I recently had the pleasure to interview Tony Wood, a consultant and CRE broker in Northern California who has written what appears to be the first significant book out about the current commercial real estate downturn:  “THE COMMERCIAL REAL ESTATE TSUNAMI: A Survival Guide For Lenders, Owners, Buyers and Brokers”. 

In his book (available at Amazon.com and in bookstores), Tony provides detailed facts showing how much CRE debt is outstanding, and how many billions of dollars will be required to refinance the coming waves of CRE loan defaults and maturities.  The book is an informative overview of current trends driving the CRE industry, and provides useful strategies for owners, lenders, brokers and other in the CRE industry.  (Full disclosure:  I knew about his book in advance because Tony asked me to contribute to it, along with several other experts in various aspects of the CRE industry.)

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

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

MOC: Tony, please give us an update on the changes you’ve seen in the commercial real estate market since last year. 

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

When this huge debt overhang was combined with the tremendous loss in CRE values (as much as a 50% decrease), it seemed that the deleveraging required to fix the problem was historic in size, and was much more complex than most lenders, investors and brokers were expecting.  The fact it was occurring during one of the worst economic crisis since the Great Depression only made things that much more difficult.  It became almost impossible to apply standard market trend strategies.

Currently, however, instead of a huge current wave of foreclosures, we are not seeing so much government intervention but lenders’ attempts to slow down losses and to slow the painful process of taking CRE properties back.  Last year, funds were formed to buy distressed CRE directly from lenders on the assumption that lenders would foreclose on such real estate when the real estate ran into trouble.  Although the underlying amounts of debt maturing have not changed, and although commercial real estate properties have generally been falling in value, the wave of foreclosures has not occurred with the level of speed or in the amounts that we thought would likely happen. 

Now much of the activity in commercial real estate is in the distressed debt side.    Banks have been given the opportunity by the Fed to borrow money at low to no interest rates and have been given a lot of discretion on how or if they mark such assets to market.  Most lenders have been extending loans and pretending that they are still good, or alternatively, delaying in taking action and praying that the market will get better.  As a result, we have seen a slow bleed of foreclosures which has continued to depress CRE values and has generally kept investors from jumping in.  It appears that the market is slowly resetting but much of the smart money is sitting on the sidelines.

MOC: What do you think is making this happen, Tony?

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

Second, some people really do believe that the overall economy is better.  I think that we have seen quite a bit of improvement in the various economic statistics from the massive amount of stimulus put in by the government – and from the self-provided stimulus given by many borrowers who have simply quit paying their home mortgages and therefore have more money to spend.  But some people really do believe it’s better.  Personally,  I feel a bit like the boy in the story of the emperor who had no clothes — pointing out what should be obvious before anyone else. 

Third, many people think that even if there is an economic recovery, that recovery is not creating solutions for real estate maturities and the lower values that have been created for real estate.  There is effectively no appreciation occurring in commercial real estate now.  We are not yet seeing any consistent recovery in values.  The only upside is to investors who buy loans for 20 cents on the dollar and sell them on 40 cents on the dollar.

MOC: Tony, what do you see happening right now in the market for distressed assets and loans?

TW:     Right now, we see a lot of people and investment funds who have money to buy distressed assets – but finding good distressed assets is hard.  The lenders generally don’t want to show their cards or provide much information, and these pools of loans combine the good, the bad and the ugly.  Many CRE investors have lost all their money.  However, many investors with money ready to invest are having a hard time finding deals on which they can actually make money — because they can’t buy them for a low enough price.  Finally, because so many investors have lost all their money, the number of people in the market, even for distressed real estate has been reduced by about 80% from the peak.

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

TW:     What I’m seeing is that the spread between bid and asked varies significantly depending on the specific offering and the specific market.  As a result, there is no market trend that people can count on.  That means every deal is done lender by lender, property by property, borrower by borrower, often under the radar,  and each takes an inordinate amount of time.  There are Class A properties on the market yielding good rents.  Such properties command much higher prices and lower cap rates than some would consider "market value".  However, right next door a building might sell at twice the cap rate and half the price because that property is not fully rented out or is distressed in some other way.  There are disparities all over the place, even in the same markets. 

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

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

TW:     Jobs drive the demand for real estate.  The lack of job growth means that the demand for commercial real estate has gone down significantly.  Only after we have some consistent job growth are we likely to see an increase in the demand for industrial space (needed to produce things), office space (needed to grow expanding companies), hotels and retail space (needed to sell the things to people with jobs who can afford to buy them). 

MOC: Tony, what do you see as the big changes in traditional commercial real estate that led to this collapse?

TW:     Formerly commercial real estate was a rather disaggregated market: there were many owners and many lenders, and the fundamentals of real estate were local.  With the growth of the Wall Street securitization machine, a lot of money was made available for investors in real estate.  However, this money treated the commercial real property, which was backing all the loans, as fungible.  The flood of easy money essentially covered up the attributes that are critical to real estate investment and for a time ignored the fundamentals (location, tenants' creditworthiness, management skill, etc.).  Now that the Wall Street money machine has effectively been turned off and the easy money has been withdrawn, then the real nature of commercial real estate is being revealed: the worth of commercial real estate depends on what a particular person is willing to pay for that particular space.  So I think we are seeing a movement back to commercial real estate fundamentals. 

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

My sense is that now many prudent investors are trying to figure out what levels of economic activity — and CRE prices — are likely to be sustainable.  That analysis takes time and effort, which seems to be contributing to how slowly the problems in commercial real estate are being worked out.  That’s why I wrote the book:  to assist people in understanding what’s going on, and to provide information to help mitigate the dangers associated with this challenging marketplace.