What the Commercial Real Estate Bailout Means for Entrepreneurs

On Tuesday, Treasury Secretary Geithner announced that one of the industries eligible for the financial recovery package would be commercial real estate. Why? According to industry trade groups, the problem of nearly $530 billion of commercial mortgages coming due between now and the end of 2011 (an estimated $160 billion this year alone) will create a systemic problem, since lenders are not renewing the heavily leveraged debt, landlords and developers are finding it difficult (if not impossible) to replace the debt and many of these mortgages were sold off as securities in the Commercial Mortgage-Backed Securities (CMBS) market. The value of these securities is unknown, so according to industry trade groups, we need for the government to finance the banks, insurance companies and other investors that buy them (using up to $100 billion from the U.S. Treasury for the CMBS and other Asset Backed Securities like auto loans, credit card debt and student loans) so we can value the underlying assets and encourage lending on properties again. The credit crunch, over-building and the economic slowdown has precipitated a rise in commercial mortgage delinquencies--from 0.6% to 0.96% last year--and delinquencies may double this year. To put this in perspective, delinquencies rose to approximately 10% during the S&L crisis.

Unlike home mortgages (the primary focus of the Financial Recovery Plan), commercial mortgages (which make up a majority of the nearly $3.5 trillion commercial mortgage market) are easier to value. In a rational investment environment, the price of assets is based the discounted value of future cash flows.

-What net rents can you reasonably expect to obtain and what can you expect to sell the asset for after a particular holding period?
-What are your projected costs (capital expenses, facility buildouts, operating costs, taxes and debt service)?
-What is your targeted return (say, 12-18% for a property with some good leases in place, 20-30% for a more speculative project) for your equity?

Answer these questions, run the analysis and there’s your price. Yes, there’s a bit more due diligence than that, but basically, that’s the financial process.

So what went wrong?

Like with home mortgages, banks extended to make loans, partially because they could easily sell the loans on the CMBS market. It wasn’t quite as bad as the sub-prime, stated-income, no-money-down home loans, but commercial mortgages for riskier investment properties that rely on tenants, loans for speculative (minimal or no leases in place) buildings or loans for existing buildings with shaky rent rolls made at 80%+ loan-to-value ratios with superficial market analyses in lieu of more careful due diligence processes allowed buyers to bid up prices. The resulting increased demand forced buyers to bid up prices to make acquisitions. While not to the same extent as with home loans, commercial banks extended debt to individuals, insurance companies, businesses, pension funds, REITs and other investors that either shouldn’t have been buying commercial real estate, shouldn’t have been buying that particular product type or shouldn’t have been buying product outside of their core market(s). The increased number of buyers coupled with the cheaper and easily obtainable debt bid up the prices well beyond what reasonable estimates of rent (even in a good economy) could support. Investors and developers kept stretching their proformas to invest their equity and build while they could.

Now that lenders are tightening standards, owners aren’t able to replace or refinance the debt as their short term loans (under 7 years in most cases) at 90% loan-to-value; they’re replacing (sometimes with multiple lenders) at 60% loan-to-value, and the rest is made up with mezzanine financing or additional equity. If that doesn’t work, the owner has to sell or either work out the loan with the bank or lose the property (and all of their equity).

Rather than letting the market determine the real values of these properties, commercial real estate lobbying groups were able to persuade the new administration to commit a portion of $100 billion from the Federal Reserve's Term Asset Backed Securities Loan Facility (TALF) to buy the securities containing the distressed properties, place a value on them and resell them to investors. Like with other articles, I’ll resist my urge to engage in political debate (like will the assets be valued at the right levels and will the taxpayers get their money back) and just focus on what entrepreneurs, as tenants and prospective tenants of these properties, should be on the lookout for.

Estoppel. If you receive an estoppel (a document from a landlord or mortgagee requiring you to verify information about your lease and the landlord), immediate and careful action is critical. This document, which you generally have a very limited time (usually specified in your lease) to fill out and return, can prevent you from making a claim against any landlord or mortgagee (present or future) for any breach that may have occurred, and if you get something wrong on the form, you can be bound by it. Also, this document is an indicator that there is about to be some change with respect to the ownership of the building that should be investigated.

Subordination. Your lease probably states that your rights are subordinate to the lien of any current or future mortgagee. It also probably states that you may have to certify this fact in writing. Like I wrote in last month’s article, ideally, there’s some non-disturbance language to protect you, but if you receive such a document, you’ll again have to respond quickly and carefully. Again, it’s a sign that a change may be in the works, and its implication can be, without proper protection, that you lose certain (or all) rights under your lease.

Term Asset Backed Securities Loan Facility (TALF) terms and conditions. Under what restrictions will the government lend money that will serve as debt to investors and property owners (if TALF is used as a direct lending source to properties, which has been discussed)? What terms and conditions will lenders (those supplementing or replacing the expiring debt) put on property owners, and how will it affect your rights as a tenant with respect to financial requirements, expansion, contraction and renewal rights, unpaid tenant improvements and rental abatement? One thing is for certain, the various lenders replacing the easy debt soon to expire will not be as forgiving as landlords and tenants default, nor will they be as passive during the lease negotiation (or renegotiation) process with tenants.

While the CMBS market is not as exposed to our region and our metropolitan area is still the strongest in the nation, there will be some impact for entrepreneurs, as tenants leasing office space and facilities. The impact may come with warning signs as subtle as I described above or with no warning at all. The key is to understand your lease; in some cases, you may have the leverage to renegotiate it to make it stronger (not to mention secure more favorable rates). In other cases, being prepared and staying informed as market conditions change can be critical to maintaining your occupancy and lease rights.