I recently had the pleasure to interview Tony Wood, aconsultant and CRE broker in Northern California who haswritten what appears to be the first significant book out about thecurrent commercial real estate downturn: “THE COMMERCIAL REALESTATE TSUNAMI: A Survival Guide For Lenders, Owners, Buyers andBrokers”.

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In his book (available at Amazon.com and inbookstores), Tony provides detailed facts showing howmuch CRE debt is outstanding, and how many billions of dollars willbe required to refinance the coming waves of CRE loan defaults andmaturities. The book is an informative overview of currenttrends driving the CRE industry, and provides useful strategies forowners, lenders, brokers and other in the CRE industry. (Fulldisclosure: I knew about his book in advance because Tonyasked me to contribute to it, along with several other experts invarious aspects of the CRE industry.)

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Tony's data, culled from many reputablesources, is being validated day after day — just today, GlobeSt.com reported that default rates on CMBSloans from 2006, 2007 and 2008 have already shot past the 10% markand are expected to reach 14.8% by year’s end, according to Fitchmanaging director Mary MacNeill.

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I asked Tony to update the readers of the PracticalCounsel blog about what changes he has seen take place in the realestate market since he began his research for the book last summer. Here’s the transcript of our interview.

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MOC: Tony, please give us anupdate on the changes you’ve seen in the commercial real estatemarket since last year.

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TW: As I did myresearch beginning in late 2008-2009 to assess what was likely tohappen, I concluded that a wave of foreclosures wasimminent. The market experts expected to see a lot moreforeclosures of commercial real estate occurring by now, becausethere was (and is) a $1.8 Trillion wave of commercial real estatedebt maturing. This is a staggering number: essentially about half of the nation’s entire commercial realestate debt is coming due in the next few years.

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When this huge debt overhang was combined with thetremendous loss in CRE values (as much as a 50% decrease), itseemed that the deleveraging required to fix the problem washistoric in size, and was much more complex than most lenders,investors and brokers were expecting. The fact it wasoccurring during one of the worst economic crisis since the GreatDepression only made things that much more difficult. Itbecame almost impossible to apply standard market trendstrategies.

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Currently, however, instead of a huge current waveof foreclosures, we are not seeing so much governmentintervention but lenders’ attempts to slow down losses and to slowthe painful process of taking CRE properties back. Last year,funds were formed to buy distressed CRE directly from lenders onthe assumption that lenders would foreclose on such real estatewhen the real estate ran into trouble. Although theunderlying amounts of debt maturing have not changed, and althoughcommercial real estate properties have generally been falling invalue, the wave of foreclosures has not occurred with the level ofspeed or in the amounts that we thought would likelyhappen.

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Now much of the activity in commercial real estateis in the distressed debt side. Banks have beengiven the opportunity by the Fed to borrow money at low to nointerest rates and have been given a lot of discretion on how or ifthey mark such assets to market. Most lenders have beenextending loans and pretending that they are still good, oralternatively, delaying in taking action and praying that themarket will get better. As a result, we have seen a slowbleed of foreclosures which has continued to depress CRE values andhas generally kept investors from jumping in. It appears thatthe market is slowly resetting but much of the smart money issitting on the sidelines.

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MOC: What do you think is makingthis happen, Tony?

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TW: Threethings seem to be happening. First, people have simply becometired of the bad news. They want to think that the commercialreal estate market is better than it really is, and are engaging inwhat sometimes is called “smoking hopium.” Unfortunately,this is not a strategy: it does not lead to effective actionsto actually deal with, recognize and resolve the problem. Instead, people are relying on hope that the market will get betterand not making or implementing any plans.

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Second, some people really do believe that theoverall economy is better. I think that we have seen quite abit of improvement in the various economic statistics from themassive amount of stimulus put in by the government – and from theself-provided stimulus given by many borrowers who have simply quitpaying their home mortgages and therefore have more money tospend. But some people really do believe it’s better. Personally, I feel a bit like the boy in the story of theemperor who had no clothes — pointing out what should be obviousbefore anyone else.

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Third, many people think that even if there is aneconomic recovery, that recovery is not creating solutions for realestate maturities and the lower values that have been created forreal estate. There is effectively no appreciation occurringin commercial real estate now. We are not yet seeing anyconsistent recovery in values. The only upside is toinvestors who buy loans for 20 cents on the dollar and sell them on40 cents on the dollar.

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MOC: Tony, what do you seehappening right now in the market for distressed assets andloans?

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TW: Rightnow, we see a lot of people and investment funds who have money tobuy distressed assets – but finding good distressed assets ishard. The lenders generally don’t want to show their cards orprovide much information, and these pools of loans combine thegood, the bad and the ugly. Many CRE investors have lost alltheir money. However, many investors with money ready toinvest are having a hard time finding deals on which they canactually make money — because they can’t buy them for a low enoughprice. Finally, because so many investors have lost all theirmoney, the number of people in the market, even for distressed realestate has been reduced by about 80% from the peak.

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MOC: Tony, I’ve heard that the bid– asked spread for distressed assets is quite big. Can youaddress that?

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TW: WhatI’m seeing is that the spread between bid and asked variessignificantly depending on the specific offering and thespecific market. As a result, there is no market trend thatpeople can count on. That means every deal is done lender bylender, property by property, borrower by borrower, often under theradar, and each takes an inordinate amount of time. There are Class A properties on the market yielding goodrents. Such properties command much higher prices and lowercap rates than some would consider "market value". However,right next door a building might sell at twice the cap rate andhalf the price because that property is not fully rented out or isdistressed in some other way. There are disparities all overthe place, even in the same markets.

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When there is no dominant market trend you cancount on, investors are very reluctant to put their money at risk –even though it’s very hard for them to earn any significant returnin anything other that real estate right now because of the lowinterest rates available through traditional banking institutionsand the massive turmoil in the stock market. Bluntly, theindustry is essentially at a standstill until a dependable markettrend emerges.

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MOC: Tony, can you address thelink between jobs and commercial real estate?

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TW: Jobsdrive the demand for real estate. The lack of job growthmeans that the demand for commercial real estate has gone downsignificantly. Only after we have some consistent job growthare we likely to see an increase in the demand for industrial space(needed to produce things), office space (needed to grow expandingcompanies), hotels and retail space (needed to sell the things topeople with jobs who can afford to buy them).

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MOC: Tony, what do you see as thebig changes in traditional commercial real estate that led to thiscollapse?

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TW: Formerly commercial real estate was a rather disaggregated market:there were many owners and many lenders, and the fundamentals ofreal estate were local. With the growth of the Wall Streetsecuritization machine, a lot of money was made available forinvestors in real estate. However, this money treated thecommercial real property, which was backing all the loans, asfungible. The flood of easy money essentially covered up theattributes that are critical to real estate investment and for atime ignored the fundamentals (location, tenants' creditworthiness,management skill, etc.). Now that the Wall Street moneymachine has effectively been turned off and the easy money has beenwithdrawn, then the real nature of commercial real estate is beingrevealed: the worth of commercial real estate depends on what aparticular person is willing to pay for that particularspace. So I think we are seeing a movement back to commercialreal estate fundamentals.

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In addition, the boom economy created a demand forspace across the nation. When the economic crisis hit, andhit so quickly, it caused massive damage, not just to employment,but also to people’s sense of confidence. Many owners of realestate and investors in real estate realized that their estimatesof the needed amount of real estate had been inflated by the hugeamounts of economic activity. Many tenants have fled frompricey digs to smaller, more economical spaces, further reducingthe income from, and values of, properties.

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My sense is that now many prudent investors aretrying to figure out what levels of economic activity — and CREprices — are likely to be sustainable. That analysis takestime and effort, which seems to be contributing to how slowly theproblems in commercial real estate are being worked out. That’s why I wrote the book: to assist people inunderstanding what’s going on, and to provide information to helpmitigate the dangers associated with this challengingmarketplace.

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