently announced an easing of rules on restructuring CMBS loans -- but
it's only a start on what's needed. The changes have to go beyond protecting Wall
Street interests, and defend the property owner's right to make improvements and
changes in building space without triggering a default or foreclosure on the loan backing
the corresponding property.
Amending REMIC laws to allow property modification and expansion would preserve
jobs for businesses that need to make better use of space -- and create construction
jobs to make those modifications. It also supports states with much needed sales and
business tax revenue.
Make no mistake -- the bust of commercial real estate will bring dozens more bank
failures and a huge loss of wealth. More bailouts of financial institutions are inevitable --
but immediate government leadership in key areas can greatly reduce the cost to
taxpayers, and help dodge a killer bullet to our economy.
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Scott S Powell is the founder of AlphaQuest, an alternative investment consulting firm
and a Hoover Institution visiting fellow. David Lowry is an owner/developer of Southern
California commercial real estate.