Why Commercial Real Estate Isn't Swamped with Foreclosures

The residential real estate market is drowning in foreclosures as the crisis there continues to broaden and worsen. RealtyTrac this week announced that foreclosures were up in 65% of U.S. metro areas, although some of the hardest-hit areas are recovering.

Why isn't there a comparable flood of commercial foreclosures?

Lending during the peak bubble years of 2005 to 2007 made as little sense in commercial lending as it did in residential lending. For example, the infamous "liar's loans" in the residential market, which allowed mortgage originators and their clients to report mythical income streams to justify huge loans, were paralleled in the commercial market by loans based on inflated revenue projections, rather than actual income.

Sham Transactions

From September 2001 through October 2005, Walter Hackett was a vice president for California's PFF Bank & Trust and oversaw the Commercial Note Department, a position that gave him a clear window on some of the banking industry's bad practices. While he believes PFF Bank's practices were particularly egregious at the time, he believes it was nowhere near unique and as the bubble continued to inflate, its practices became relatively common.

Hackett put those practices in the context of lending decisions made to Empire Land, a real estate developer and speculator that was the bank's biggest client. Empire Land ultimately went belly up, a failure that was one of the causes of the bank's 2008 demise. Hackett explains that Empire created a number of subsidiaries and would "sell" a property from one to the other, inflating the price with each transaction.

These transactions were such shams that Empire didn't even transfer money among its entities. After Empire got the price of the property at the level it wanted, it asked PFF for a loan, seeking to use the parcel as collateral. Although Hackett uncovered the price inflating transactions, and although Empire was doing it with several properties, PFF decided to make the loan anyway, giving the client 65% of the inflated value.

"We were effectively making 'hard money' loans," says Hackett. "Those are loans made without regard to the borrower's ability to pay, you just look at what you could get if you took the collateral. The bank thought that since they were only lending 65% of the inflated property value there would be no problem." He added: "A local economist said housing prices in the area were 'bulletproof' and senior management believed him."

"Besieged by Lunatics"

The practices were a radical departure from traditional banking, Hackett noted:

"A lot of the stuff I saw over the years that made business sense was gone. I started to see bigger and bigger assumptions being made. It stopped being about the numbers and common sense. I heard people say things such as 'it's Bob doing the deal, so there's nothing to worry about. It's real estate, it's secured, there's no problem.' In 27 years I had never seen deals done that way. I started to feel like I was besieged by lunatics."

Proper paperwork became unimportant. On one deal involving Empire, the documents were so bad -- Hackett was concerned the contracts wouldn't be enforceable -- that he tried to stop the deal. He was overridden, and the loan was made. Hackett reported it to the Office of Thrift Supervision and his internal actions were deemed "whistleblowing" by the bank's internal attorneys.

One of the factors driving all the bad loan decisions, Hackett explains, was that the bank paid its loan officers commissions on each deal, which undermined loan quality just as much as the incentives given to residential mortgage brokers to steer clients into the most expensive loans did.

And even without assuming the worst of PFF Bank's practices were widespread, it's clear that bubble commercial real estate lending made no sense from a traditional banking perspective. Commercial real estate attorney Ed Mermelstein explains that in peak bubble markets such as New York, "where trillions of dollars were loaned out in a very short period of time -- 2005 to 2007 -- in both refinancing and acquisitions, that's when the lenders were lending on projections instead of actual revenue. That's where most of the equity has been lost. " He added: "Pretty much anything that traded hands in 2005 and 2007 is underwater or will be soon as expiring leases will be renewed at low rate."

Rather Than Foreclosure, "Extend and Pretend"

One spectacular deal failure has been the Stuyvesant Town housing complex in New York City, which is poised to go into foreclosure. But it's by no means the only deal done based on unrealistic revenue projections. New York City deals so "aggressively" priced that they had a hard time closing even at the peak of the bubble include the famous "lipstick building" on Third Avenue, 450 Park Avenue, and others. Most bubble properties, wherever they are in the country, aren't being foreclosed on. Instead lenders are engaging in what's derisively referred to as "extend and pretend."

Apparently, the banks don't dare foreclose, because it would devastate their balance sheets. As Mermelstein notes: "The way the value of the properties is determined plays a big part in the calculus [of whether or not to foreclose]. The residential market just has a lot more comparable sales. In the commercial real estate market there's a lot less volume, so there's a lot less ability to get a price point."

Or to put it another way, commercial real estate is a relatively illiquid asset, and if banks foreclose in any volume, "fire sale" prices will be set and determine how other assets are "marked to market" (that is, using an asset's actual market value on the bank's balance sheet), which would devastate bank balance sheets.

Sounds familiar. Remember when the banks worked so hard to eliminate "mark to market" accounting for the various collateralized debt obligations, mortgage backed securities and other "complex illiquid assets" on their books? And just as with those assets, regulators accommodated the banks on commercial real estate accounting, making it easier to "extend and pretend" in October 2009. Indeed, the FDIC's Shelia Bair defended the practice recently.

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Bloomberg reports that some lenders may be getting a little more honest -- at least the lenders say they will next year -- and engage in "extend and amend." In some markets, such as hard-hit Las Vegas, it's possible that the foreclosures will start happening.

It's unlikely that many of the big banks will do mass foreclosures, however, because of the potential balance-sheet damage. Mermelstein notes that as things stand now, "In commercial real estate, banks can write loan losses down in smaller pieces over a longer period of time, you know, balance sheet window dressing, like the way the banks took debt off their books to report at quarter's end."

Why would they want to give that up?