Friday, September 4, 2009
I would like to begin my blogging by setting up a discussion about the commercial real estate industry, the looming crisis, and what this all means for property law. In a nutshell, the problem is this:
(1) Over the past ten years, commercial rents rose quickly, which supported a rapid increase in the “value” of commercial real estate.
(2) The emergence of the Commercial Mortgage-Backed Securities (CMBS) market and the explosion of IPOs by real estate investment trusts created strong incentives for real estate owners to expand and to continue to drive up prices through demand, particularly in desirable markets like Florida and urban centers.
(3) Many CMBS loans were underwritten aggressively by lenders who were focused on closing a portfolio quickly and selling the securities. As in the residential mortgage securities market, the lenders who originated the loans did not keep them on their books very long. (This incentives problem has been obvious for a while -- here is an interesting 2007 article on the subject.)
(4) The pressure of the recession on tenants and their ability to pay ambitious rents, combined with the sudden evaporation of capital means that most, if not all, collateral in the CMBS pools could not be sold or refinanced today for the amount of the existing debt. (Here is a recent story from the New York Times on the subject.)
This all sounds familiar, right? It is a very similar story to the residential real estate debacle. There are a few important differences.
First, although financial institutions have largely taken the hit for the losses felt in the residential real estate market, the significant losses in the commercial real estate market have yet to be fully internalized by either lenders or owners. Unlike residential mortgages, which have a standard term of 30 years, “permanent” commercial loans have a standard term of 10 years. Adjustable rate mortgages, aggressive borrowing, and a rising unemployment rate meant that many homeowners were unable to make their mortgage payments, triggering banks to recognize that some debt was unlikely to be repaid. In the commercial realm, owners usually have other sources of income (or credit) that they can tap into to cover a property that isn't generating sufficient income to satisfy its own mortgage payments. That strategy only stalls the inevitable, however and we will see a significant amount of commercial real estate debt begin to mature over the next 24 months.
Second, commercial real estate attorneys have put some fairly creative legal structures into place during the boom years. As tenants seek to get out of their lease obligations and lenders seek compensation for vanished equity, we are (anecdotally) already seeing a significant uptick in commercial real estate litigation. Surely some of these cases will make it to the appellate level, giving the courts new opportunities to consider the law of modern real estate transactions, financing, and leasing.
One such case, to which I plan to dedicate one or more posts, is the Chapter 11 filing of General Growth Properties (GGP), the second-largest operator of enclosed malls in the nation. GGP filed for bankruptcy on April 16, 2009 citing “broken credit markets” which “require GGP to reduce and restructure [its] debt.” (Read GGP’s fascinating FAQ on its bankruptcy here.)
The GGP case highlights the box that CMBS loans created for borrowers – easy access to capital had a trade-off in the form of stringent loan covenants and restrictions on sale and refinancing. It also highlights the economic reality faced by commercial real estate owners (and lenders) across the company. When loans mature, extensions run out, and proceeds from sale or refinance are insufficient to pay off the debt, both owners and lenders will be faced with limited and undesirable options.
Sorry for such a long post, but I wanted to set up future posts on the GGP bankruptcy, the legitimacy of special purpose entities, and other related topics. Please comment below to let me know if there are any related issues that you are particularly interested in!
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