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TOOBIGTOFAILVS.TOOSMALLTONOTICE:

ADDRESSINGTHECOMMERCIALREALESTATEDEBTCRISIS

byTanyaD.Marsh1

ABSTRACT

Thecommercial real estate industryhas been devastated by thecurrenteconomic crisis,losing40%invaluesincetheendof2007.Asaresult,commercialrealestateborrowersowe lenders $1 trillion more than their properties are worth. Although the federalgovernment has been warned that the commercial real estate debt crisis may cause adouble-diprecession,thegovernment’sresponsethusfarhasbeentoallowthemarkettowork itself out. This Article argues that this laissez faire response rests upon flawedassumptionsaboutthestructureofthecommercialrealestateindustry.Compoundingtheproblem,policymakersare incorrectly interpretingincreased lendingandtransactions intheupperechelonsofthemarketasasignalthattheirpoliciesareworking.Instead,thecurrentapproachhasforcedsalesatdistressedprices,numerousforeclosures,and,perhaps

most importantly, significant small bank failures without any systemic benefits.Policymakershaveseentheselossesasanunfortunatebutunavoidablecostoftherecoveryprocess, and dismissed these small actors as not “systemically important.” In fact, thisArticle argues that in the aggregate, small commercial real estate borrowers and smallbanksarevitaltofuelingjobcreationandeconomicrecovery.Byfocusingprimarilyonthehealthoflargefinancialinstitutions,borrowers,andpropertieswithoutdueconsiderationfor the smaller players, the current policy may lengthen the economic crisis by placingfurtherstressanduncertaintyonsomeofthemostvulnerablesegmentsoftheeconomy.

INTRODUCTION

Thecollapseoftheresidentialrealestatemarketinthesummerof2007pushedthe

world’s economy off a cliff. All Americans felt the pain. Unemployment rates rose.

Residentialforeclosure ratesskyrocketed. Corporateinvestmentplummeted. Inthepast

threeyears,policymakers,legalacademics2,andthepresshavepaidsignificantattentionto

1AssistantProfessor,WakeForestSchoolofLaw,Winston-Salem,NorthCarolina.FormerlyVicePresidentofLegal,KiteRealtyGroupTrust,arealestateinvestmenttrustbasedinIndianapolis,Indiana.Manythankstotheborrowers,lenders,attorneys,andtenantswhospokewithmefrankly

andofftherecordabouttheirownexperiencesinthecurrentcommercialrealestatemarketandtheirthoughtsregardingtheissuesexploredinthisarticle.ThanksalsototheCoStarGroupfortheuseofitsimpressivedatabaseofcommercialrealestatepropertiesandtransactions.

2See,e.g.AdamJ.LevitinandTaraTwomey,MortgageServicing,28YaleJ.onReg.1(Winter2011);JeanBraucher,HumptyDumptyandtheForeclosureCrisis:LessonsfromtheLacklusterFirstYearoftheHomeAffordableModificationProgram(HAMP),52Ariz.L.Rev.727(Fall2010);OrenBar-Gill,TheLaw,EconomicsandPsychologyofSubprimeMortgageContracts,94CornellL.Rev1073(July2009);andChristopherL.Peterson,PredatoryStructuredFinance,28CardozoL.Rev.2185(April2007).

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the structural causes of the residential real estate crisis and debated the government’s

response.Thesubprimeaspectoftheresidentialrealestatecrisishasreceivedthemost

attention,andrightlyso,foritreadslikeatraditionalmoralitytale.Greedyinvestors,banks

and even some borrowers profited handsomely in the short term from loans that were

unlikelytoberepaid.Fraudandpredatorylendingwererampant. 3Whenthesubprime

machine collapsed in the summer of 2007, itdragged homeowners, investors, and large

lendersdownwith it.4 While residential borrowers continue to struggle topick up the

pieces, several large lenderswere deemed “too big tofail,” and, so the storygoes,were

“bailedout”bythefederalgovernment.5Inthisnarrative,thegreedywerepunished,unless

theyweresocentraltotheeconomicsystemthattheirfailurewouldhavecausedfurther

damage.

A few months after the collapse of the residential real estate industry, the

commercial real estate industryfollowed, losing 40% of its valuesince the end of2007.

Commercial real estate borrowers currently owe lenders $1 trillion more than their

propertiesareworth.Asaresultofthedepressedvaluations,borrowersandlendershave

bothsuffered.BetweenJanuary1,2008throughDecember31,2010, theFederalDeposit

InsuranceCorporationhasquietlyclosed322smallbanks,6nearlyallofwhichfailedunder

the weight of non-performing commercial real estate loans. Countless owners of

commercialrealestatehavelosttheirpropertiestoforeclosureorbeenforcedtosellintoa

distressedmarket.

Thegovernmenthasbeenwarnedrepeatedlythatthecommercialrealestatedebt

crisishasthepotentialtocausea“secondwaveofproperty-relatedstress”7totheAmerican

3Seegenerally,KathleenC.EngelandPatriciaA.McCoy,TheSuprimeVirus:RecklessCredit,RegulatoryFailureandNextSteps,OxfordUniversityPress(2011).

4See,generally,MichaelLewis,TheBigShort:InsidetheDoomsdayMachine,W.W.Norton&Company(2010).

5See,generally,AndrewRossSorkin,TooBigtoFail,PenguinBooks(2009)

6FederalDepositInsuranceCorporation,FailedBankList(lastvisited:February17,2011).

7Cong.OversightPanel,FebruaryOversightReport:CommercialRealEstateLossesandtheRisktoFinancialStability6(2010);CREComplicationsInfectingSmallBanks,MayCauseDoubleDip,SaysHillRoundtable,3RealEstateL.&Indus.Rep.840(BNA)(November8,2010)(quotingRep.WalterMinnickasstatingthat“thelossesarecoming,andiftheCREcreditmarketsarenotstabilized,thelossescould…triggerbothanavalancheofbankfailuresandthemuchtalked-aboutseconddipoftherecession.”)

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economyandtoderailafragilerecovery,8however,thecrisishasgonelargelyunexamined

bypolicymakers,legalscholars,andthepress.Instead,thegovernmenthasdecidedto

allowthemarkettoworkitselfout.Althoughthecasualtiesofthisapproacharenumerous,

policymakers haveaccepted themas regrettable butnecessary, dismissing themas “not

systemicallyimportant.”9Policymakersarguethatsmallsacrificesarenecessarybecause

commercial realestatecannotrecoveruntil ithitsbottom,andthatcannothappenunless

borrowersandlendersareforcedtoaccepttheirlossesandmoveon.

ButthisArticlearguesthatthegovernment’slaissezfaireresponseisbasedupon

flawed assumptions about the commercial real estate industry. Most significantly,

policymakershaveadaptedthenarrativeofthesubprimeresidentialrealestatecrisistothe

commercial real estate crisis to tell anothermorality tale. In this telling, sophisticated

commercialrealestateborrowersandlendersweregreedy.Theyprofitedhandsomelyon

the run-up of the bubble and must now accept the consequences of their actions. In a

slightly different version, lenders relaxed underwriting standards to maximize profits,

providing loans to unworthy borrowers. When the market corrects itself, the marginal

borrowers will be weeded out and the non-performing loans will be right-sized.

Creditworthyborrowers andresponsible lenderswill survive the carnage to re-start the

flowofcapitalandallwillbewell.

Whilethisnarrative is compelling, reality ismuchmore complicated. Yes,many

commercial borrowers andlendersmadeimpressiveprofitsduring theboom years. But

thatisn’tthewholestory.Thosewhoprofitedmostduringthebubblearenotnecessarily

thesamepartiesthatstandtolosethemosttoday.Thereisstrongempiricalevidencethat

mismatched incentives andoutright fraud contributed to themeltdownof the subprime

residentialrealestatesector.Thereisnoempiricalevidencethatthosesinswerepresentin

commercial real estate. Compounding the problem, policymakers have demonstrated a

fundamental lack of understanding about how commercial real estate is structured,

financed, and valued. They fail to accurately perceive the marketplace and therefore

confuserecoveryinatinyadvantagedsliverofthemarketwithsystemicrecovery.

8See,e.g.StuartSaft,CommercialRealEstateWillCollapse,Forbes.com(November19,2009)(“[T]hecommercialrealestatemarketisonitslastlegsandunlessdrasticactionsaretaken,theeffectsonthebroadereconomywillbecatastrophic.Theobviousproblemistheexcessiveamountofdebtplacedonthepropertiesandtheamountofdebtthathastoberefinancedduringarelativelyshortperiodoftime.”)

9StatementbyPatrickM.Parkinson,beforeCongressionalOversightPanel,February4,2011hearingatp.2.

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Ultimately, thisArticle argues that thegovernment’slaissez faire approachto the

commercial real estate debt crisis will lead toevenmore significant systemicproblems.

Policymakersonbothsidesoftheaislehaverepeatedlystatedthatsmallbusinessesarethe

“engineofjobcreationinAmerica”andthereforeintegraltotheeconomicrecovery. 10But

smallbusinessesaredependentonlocalandregionalbankstofueltheirinvestmentandjob

creationefforts.11 They are alsodependent oncommercial realestate ownerswho offer

premisesforrent,freeingthemfrominvestingheavilyinrealestate.Sowhilethefailureof

eachindividualcommercialrealestateborrowerorbankmaybetoosmalltonotice,inthe

aggregate, these small institutions and entities should be considered too big, and too

essentialtotheAmericaneconomy,tobeallowedtofail.

In Part I, this Article examines the commercial real estate debt crisis and the

government’stepidresponse.PartIbeginswiththestoryofasinglecommercialrealestate

property,WhiteacreTowers,andusesthatexample toexplainhowthelossofvaluesince

2007 has resulted in an industry-wide debt crisis. Relying on the analysis of industry

economists, theArticle then describes thescaleanddepth of thecrisisandthepotential

impactonthebroadereconomy.Congressionaleffortstostudytheproblemarediscussed,

alongwiththelimitedregulatoryresponse.

PartIIcritiquesthegovernment’sflawedinterpretationofthecrisisandpresentsan

alternativenarrative.TwokeyassumptionsofpolicymakersarecorrectedinPartII.First,

theArticledemonstratesthatratherthanasingleintegratedcommercialrealestatemarket,

thereisagrowingmarketsegmentationexacerbatedbythegovernment’sinaction.Second,

the Article challenges the government’s assumption that valuations of commercial

properties aremeaningful or lasting, demonstrating that valid valuations aredependent

uponafunctioningmarket,which,ofcourse,doesnotpresentlyexist.

10PresidentBarackObama,WeeklyAddress(February6,2010)(“Wecanrebuildthiseconomyonanew,strongerfoundationthatleadstomorejobsandgreaterprosperity.IbelieveakeypartofthatfoundationisAmerica’ssmallbusinesses–theplaceswheremostnewjobsbegin.”)

http://www.whitehouse.gov/the-press-office/weekly-address-president-obama-calls-new-steps-support-americas-small-businesses;KateAndersonBrower,ObamaSaysEconomyDependsonSuccessofSmallBusinesses,Bloomberg(February22,2011)(“Whensmallbusinessesdowell,thenAmericadoeswell.”)http://www.businessweek.com/news/2011-02-22/obama-says-economy-depends-on-success-of-small-businesses.html;LetterfromRepublicanleadersofUnitedStatesHouseofRepresentativestoPresidentBarackObama(December9,2009)(“Thetruthofthematteristhatsmallbusiness,notgovernment,istheengineofjobcreationinAmerica.”)11NFIBResearchFoundation,FinancingSmallBusinesses:SmallBusinessandCreditAccess,Washington,D.C.(January2011)

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Finally,PartIIIdescribestheinevitableeffectsofthecommercialrealestatedebt

crisis.Consolidationatthetopofthemarkethasalreadybeguntotakeplace,whileinless

advantagedmarkets,banksandborrowersareincreasinglymarginalized.

ThisArticlearguesthatpolicymakerscannotmeaningfullyaddressthecommercial

realestatedebtcrisiswithout:(1)aclearunderstandingofthewaythatcommercialreal

estate is structured, financed and valued; (2) an appreciation of the true structural and

economiccauses ofthe crisis; and (3) a recognitionof the impactof the failureof small

borrowersandlendersonthebroadereconomy.Althoughathoroughdiscussionofspecific

policyrecommendationsisbeyondthescopeofthisArticle,severalpotentialresponsesare

outlinedintheConclusion.

I. THECOMMERCIALREALESTATEDEBTCRISISANDTHECURRENTPOLICYRESPONSE

Incomparisontoresidentialforeclosurestatistics,12thecommercialrealestatedebt

problemscurrentlyappeartobemild.13Over50%ofoutstandingcommercialrealestate

debtisheldbybanks,whichreportedthatasofSeptember30,2010,only4.41%ofsuch

mortgagesweremorethan90daysdelinquent.14Approximately20%ofcommercialreal

estate debt is held in asset-backed securities, particularly commercial mortgage backed

securitiesor“CMBS.”CMBSloansarealsoknownas“securitizedloans”becauseoriginating

banks made commercial mortgage loans, then packaged them into a pool, sliced the

interests into tranches, and sold the interests to mainly institutional investors. As of

September30,2010,8.8%ofCMBSloansweremorethan30dayslateinpaymentsorin

“REO,”whichmeansthattheinvestorshadtakenownershipofthesecuredassetthrough

12Inthethirdquarterof2010,nearly14%ofresidentialmortgageloanswereinforeclosureoratleastonepaymentpastdue.Althoughtheoveralldelinquencyrateisimproving,thepercentageofloansthatare90daysormorepastdueremainsalmostfourtimestheaveragepercentageoverthepasttwentyyears.MortgageBankersAssociation,DelinquenciesandLoansinForeclosureDecrease,butForeclosureStartsRiseinLatestMBANationalDelinquencySurvey(Nov.18,2010)at

http://www.mortgagebankers.org/NewsandMedia/PressCenter/74733.htm.

13Inthethirdquarterof2010,8.58%ofmortgagesheldincommercialmortgagebackedsecurities,whichrepresent25%ofoutstandingcommercialrealestatedebt,wereatleastonepaymentpastdueorinforeclosure.MortgageBankersAssociation,Commercial/MultifamilyMortgageDelinquencyRatesAmongMajorInvestorGroupsQ32010(December2010)atwww.mortgagebankers.org/files/Research/CommercialNDR/3Q10CommercialNDR.pdf[hereinafterMBAReport ].

14Id.

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basis. Therefore, the story of one typical commercial real estate asset is helpful in

understandingtheproblemsonasystemicbasis.

A. AProperty-LevelViewoftheCrisis

WhiteacreTowersisasmallofficebuildinginMiddletown,AnyState,USA.Itwas

built in 2004 by ACME Developers, a regional real estate developer, at a cost of $9.5

million.17In2005,ACMEDevelopersobtainedatypicalpermanentbankloanwithafive-

yearterm18topayoffthecostsofconstruction.Atthattime,WhiteacreTowerswasnearly

fullyleasedtoavarietyoftypicalofficetenants,includinglocallawfirms,accountants,and

insuranceagents.Likemostpermanentcommercialrealestatedebt,theloanonWhiteacre

Towers was partially amortizing.19 The 2005 loan (Loan #1) was made under market

conditions,includingan80%loan-to-valueratio. 20Giventhestructureoftheloan,ACME

Developers knew thata significant balloonpaymentwould comedueuponmaturity and

thatACME’sabilitytorepaywoulddependuponitsabilitytorefinance.IfWhiteacreTowers

maintainedor increased its value, and if lenderswerewilling to loanmoneyonsimilar

terms as Loan #1, then ACME Developers would have no problem refinancing. The

followingtabledescribesLoan#1aswellasACMEDevelopers’anticipatedsituationupon

maturity.

17WhiteacreTowersisahypotheticalproject.

18Thetermofacommercialrealestateloandependsuponwhichcategoryitfallsinto:development/construction,mini-perm,orpermanent.Constructionloansaretheshortest-termloans,usuallyonetothreeyearsoruntilaprojectiscompleteandbeginstocashflow.Amini-permloanisdesignedtobridgethegapbetweenaconstructionloanandapermanentloan,ifaborrowerneedsadditionaltimetoleaseupaproject.Onceconstructionisfinishedandaprojectbeginstocashflow,aborrowerhasastrongincentivetopayoffthemoreexpensivevariable-rateconstructionloanandacquireapermanentloan,preferablywithafixedinterestrate.Amini-permloanisashort-termloan(onetothreeyears)thathasmanyfeaturesofapermanentloanbutisforashorterperiodoftime,whileaprojectisleasedupandreachesstability.Despiteitsname,apermanentloanisnotpermanent.Instead,itstermistypicallyfivetotenyears.Aborrowerseekingtoowncommercialrealestateinthelongtermwillanticipateaseriesofpermanentloans.Whenonematures,theborrowerrefinancesatathen-currentinterestrateeitherwithitspreviouslenderoranewlender.Theloanproceedsofthesecondpermanentloanareusedtopayofftheremainingprincipalofthe

firstpermanentloan.

19“Partiallyamortizing”meansthattheprincipaloftheloanwasamortizedoveralongerperiodoftimethantheterm.Forexample,aloancouldbeamortizedover30yearsandrepayablein10,leavingalargelumpsumofprincipaldueatmaturity.See,e.g.Inre:GeneralGrowthProperties,supranote__at53.

20Theloan-to-valueratiois,simply,theratiobetweentheoriginalprincipalamountoftheloanandtheappraisedvalueoftheproperty.Ifthepropertyisappraisedat$10millionandtheloanis$8million,thentheloan-to-valueratiois80%.

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Table2:2005–WhiteacreTowersfinancedwitha5-yearloansecuredbyamortgage(Loan#1)30-yearamortization,6%interestrate

AppraisedValuein2005 $10,000,000

RequiredLoan-to-ValueRatioforLoan#1 80%

OriginalPrincipalLoan#1 $8,000,000

RequiredEquityforLoan#1 $1,500,00021

During the five-year term of Loan#1, the general stateof the economy changed

drastically.AfewofthetenantsofWhiteacreTowersfailedduringtheearlyyearsofthe

recessionanddefaultedontheirleaseobligations.ACMEwasabletoreplacemostofthem,

albeitatslightlylowerrents,andthecashflowfromWhiteacreTowersremainedsufficient

to cover the monthly mortgage payments. When Loan #1matured in 2010,Whiteacre

TowerswasstillperformingwellandalthoughACMEDeveloperswasn’tmakingmuchofaprofit,thepropertyincomewasstillcoveringitscostsanddebtservice.Giventhepartially

amortizingstructureofLoan#1,ACMEDevelopersowedaballoonpaymentof$7,444,320

upon maturity. Based on its expectations in 2005, it should have had no problem

refinancingtheballoonpayment.

But in2010, ACME Developers faced a radically different economicenvironment.

Whiteacre Towers did not maintain or increase its value. Instead, the 2010 appraisal

concludedamarketvalueof$8,000,000,a20%declinefrom2005.Althoughstriking,this

decline represents a conservative loss. From the peak of the market, in October 2007,

throughDecember2010, thecommercial real estateprice indexdeclinedby 41.9%.22 In

addition to thedecrease invaluation,ACMEDevelopers found that any lenderwilling to

loanmoneysecuredbyWhiteacreTowersrequiredmoreconservativetermsthanLoan#1.

No lender was willing to make a loan at an 80% loan-to-value ratio. Instead, lenders

generallyofferedloan-to-valueratiosbetween60and70%.23

21Thecostsofconstructionwere$9.5millionandtheloanproceedswere$8million.Therefore,

ACMEDevelopershadtocontribute$1.5millioninequitytopayoffthecostsofconstruction,whichwouldhavetypicallybeenfundedwithafloating-rate,short-termconstructionloan.

22Moody’sInvestorsService,Moody’s/REALCommercialPropertyPriceIndiciesDecember2010(onlineathttp://www.rcanalytics.com/Reports/misc/Moody’s_December_2010_Report.pdf).AprojectlikeWhiteacreTowerswouldhaveappreciatedinvalueatleast10-20%between2005and2007,beforethemarketcollapsed.

23Duringthemid-2000sresidentiallendingboom,loan-to-valueratioscouldeasilyexceed100%,meaningthataresidentialborrowercouldobtainaloanwithaprincipalamountinexcessofthevalueofthesecuredrealestate.Thiswasduebothtoirrationalexuberanceand,intoomanycases,

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ThefollowingtableillustratestheeconomicrealityfacedbyACMEDevelopersupon

thematurityofLoan#1.

Table3:2010–Loan#1Matures

AppraisedValuein2010 $8,000,000

PayoffofLoan#1 $7,444,320

Loan-to-ValueRatioofLoan#1atMaturity 93%

RequiredLoan-to-ValueRatioforLoan#2 70%

OriginalPrincipalLoan#2 $5,250,000

RequiredEquityforLoan#2 $2,250,000

SubtractExistingEquity ($555,680)

EquityGap $1,694,320

Usingconservativecalculations,andassumingthata lenderiswillingtoprovideLoan#2,

ACMEDeveloperswillneedtocontributeanadditional$1,694,320ofequitytorefinance

Whiteacre Towers. Ifthemarket valueforWhiteacre Towers dropped further,or ifthe

lender was willing to refinance only with a lower loan-to-value ratio, the “equity gap”

betweentheamountneededtorefinanceLoan#1andthenewprincipalofLoan#2would

beevenmoredramatic.24

ButACMEDevelopers,a privately-held regional developer,haddifficultyfindinga

lender on any terms. The community bank that held the 2005 mortgage was eager to

removetheloanfromitsbooksandwasuninterestedinrefinancing.Nationalsourcesof

debt, like commercial mortgage backed securities and life insurance companies, were

outrightfraud.Buteveninthemostaggressivemarket,commercialloan-to-valueratiosrarelyexceeded85%.(Thisistruewithrespecttofirstmortgagecommercialrealestateloans.Ownersmayhaveobtainedequityinvestments,structuredlikedebt,thatcouldhavereducedtheirownequitystakeintheprojectto$0.)Theredonotappeartobeanyempiricalstudiesofloan-to-value

ratiosemployedbylendersinthe2000s,however,basedoninterviewswithownersandlenders,loan-to-valueratiostoppedoutat75-85%in2007,withrareexceptions.In2008-2009,ifanownercouldobtaindebt,itwasonlyatasuper-conservativeloan-to-valueratiolike50-55%.Lenderswillingtomakecommercialrealestateloanshavebeguntorelaxloan-to-valueratiosabitatbytheendof2010,mostratioswerereportedlyinthe60-70%range.See,e.g.CBREReport,supranote___at18-19(predictingthatloan-to-valueratioswill“eventuallyincreasetoa70%LTVstandard”andthat“CMBSloanswillremainconservativelysizedat50%to60%LTV.”)

24Forexample,ifthelenderforLoan#2requireda60%Loan-to-ValueRatio,reducingtheproceedsfromLoan#2to$4.8million,theresultingequitygapwouldbeover$2million.

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unavailable to ACME Developers. This drama played out across the market. Banks

essentially stopped commercial real estate lending in2008and2009, and tepidlybegan

lending again in 2010.25 The commercial mortgage backed securities (“CMBS”)market,

which originated $230 billion in commercial real estate loans in 2007, seemingly died

overnight,originatingjust$27billionbetweenJanuary1,2008andDecember31, 2010.26

Although the CMBS market has shown some signs of rebirth,27 a small project like

WhiteacreTowerswouldhavelittlechanceofsecuringCMBSfinancinginanymarket.

Thewayinwhichtheequitygapissatisfiedcouldhavesignificantrepercussionsfor

the American economy. The likelihood that ACME Developers will be able to raise the

additionalrequiredequityandretainownershipofWhiteacreTowers largelydependson

thesizeandstatusofthedeveloperandtheproject.IfACMEDevelopersfailstofindthe

requiredequity,itmaybeforcedtohandthekeysbacktothebankandwalkaway.Thisis

a lose/lose outcome because ACME Developers forfeits the potential appreciation of an

assetthatitdevelopedandbuilt,andthebankisleftholdingtitletoanassetthatitwillbe

forced to sell into a distressedmarket. Foreclosure, or a deed in lieuof foreclosure, is

therefore theworstoptionforbothborrowerandlenderbecauseitforcesbothpartiesto

realizealossimmediately.

B. EstimatingtheScopeoftheCommercialRealEstateDebtCrisis

TheproblemsfacingACMEDeveloperswithrespecttoWhiteacreTowersarebeing

playedoutthroughoutthe$6.5trillioncommercialrealestateindustry.Approximately$1.4

trillionofcommercialrealestatedebtwillmaturebefore2013.28Ithasbeenestimatedthat

forborrowerswhofinancedbetween2005and2008,thepeakyearsofthemarket,falling

propertyvaluescombinedwithreducedloan-to-valueratioscouldresultinequitygapsof

25CBRichardEllis,FindingtheWayBack,AnnualTrendsReport2010(2010)

26CREFinanceCouncil,CompendiumofStatistics,Exhibit1–CMBSIssuancebyMonth2008-2011

(updatedFebruary11,2011)(onlineat:http://www.crefc.org/uploadedFiles/CMSA_Site_Home/Industry_Resources/Research/Industry_Stat istics/CMSA_Compendium.pdf)

27ElaineMisonzhnik,CMBSLendersAreComingBack,asisTheirAppetiteforRisk,RetailTraffic(January12,2011)(“Fasterthananyonethoughtpossible,andwithoutmuchinthewayofgovernmenthelp,theCMBSmarkethasregaineditsvigor.”)

28RichardParkusandJingAn,CMBSResearch:TheFutureRefinancingCrisisinCommercialRealEstate,DeutscheBankGlobalMarketsResearchatpage7(23April2009).

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bankportfolios,Parkusconcludedthatofthe$1.3trillionofcommercialrealestateloans

maturing between mid-2009 and mid-2014, nearly $800 billion in loans would likely

experienceanequitygapseriousenoughtolikelypreventtheirrefinancing. 35

Prudential Real Estate Investors conducteda similar analysiswithrespect to the

$2.8 trillion of commercial mortgages originated between 2005 and 2008. Based on

assumptions of reductions in market values and higher loan-to-value ratios, Prudential

concluded that the equity gap for those mortgages is between $610 billion and $825

billion.36

A studyconductedbyCBRichard Ellisinearly2010 came toa different,but still

troubling,conclusion.AnalyzingCMBSloansscheduledtomaturebetween2010and2019,

CBRichardEllisestimatedatotalequitygapof$89billion,whichrepresents15.8%ofthe

totalloanbalances.37Butthestudynotedthatnotallpropertieswereaffectedtothesame

degree.TheCBRichardEllisstudyfoundthat39%ofCMBSloanshadequitygaps,andthat

the average size of thosegaps was 27.7%of the maturity loan balance.38 It also found

disparitiesintheyearoforigination.Loansmadein2007thatarescheduledtomaturein

2012and2017werefoundtohavethehighestpercentageequitygaps.39

CBRichardElliscautionedaboutextrapolatingthefindingsbasedonCMBSdatato

loansheldbyotherlendergroups.40Itechoedtheconventionalwisdomthatlifeinsurance

companiesmademoreconservative loans than either CMBSoriginators or banks,which

meansthatthesizeoftheirequitygapislikelytobesmaller.Unfortunately,thereisno

public data regarding the performance of loans held by life insurance companies. CB

RichardEllisalsocautionedthatbanksmayfaceamoresignificantequitygap,particularly

because of the volume of short-term construction and development loans in their

portfolios.41

Richard Parkus, Prudential Real Estate Investors, and CB Richard Ellis each

evaluatedadifferentpoolofCMBSloans,originatedandscheduledtomatureatdifferent

35ParkusTestimonyat34.

36

FiorillaandTaylor,supranote___at1.37CBRichardEllis,AnnualTrendsReport:FindingtheWayBack 19-20(2010)

38Id.at20.

39Id.at20.Thisconclusionmakessensesince2007wasthetopofthemarketandloansoriginatedinthatyearwouldhavebeenunderwrittenattheheightoftheirvalue.

40Id.at21.

41Id.at21.

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times.Theirestimatesoftheequitygap,therefore,varysomewhat,however,itisclearthat

a substantialequitygap ofat least $600billionexists inthe short-term (twoyears) and

more than $1 trillion over the long-term. This equity gap must be filled, either by the

borrowers in theformofadditional contributedequity,or by thelenders throughwrite-

downs.

Many industry analysts and policymakers have sounded the alarm that the

commercialrealestatedebtcrisis,andtheequitygapinparticular,couldfurtherhamper

the economic recovery.42 Despite these warnings, as 2011 begins, the commercial real

estate debt crisis remains a looming threat totheeconomicrecovery. The equity gap is

significant on a macro basis, and perhaps even more significant to the hundreds of

thousands of small businesses like ACME Developers who face bankruptcy and/or

foreclosureasaresultofdropsinvaluation.Banks,primarilylocalandcommunitybanks,

failed on nearly a daily basis in 2010 and continue to suffer under the weight of

nonperformingcommercialrealestatedebt.

C. TheCurrentPolicyResponse

Despite the dire warnings and real consequences of inaction, the federal

governmenthas taken very limitedaction to respond to thecommercial real estatedebt

crisis. Several Congressional committees and the Congressional Oversight Panel43 held

hearingsandissuedreportssummarizingthetestimonyofwitnessesrepresentingavariety

ofindustryparticipants.Ineachcase,industryparticipantswarnedoftheemergingcrisis

while representatives of regulatory agencies, including the FDIC, Federal Reserve, and

OfficeoftheComptrolleroftheCurrency,assuredlawmakersthatthesituationwasunder

control.

42See,e.g.,CongressionalOversightPanel,FebruaryOversightReport:CommercialRealEstateLossesandtheRisktoFinancialStability6(Feb.10,2010)athttp://cop.senate.gov/reports/library/report-021110-cop.cfm[hereinafterCOPReport ](TheCongressionalOversightPanelissuedareportinFebruary2010thatwarnedthattheseproblemscouldcausea“secondwaveofproperty-basedstress

onthefinancialsystem.”);BNARealEstateLaw&IndustryReport,CREComplicationsInfectingSmallBanks;MayCauseDoubleDip,SaysHillRoundtable ,3REAL840(quotingRep.WalterMinnick–“thelossesarecoming,andiftheCREcreditmarketsarenotstabilized,thelossescould...triggerbothanavalancheofbankfailuresandthemuchtalked-aboutseconddipoftherecession.”)

43TheCongressionalOversightPanelwasformedbyCongressonOctober3,2008to“reviewthecurrentstateoffinancialmarketsandtheregulatorysystem.”TheCOPhasbeenquitetransparentinitswork.Thewebsiteincludeswebcastsofhearings,transcriptsoforaltestimony,writtentestimony,andfulltextofthereports.CommercialRealEstateLossesandtheRisktoFinancialStability,http://cop.senate.gov/reports/library/report-021110-cop.cfm.

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TheCongressionalOversightPanelheldseveralhearingsoncommercialrealestate,

includingafieldhearinginNewYorkCityonMay28,2009,afieldhearinginAtlantaon

January27, 2010,anda hearing inWashington,D.C. onFebruary4, 2011.Ateachofthe

hearings, testimony was presented by banking regulators44, Wall Street analysts45,

attorneys46,andtradegroupsrepresentinglenders 47andowners.48Basedontestimonyat

the first two field hearings, the Panel issued a report on February 11, 2010 entitled

“CommercialRealEstateLossesandtheRiskto FinancialStability.”49AlthoughthePanel

hasbeenthoroughinitsresearchofthecommercialrealestatedebtcrisis,itsworkdidnot

resultinanyreforms.

SeveralCongressionalcommitteesalso held hearings,50 although noreportswere

issued and no legislation was enacted.51 The only governmental responses to the

44TilScheurmann,VicePresident,FederalReserveBankofNewYorktestifiedonMay28,2009;JonGreenlee,AssociateDirector,DivisionofBankingSupervisionandRegulation,BoardofGovernorsoftheFederalReserve,testifiedonJanuary27,2010;DoreenEberley,ActingAtlantaRegionalDirector,FederalDepositInsuranceCorporation,testifiedonJanuary27,2010;SandraThompson,Director,DivisionofSupervisionandConsumerProtection,FederalDepositInsuranceCorporation,testifiedonFebruary4,2011;PatrickParkinson,Director,DivisionofBankingSupervisionandRegulation,BoardofGovernorsoftheFederalReserve,testifiedonFebruary4,2011;andDavidWilson,DeputyComptrollerforCreditandMarketRisk,OfficeoftheComptrolleroftheCurrencytestifiedonFebruary4,2011.

45RichardParkus,HeadofCMBSandABSSyntheticsResearch,DeutscheBankSecurities,Inc.testifiedonMay28,2009;RichardParkus,thenExecutiveDirectorofMorganStanleyResearch,testifiedonFebruary4,2011;andMatthewAnderson,ManagingDirector,ForesightAnalytics,

testifiedonFebruary4,2011.

46MarkElliott,HeadoftheOfficeandIndustrialRealEstateGroup,TroutmanSanders,testifiedonJanuary27,2010.

47KevinPearson,ExecutiveVicePresident,M&TBanktestifiedonMay28,2009;ChrisBurnett,ChiefExecutiveOfficer,CornerstoneBank,testifiedonJanuary27,2010;JamieWoodwell,VicePresidentofCommercialRealEstateResearch,MortgageBankersAssociation,testifiedonFebruary4,2011.

48JeffreyDeBoer,CEOoftheRealEstateRoundtabletestifiedonMay28,2009;DavidStockert,ChiefExecutiveOfficerofPostPropertiestestifiedonJanuary27,2010.

49FebruaryOversightReport,supranote___.

50See,e.g.MortgageLendingReform:AComprehensiveReviewoftheAmericanMortgageSystem

BeforetheSubcommitteeonFinancialInstitutionsandConsumerCredit ,111th

Cong.(2009);TheStateoftheSmallBusinessEconomyandIdentifyingPoliciestoPromoteEconomicRecoveryBeforeH.Comm.

OnSmallBus.,111thCong.(2009);SubcommitteeonFinanceandTaxFieldHearingonExploringWays

forSmallBusinessestoAccessCapitalBeforetheH.Comm.OnSmallBusiness ,111thCong.(2009);ConditionofSmallBusinessandCommercialRealEstateLendinginLocalMarketsBeforetheH.Comm.

onFinancialServices ,111thCong.(2009).

51H.R.5816,titled“TheCommercialRealEstateStabilizationActof2010”wasintroducedinJune2010andreferredtotheHouseCommitteeonFinancialServices.Itdidnotpassoutofcommitteepriortotheadjournmentofthe111thCongress.

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legacyassetclasstothelistofeligibleTALFcollateral.”57TheFederalReserveBoardhadan

ambitiousobjectivefortheprogram:

torestartthemarket for legacy securities and, bydoing so, stimulate theextensionofnewcreditbyhelpingtoeasebalancesheetpressuresonbanksandotherfinancialinstitutions. 58

FromJulythroughDecember2009,$2.33billioninCMBSwereissued.Only$72.3

million,orapproximately3%,receivedsupportfromTALF.Duringthatsametimeperiod,

demand for TALF financing for legacy CMBS was much stronger – $9.22 billion was

requested.59Whileamoresignificantfigure,itstillrepresentedonlyabout1%ofthe$900

billionCMBSmarket.60TheFederalReserveclosedthewindowonTALFsupportforCMBS

inJune2010.BetweenMay2009andJune2010,atotalof$14.3billionwasinvestedinthe

program,61adropinthebucketcomparedtothetotalCMBSmarketorthe$3trillionin

outstandingcommercialrealestatedebt.

AlthoughtheFederalReservestatedthatthepurposeofTALFwastoeasestresson

banksbyencouragingtheissuanceofnewCMBSdebt,itfailedtomakemuchofadifference.

DavidTurnbull,presidentofBrightonCorp.,arealestatedevelopmentfirminBoise,Idaho,

told theHouseFinancialServicesCommitteethat“theTALFrequirementsare socomplex

thatitisrealisticallyavailableonlytotheverysophisticatedandeliteborrowers.”

2. RegulatorGuidanceonWorkouts

If a loan goes into default, the lender has several options. Depending upon the

process established by the loan documents and state law, the lender has the right to

foreclose itsmortgage inthecollateral.62Orthelendermaychoosetonegotiatewiththe

57Id.

58Id.

59McConnell,supranote___.

60McConnell,supranote___.

61CoStarGroup,RealMoney:$5.8BillioninTALFCMBSLoansStillOutstanding(December15,2010)http://www.costar.com/News/Article/Real-Money-$58-Billion-in-TALF-CMBS-Loans-Still-Outstanding/125065

62Nelson,etal,supranote___at586-842.

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borrowerthrougha“workout”arrangement. 63Theuniquecircumstancesoftheloanand

theassetdictatetheworkoutarrangement,whichgenerallyfollowsoneofseveralmodels.64

Forexample,thepartiesmayagreetoadiscountedrepaymentagreementasanexit

strategy.Underthisstrategy,thelendermayagreetodiscounttheoutstandingdebtasan

incentivefortheborrowertoselltheassetandcloseouttheloan.Thepartiescouldalso

agreetoashortorlong-termforbearanceagreementtoprovidetheborrowerwithtimeto

re-tenant a propertyor solve anotherperformance problem. Inexchange,the borrower

mayagreetocontributeadditionalequitytotheprojectorstrengthenapersonalguaranty.

Moreradicalrestructuringsalsotakeplace,includingsplittingtheoriginalnoteinto

NotesA,B,andC.NoteAwouldbe“right-sized”topermittheloantoconformtomarket

loan-to-value ratios. Note Bwouldbe tied to cash flow formulasto allow the lender to

recapture value if the operation of the property improves. Note C, if used,would be a

“deferral”notewhichwouldonlycomedueintheeventofdefaultbutwouldbeforgivenif

theborrowermetitsobligationsunderNoteAandperhapsNoteB.

The common theme of these approaches is that workouts generally include

concessionsbytheborrower,intheformofadditionalequityorstrengthenedguarantees,

inexchangeformaturityextensions,interestrateadjustments,partialforgiveness,orother

concessions by the lender.65 Workouts in lieu of foreclosure are possible only if the

borroweriswillingandabletomakeadditionalcontributionstosupportthepropertyand

the lender has faith in the borrower’s continued willingness and ability to profitably

managetheproperty.Thelender’sapproachtoadistressedassetdependsinlargeparton

theborrower.

Ifthelenderisabank,itsapproachalsodependsinlargepartupontheattitudeof

its supervisor andguidance from the relevant bank regulators. Particularly in theearly

yearsoftherecession,bankscomplainedthattheywerecaughtinanimpossiblesituation–

non-performingcommercialrealestateloanswereincreasing,foreclosurewasalose/lose

option,butregulatorswerecontradictoryorinflexibleregardingworkouts.

63Foradiscussionofworkoutstrategies,seeBenPolen,WholeLoanWorkoutsandRecapitalizationOpportunities,TheStevenL.NewmanRealEstateInstitute,BaruchCollege,CUNY(Fall2010);

64SeegenerallyRichardS.Fries,DebraGrassgreen,JamesH.M.Sprayregen,andRobertG.Gottlieb,Minefields,SheerCliffsandRoughRoads:TheLandscapeofLoanWorkoutsin2010,presentedtotheInternationalCouncilofShoppingCentersU.S.ShoppingCenterLawConference(November3,2010).

65WilliamB.BrueggemanandJeffreyD.Fisher,RealEstateFinanceandInvestmentsat28-32.

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Inresponsetotheseconcerns,onOctober30,2009,theFederalDepositInsurance

Corporation, along with other supervisory agencies, released a policy statement that

addressed commercial real estate loan workouts.66 The statement endorsed “prudent”

workouts for certain non-performing commercial real estate loans as an alternative to

foreclosure,andnotedthat:

Financial institutions that implement prudent commercial real estate loanworkoutarrangementswillnotbesubjecttocriticismforengagingintheseeffortseveniftherestructuredloanshaveweaknessesthatresultinadversecredit classification. In addition, renewed or restructured loans toborrowerswhohavetheabilitytorepaytheirdebtsaccordingtoreasonablemodifiedtermswillnotbesubjecttoadverseclassificationsolelybecausethevalueoftheunderlyingcollateralhasdeclinetoanamountthatislessthantheloanbalance. 67

Thispolicystatementisanappropriateresponsetothecommercialrealestatecrisis

becauseit focusesthebank’sattentionon theborrower’sabilityto repay theloan,rather

thanthecurrentmarketvalueoftheproperty.Byassertingthattheywillnotcriticizebanks

for “prudent” workouts, the regulatory agencies have provided the banks with much-

neededflexibilitytoavoidwrite-downsandwrite-offsonassetsthatmayrecoverwiththe

economy.68

However,thereisnoempiricalresearchthatanalyzeswhetherthispolicystatement

has resulted in a change in behavior on the part of banks. In order to evaluate the

effectivenessofthisprogramandcraftmoreeffectivepolicystatementsmovingforward,itisimportanttomeasurewhetherbankshaverespondedbyengaginginincreasedworkout

activity,andalsotodeterminethenatureofthoseworkoutarrangements.69

66FederalDepositInsuranceCorporation,PolicyStatementonPrudentCommercialRealEstateLoanWorkouts(October30,2009)(onlineatwww.fdic.gov/news/news/financial/2009/fil09061a1.pdf).Thepolicystatementwasco-authoredbythefollowingagencies:theBoardofGovernorsoftheFederalReserveSystem,theOfficeoftheComptrolleroftheCurrency,theOfficeofThriftSupervision,TheNationalCreditUnionAdministration,andtheFederalFinancialInstitutionsExaminationCouncilStateLiasionCommittee.

67Idat___.

68Accordingtotheregulatoryagencies,thisguidancewasreceivedwellbythebanksand91%foundithelpful.

69JasonPhilyaw,Commercialmortgagemodificationbecomehugetrendinjusttwoyears,HousingWire(January6,2011)(“From2000to2008,commercialmortgagemodificationswererelativelyunheardof.Itwasadifferentstoryin2009and2010.Ofallloanmodificationsinthecommercialmortgageindustryoverthepastdecade,96%occurredinthelastyears,accordingtoStandard&Poor’s.”)

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Manyborrowerswhoseloansweresettomaturebetween2008and2010wereable

to negotiate short-term extensions with their existing lenders. Those extensions were

admittedly notpermanent solutions.70 Instead, they recognized that neither partywins

whenaborroweris forced tosell intoa distressedmarket inorder topartially satisfy a

maturingloan.Thestrategy,dubbed“extendandpretend”bycritics,isnotpopularwith

thosewhobelievethatthemarketwillcorrectitself.71Forexample,theWallStreetJournal

chargedthatthepracticemayprolongtherecessionbecause“[t]hereadinesstostretchout

loansputsafloorundercommercialrealestateandkeepsitfromhittingbottom,whichmay

beapreconditionforarobustrevival.” 72

WhiletheexpansionofTALFto CMBS loansand the guidanceonworkoutswere

both positive, neither policy has had much of an impact on the underlying problems.

Policymakershaveresistedanysignificantinterventioninthecommercialrealestatedebt

crisis,essentiallyoptingtoallowthemarkettoresolveitself.

II. CRITIQUINGTHEGOVERNMENT’SRESPONSE

Althoughitisnotclearwhypolicymakershavechosentoallowthecommercialreal

estatemarkettoresolveitsownproblems,threefundamentalassumptionslikelyunderlie

this policy. First, some policymakers, even bank regulators, appear to have a limited

understandingofhowcommercialrealestateassetsarevaluedandfinancedandtherefore

fail to understand why the market is unlikely to resolve itself without significant and

widespreadpain. Forexample,in aCongressionalhearingregardingthecommercialreal

estate debt crisis, Representative Melvin Watt revealed a fundamental lack of

70CBREReport,supranote___at11(“Manylendersfindthemselveswithalargeportfolioofrecently-originatedperformingloansthatarenow‘underwater,’asunderlyingpropertyvalueshavesunkbelowoutstandingloanbalances.Astheseloansnearmaturity,lenderswillbefacedwiththeprospectofcontinuallyextendingtheloanterms,whichmayultimatelyresultintheacceptanceofa

loanrestructuringordiscountedpayoff.”)

71CarrickMollenkampandLinglingWei,ToFixSourPropertyDeals,Lenders‘ExtendandPretend,’TheWallStreetJournal(July7,2010);CBREReport,supranote__at11(“Whilethebanksmaybeclearlymotivatedandjustifiedintheiractionstoextendloanstocontinuetoearnincomeratherthantakesteeplossesinaliquidity-challengedcapitalmarket,suchactionsmaysimplybedelayingtheinevitable,especiallyatpropertiesthatarebeginningtofalterundertheweightofdecliningnetoperatingincome.”)

72Id.

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understandingof commercial real estate loan practices while questioningawitnesswho

hadtestifiedabouttheequitygap.

[M]ostofthepeopleIknow,whentheygetashort-termballoonloanandtheygettotheendofit,theyknowthattheyhaveanobligationtopaythatloan,nottorefinanceit.Thatisthesamethingthatwehavecriticizedthe

speculatorsabout.Yougotalowerinterestrateona10-yearloanwithaballoon than you would have gotten on a 30-year loan had you fullyamortized it. SodoI understand thattherealestatemarket isnotsetupanymore to amortize loans ever? Do we always contemplate that theywouldberefinancedattheendofsomepaymentterm?Thatisatroublingnotiontome,becauseIneverthoughtofthat.…Whenwegotaloan,weexpectedtopayit.Andthatisthekindofpersonalresponsibilitythatwehavebeenpreachingtoeveryborrowerinthiscountry.73

Thewitnessrepliedthatincommercialrealestate,a10-yearpartiallyamortizingloanisthe

longesttermloanavailable.While30-year,fully-amortizingloansaretypicalinresidential

real estate, they are simply unavailable for income-producing commercial real estate.

Lendersareunwillingtocommittoacommercialrealestateborrower,property,orinterest

rate longerthan10 years. WhatRepresentativeWatt interpretedas speculativebehavior

antitheticaltoamessageofpersonalresponsibility,isapracticeconsistentwiththeadvice

ofbankregulators,whofrownonsuchlong-termloans.

Second,asRepresentativeWatt’squestionreveals,manypolicymakersbelievethat

the commercial real estate debt crisis is the result of risky behavior by borrowers and

lenders.Essentially,theyhaveadoptedthenarrativeofthesubprimeresidentialcrisis74

tothecommercialrealestatedebtcrisis,blamingpoorandaggressiveunderwritingtonon-

creditworthyborrowersforthecrisis.StatementsbyrepresentativesoftheFederalDeposit

InsuranceCorporation,FederalReserve,andOfficeoftheComptrolleroftheCurrencyare

consistent with a perspective that poor underwriting contributed to the crisis, although

none of the statements specify what relaxed standards may be to blame. A remark by

RepresentativeHenslaringistypicalofthecritique:

Therearemanypeoplewho benefited ontheupside ofthe run-up ofthecommercialrealestatemarket.Theyenjoyedtheupside,andnowtheywant

thetaxpayertobeexposedtothedownside.7573SeeAlternativesforPromotingLiquidityintheCommercialRealEstateMarkets,supranote___at28(TestimonyofRep.Watt)

74Foradiscussionofthe“subprimenarrative,”seeFatenSabryandChudozieOkongwu,StudyoftheImpactofSecuritizationonConsumers,Investors,FinancialInstitutionsandtheCapitalMarketsat64-76(June17,2009).

75Id.at7(TestimonyofRep.Hensarling)

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AsPatrickParkinsonoftheFederalReservetestifiedtotheCongressionalOversight

Panel,regulatorsbelievethatsomepropertiesareinthehandsof the“wrong”borrowers,

and that if loans are modified or extended, the assets will continue to decline in value.

While some commercial properties are mismanaged, this curious statement reveals

somethingabouttheregulators’perspective.Itfocusesmoreonthequalityoftheborrower

andlessontheoveralldeclinesinrealestatefundamentalandmarketvaluesthathavebeen

welldocumentedduringthepastthreeyears.Alloftheregulatorsemphasizethatwhile

“poor”borrowersmayfind itdifficult toobtainloansin this environment,“creditworthy”

borrowerswillstillbeabletoobtainloans.Theimplicationisthatrelaxedunderwriting

standardsallowedundeservingborrowerstoobtaindebtandthoseborrowerswillnowbe

weededout.Again,thisisconsistentwiththesubprimenarrativebutacuriousperspective

inlightoftheunderwritingofcommercialrealestate,whichlookstotheincomegenerated

by the asset itself to pay debt service and generally offers borrowers non-recourse or

limited-recourseloans.76 Thesestatementsmaybeasubtlesignalthatregulatorswantall

newcommercial real estate loans tobe full-recourse,withmoreemphasisplaced on the

otherassetsandincomestreamsoftheborrower.Ifso,thatchangewouldhavesignificant

distributiverepercussionsforthecommercialrealestatemarketandfurtherprivilegelarge,

well-capitalized borrowers at the expenseof small borrowers. Itwouldalso ignore the

historicalreasonswhy lenderschosetoemploynon-recourseor limited-recourseloansin

commercialrealestate.77

Finally, in the absence of commercial real estate borrowers or lenders who are

deemed“toobigtofail,”policymakershavedismissedmanyCREborrowersandlendersas

too small to notice, ignoring the aggregate importance of these small institutions and

76Brueggeman,supranote___at447.

77SeeLefcoe,supranote___at205(explainingthatnon-recoursepermanentdebtbecameroutinefollowingtherealestatecrisisoftheearly1990s.“Lendersnoticedthatnonrecourseborrowerswerefarmorewillingthanrecourseborrowerstostandasideandallowtheirlenderstoforecloseonceconvincedtheyhadlittlechanceofrealizinganyequityvalue.Recoursecommercialborrowers,thosewhohadguaranteedorsignedmortgage-securednotes,andwerenolongerabletoservicethedebtfromtheirrecliningrentrolls,aggressivelysoughttodelayforeclosurebyfilinglenderliabilitylawsuits,contestedbankruptcyactionsoranythingelsetheycouldthinkoftostaveoffthedaywhentheywouldbebootedoutoftheirhomesbylenderspursuingdeficiencyclaimsfollowingforeclosure.Thesedelaysprovedcostlytolendersasrealestatevaluesweredecliningduringtheperiod.”)

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entitiestothebroadermarket. 78 TwomembersoftheCongressionalOversightPanel,A.J.

MarkMcWattersandPaulS.Atkins,arguedthatthemarketshouldresolveitselfand“cull”

thesesmaller,weakeractors,nomatterhowpainful:

Amarketeconomybynecessitymustcullormarginalizetheproductsand

services of the weakest participants so that those who have developedinnovativeandcompetitiveideasmayprosperonalevelplayingfield.Anyattempt by the Administration to prop-up the financial institutions anddeveloperswhocontributedtotheoversupplyofCREpropertyisnotinthebestinterestsofthemoreprescientandcreativemarketparticipantsorthetaxpayers. Theopportunity forentrepreneurs tosucceedor fail basedontheirownacumenandjudgmentmustsurvivethecurrentrecession…79

Thisargumentfocusesontheallegedmoralfailingsofthecommercialrealestateborrowers

andlenders.Italsoassumesthatsomeonewillstepintofillthevoidleftbythedepartureof

theweakestparticipants.Totheextentthisstatementreferstoownersandborrowers,itis

not clear that other more innovative actors are clamoring to acquire their real estate

holdings,particularlyinstrugglingmarkets.Ifthestatementreferstotheweakrealestate,

itwill not simply goaway. Anolderretailcentermaybeout-positionedbyashiny new

shoppingcenterinabetterlocation,buttheweakerassetwillnotsimplyvanish.Itmaybe

redeveloped into a better use, but that kind of transformation is expensive, requires

financing,andisoftenanillusivegoalinruralareas,matureurbanor suburbanareas.By

advocating for the weakest participants in commercial real estate to be culled or

marginalized,somepolicymakersappearwillingtosacrificenotonlysmallbusinessesandsmallbanks,butentirecommunitieswhocannotcompetefortenantswithhigher-income,

moredenselypopulatedareas.

Policymakers’attempttoapplythenarrativeofthesubprimeresidentialrealestate

crisis to thecommercial real estate crisisdemonstrates that theydo notunderstand:(1)

whatactuallycausedthe commercial realestatedebtcrisis;and (2)howcommercial real

estateisstructured,financed,andvalued.ThisArticlewillpresentanalternativenarrative

ofthefactorsthatledtotheequitygapandthecommercialrealestatedebtcrisis.Itwill

continuebyrefutingtheflawedassumptionthatasingle,fungiblecommercialrealestatemarketexists.Finally,PartIIconcludesbyconfrontingthegovernment’sassumptionthat

current valuations are meaningful with an explanation of the valuation methodologies

78FinancingSmallBusiness,supranote___at31(“Smallemployersownaconsiderableamountofcommercialrealestate.”)

79COPFebruaryReport,supranote___at158.

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utilizedincommercialrealestateandananalysisofthevalidityofsuchmethodologiesina

non-functioningmarketplace.

A. WhatReallyCausedtheCommercialRealEstateDebtCrisis

Thestructuralrealitiesandeconomicconditionsthatledtotheequitygapand,more

broadly,thecommercialrealestatedebtcrisisarecomplexandintertwined.Atleastsix

separatefactorscanbeidentifiedascontributingtothecurrentproblems.

First,commercialrealestatepricesrosenearly60%between2004andthemarket’s

peakinmid-2007.80Theseincreasedvaluesweredrivenbypositiveeconomicconditions,a

tighteningoftherelationshipbetweensupplyanddemand,andaninfluxofcapitalintothe

commercial real estate market, which drove values up. Attracted by the high fees that

commercial real estate loans generate, plus the fairly lowdelinquency anddefault rates

duringmid-2000s,lenderscompetedtomakeloanstoqualifiedborrowers,puttingupward

pressureon loan-to-value ratios. This combinationof high valuations and high loan-to-

valueratiosleftborrowersparticularlyvulnerabletosteepdropsinvaluation.

Second,thestressofthecurrenteconomiccrisishascausedvacancyratestorise,

askingrentstofall,andlandlordstograntrentconcessionstokeeptenantsopen. 81 The

drag on these fundamental metrics has reduced the net operating income of many

commercial properties. Appraisers, stung by criticism that their overly-optimistic

evaluationsofvaluemighthaveplayedaroleintheresidentialsubprimecrisis,retreatedto

more conservative assumptions.82 So in addition to experiencing actual drops in net

operatingincome,borrowersfacedappraisalsthatassumedfurthervacancyallowancesand

reductions inmarket rent going forward. This combination of factors has led to severe

dropsinvalue.

Third,theparalyzedcapitalmarketsandinitialwaveofforeclosuresanddistressed

propertysalesdistortedvaluationsfurther.In2010,approximately22%ofallcommercial

80TestimonyofRichardParkus,DeutscheBankSecurities,Inc.,page34.

81EmergingTrends,supranote___at51.(“Levelsofconcessionshavebeenunprecedented.Mallslookfull,butownersforgivebackrent,capCAM[common-areamaintenance]charges,orjustletstoresstayopenwithoutpayinganything.”)

82TestimonyofZolaFinch,NationalAssociationofDevelopmentCompanies,HouseofRepresentativesSmallBusinessAccesstoCapitalHearing(October15,2009)(“[A]ppraisershavebecomemuchmoreconservativeintheirvaluationsofcommercialrealestate…”)

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realestatetransactionsinvolveddistressedproperty.83Analystspredictthat“distresswill

continuetobeasignificantfactorinthemarketwellinto2011andbeyond.” 84

Fourth, the short-term nature of commercial real estate loans dictates that

significantmaturityroll-overwilltakeplacebeforethecapitalmarketshavetimetothaw.

Theyears2005-2008sawdramaticincreasesinloanoriginations–nearly$2.8trillionin

commercial real estate loansweremadeduring this four-yearperiod, nearlydouble the

$1.5trillioninloansmadeduringthepriorfouryears. 85Assumingaveragetermsbetween

five and ten years, these loans are expected to mature between 2010 and 2018. The

following table depicts estimates of the maturity dates of commercial real estate debt,

categorizedbytypeoflender.

Table4.CommercialMortgageMaturitiesbyLenderType86

83RealCapitalAnalytics,USCapitalTrends:TheBigPicture(January2011);MarkHeschmeyer,LatestRepeatSalesAnalysisFindsCREPricingHoldingtoSeeSawPattern,CoStarAdvisorNewsletter(February16,2011)http://www.costar.com/News/Article/Latest-Repeat-Sales-Analysis-Finds-CRE-Pricing-Holding-to-SeeSaw-

Pattern/126557?ref=100&iid=219&cid=6DB0336BB4DD8B95D269974470E02B4584USCapitalTrends,supranote___at3.(“Atotalof$300[billion]ofsignificantcommercialpropertybecamedistressedthiscycle,and$190.1[billion]ofthatremainsunresolved.Itisalsoimportanttonotethatwhilenewinstancesofdistressareslowing,the$13.8[billion]ofnewdistressrecordedinQ4[2010]issmallonlyincomparisontopriorquarterlyinflows.”)

85PaulFiorillaandJackTaylor,LifeAfterDebt:ComingtoGripswiththeFundingGap,PrudentialRealEstateInvestorsResearchReport(September2009)

86COPReportat71.DataprovidedbyForesightAnalytics,LLC.

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The flood ofmaturities, combinedwith thelack of available financing hascaused

valuestoartificiallydropevenfurther.87ThebankruptcyreorganizationofGeneralGrowth

Properties, the second largest public real estate investment trust (REIT) dramatically

demonstratestheproblem.OnDecember31,2008,GeneralGrowthreported$29.6billion

inassets,primarilyownershipinterestsin200shoppingcentersin44states,88and$27.3

billionindebt.89 Approximately$18.4billionofthatdebtwasscheduledtomaturebefore

2012.90Theproject-levelloansthatconstitutedthevastmajorityofthedebtweretypicalof

the industry: three-to-seven year terms, lowamortization, andballoon paymentsdue at

maturity.Likeotherownersofcommercialrealestate,GeneralGrowth’sbusinessplanwas

premisedonitsabilitytorefinance.91Whenthecreditmarketsfrozeinmid-2008,General

Growthsuddenlyfounditselffacingbillionsinmaturingdebtandaninabilitytorefinance.

InJanuary2009,GeneralGrowthattemptedtoworkwiththemasterservicersonitsCMBS

loans scheduled to expire through January 2010, but found the CMBS structure did not

permit such a proactive approach.92 Without refinancing proceeds and facing a steady

streamofmaturities,GeneralGrowthwasforcedtouseitsoperatingcashtopaymounting

financing obligations. On April 16, 2009, suffering from a liquidity crisis, its capital

structure devastated by the inability to refinance,GeneralGrowth caused 388of its750

subsidiariestofileforChapter11bankruptcyrestructuring.93

Fifth, lenders, reeling from the residential real estate crisis began paying closer

attentiontoloancovenants,particularlyloan-to-valueratios.Althoughtheseproblemsare

particularly acute for the borrowers unable to refinance upon maturity, the equity gap

represents a challenge forallcommercial real estateborrowers because of the standard

covenants that require maintenance of loan-to-value ratios and debt service coverage

ratios.94 Combine a partially amortizing loan with a steep drop in market value, and

87DeboerTestimonyat89.

88Inre:GeneralGrowthProperties,supranote___at47.

89Id.at48.

90Id.at55.

91Id.at53.

92Id.at53-54.AfterCMBSdebtissecuritized,a“masterservicer”ischargedwithadministeringtheloanonbehalfoftheinvestors.

93Id.at54.

94Thedebtservicecoverageratiorepresentstherelationshipbetweenthemonthlydebtpaymentsandthenetoperatingincomeofthesecuredasset.Theredonotappeartobeanyempiricalstudies

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millions of commercial real estate loans are out-of-balance and therefore in technical

default,eveniftheborrowerhasnevermissedapayment.

Mostcommercialloansarestructuredwithcovenantsthattheloan-to-valueratio

anddebtservicecoverageratioinplaceduringunderwritingwillbemaintainedduringthe

lifeoftheloan.95Iftheloan-to-valueratiofallsbecausecapitalizationratesspike,evenifthe

netincomeofthepropertyremainsconstant,theborrowerwillbeindefault. 96Ifatenant

defaultsearlyonaleaseandthedebtservicecoverageratiofallsoutofbalanceduringre-

tenanting, the borrower will be in default.97 These kinds of defaults are often called

“technical”defaultssincetheyarenottriggeredbytheborrower’sfailuretomeetmonthly

debtservicepayments. Butthefactthatdefaultsare“technical”doesnotmakethemless

meaningfulfortheborrowerorforthelender.98Covenantsthatrequirecompliancewith

theseratiosareakindofearlywarningsystemforlenders.Ifthepropertybecomesover-

leveraged,orifthedebtservicecoverageratioisoutofbalance,thenthelenderbecomes

concernedthattheborrowermightbeonthevergeofpaymentdefault,ormaybeatriskto

walkawayfromthepropertyandtheloan.

During the2000s, ownersworried little about technical defaults, so long as they

maintainedthecontractualpaymentschedule.Butduringadownmarket,lendersneedto

bemoreawareofthefluctuatingmarketvalueoftheunderlyingcollateraltoallowthemto

takeactiontopreservethevalueofthatcollateral,ifnecessary.Althoughthisissueisclear

onaproject-specificbasis,theredoesnotappeartobeanyempiricaldatathatmeasuresthe

numberofbankloansintechnicaldefault,ortheaverageloan-to-valueratiosofcommercial

thattrackdebtservicecoverageratiosovertime.However,itappearsthatoverthepastdecade,theyhaveremainedinthe1.25xto1.50xrange.SeeMisonzhnik,supranote___.Thismeansthattobeincompliancewitha1.25xdebtservicecoverageratio,thenetoperatingincomeofapropertymustexceed125%ofthedebtservicepayments.Thisrequiredratioisdesignedtoensurethatapropertyisabletogeneratesufficientincometocoveritsexpenses(taxes,maintenance,etc.)anddebtservicewithcashtospare.

95Story,supranote___at430-31.

96GeorgeLefcoe,RealEstateTransactions,Finance,andDevelopment(SixthEd.2009)at200.

97

Lefcoe,supranote___at201.98Forexample,considerthesagaofOneKendallSquare,a676,000squarefootcommercialpropertyinCambridge,Massachusetts.Although90%leasedandcurrentonalldebtpayments,theholderofthe$180millionmortgage,AngloIrishBank,initiatedforeclosureproceedingsbecausethepropertyfailedtomeetitsrequiredloan-to-valueratio.Althoughthepropertywasdescribedas“oneofthebest-performingassetsinthebank’sU.S.portfolio,”thelenderwasintroubleandattemptedtousethetechnicaldefaultasleveragetoforcetheownertorefinanceandrepaytheloaninfullpriortomaturity.See,e.g.AnglogoesafteritsBostonloanbook,TheIrishEmigrant,http://www.irishemigrant.com/ie/go.asp?p=story&storyID=7805.

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realestateloansheldbybanks.Ifestimatesofthesizeoftheequitygaparecorrect,thena

significant number of commercial real estate borrowers areat least in technical default.

Anecdotalinformationfromborrowersandlendersindicatethatloancovenantsarebeing

usedbylenderswidelyinordertoforceborrowerstoinvestadditionalequityintoprojects

andbringloan-to-valueratiosbackintobalance.

A final factor contributing to the emergence of the equity gap is property taxes.

Property taxes are often tied to the most recent purchase price, therefore the rise in

propertyvalues during the 2000s led to significant increases inproperty tax burdens.99

Municipalities arenot so quick to apply downward adjustments to property taxeswhen

market values fall. In addition, taxing authoritiesare underincreased stress due to the

economicdownturn,whichdiscouragesmajoradjustmentstoassessedvaluations.

B. TheTrifurcationoftheCommercialRealEstateMarket

At the center of the policy responses to the commercial real estate crisis is the

assumption that there is a single commercial real estate market. The Federal Reserve

believedthatre-startingtheCMBSmarketthroughTALFsupportwouldbeginthe flowof

credit and relievepressureonbanks. The regulatory agenciesencourage workouts, but

ultimatelybelievethatborrowersandlendersshouldacceptlossesonnon-viableprojects

andmoveon.Thesepoliciesassumeasingle,fungiblemarketinwhichborrowers,buyers,

sellers, lenders, and tenants move freely. It is a market in which a non-creditworthy

borrowercanloseapropertythroughforeclosureandbereplacedbyamorecreditworthy

ownerbetterabletosecurealoan.Itisamarketinwhichanycreditworthyborrowercan

availthemselvesofCMBSfinancing.Itisamarketthatdoesnotexist.

Instead, the income-producing commercial real estate industry is fragmented

accordingtoanumberofdifferentcriteria:(1)sizeoftheasset;(2)locationoftheasset;(3)

producttype;(4)qualityofasset;(5)tenantmix;(6)typeofowner;and(7)typeoflender.

Oncethemarketisbrokendownbythesecriteria,atleastthreedifferentcommercialreal

estatesubmarketsclearlyemerge:theInvestmentsegment;theRegionalsegment;andthe

Localsegment.

99ChristopherHahn,Commentary:Dealcreativelywithpropertytaxes,LongIslandBusinessNews(December10,2009)(“[V]acancyratesareat20-yearhighsandsoarepropertytaxes.”)

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1. SizeoftheAsset

Commercialreal estate assetsrun thegamut fromsmall,singletenant buildings

worthless than$100,000to super-regionalshoppingmallsand40+ storyofficebuildings

worthhundredsofmillionsofdollars.Itdoesnotappearthatanyempiricalstudieshave

beendonetoquantifythedistributionofcommercialrealestateassetsbysize.However,a

quickdrivearoundtowndemonstratesthatinsheernumbers,themajorityofcommercial

real estate assets are small, particularly in rural areas and the olderparts of cities and

suburbs.

2. LocationoftheAsset

Commercialrealestateassetsareclassifiedbygeographiclocationinanumberof

differentways.Firstisthedivisionintoprimary,secondary,andtertiarymarkets.“Primary

markets” is a very exclusive category limited to New York City (primarily Manhattan),

Boston,LosAngeles,SanFrancisco,andWashington,D.C.100“Secondarymarkets”arelarge

cities with strong, diversified economies like Chicago, Atlanta, Miami, Phoenix, and

Charlotte.101“Tertiarymarkets”are,essentially,therestofthecountry. 102

Geographiclocationcanalsobedividedbylocationwithinapopulationcenter.The

“centralbusinessdistrict”or“CBD”isbasicallythecoreofdowntownwhereofficebuildings

and economic activity is clustered.103 The suburbs can be classified as “emerging” or

“mature”dependingonwhetherdevelopmentactivityisongoingortheareaisfullybuilt

out.Ruralareasareobviouslyoutsideofcities.Theseclassificationsareimportantbecause

theyplayaroleinvaluationmethodologies.

100EmergingTrends2011,supranote__atp.12(“Everybodywantstobeintheprimarycoastalcitieswithinternationalairporthubs.Businessandcommerceconcentratethere,attractingmorehighlyeducatedworkerstohigher-payingjobs.”);atp.27(“dominantinstitutionalbuyersconcentrateononlyeightorninemarkets”….“globalgatewaycitiesforheadquartersandlower-costSunbeltcitieswithinternationalairportaccessforbackoffice.…Accessibilityandworkforcearekey.It’stheyinandyangofglobalpathways–bigairports,goodlaborpools,andcompanyoperationscenters.”

101ElaineMisonzhnik,BushLeagueNoMore,RetailTraffic(June1,2007)(“Therealestateindustry

isstillsplitonwhatconstitutesasecondaryortertiarymarket.REIS,Inc.,forexample,definesthemarketsbasedontransactionvolume.Theareasonthebottomofthescalefallintothesecondaryortertiarycategory.CBRichardEllis,ontheotherhand,looksatpopulationdensityatradeareawithlessthanonemillionpeopleisconsideredtobeasecondarylocation,thosewithlessthan400,000peopleatertiaryone.Somecompaniesmightweighadditionalconsiderations,includingprojectedjobgrowthandmigrationpatterns.”)

102Id.

103ICSC’sDictionaryofShoppingCenterTerms(2ndEd.2005)at22.

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3. ProductType

Therearefivemajortypesof income-producingcommercial real estate:(a)multi-

family housing and apartments; (b) retail; (c) office; (d) industrial; and (e) hospitality

(includinghotelsandresorts).104Somepropertiescombinetwoormoreoftheseusesina

single“mixeduse”project. Forexample,amulti-storybuildingcouldincluderetailonthe

first floor and office or apartments on the higher floors. Commercial real estate also

includes some other highly specialized income-producing uses like medical, educational

facilities,sportsfacilities,andentertainmentvenues.

4. QualityofAsset

Commercialrealestateassetsareclassifiedbylettergradesgenerallyrangingfrom

AtoC.ClassAassetsaregenerallylarge,newer,builtofhigh-qualitymaterialsandwitha

highleveloffinish.Theyarelocatedatthemostconvenientlocationsinthemostdesirable

markets.Theyhavereadyaccesstoparkingandothercustomaryamenitiesfortheproduct

type. Class B properties are generally a little older and/or smaller. They are in good

locations,butmay beout-positionedby newer,ClassAproperties. ClassCbuildings are

generallyolderoroflesserqualityconstruction.Theyarenormallyunrenovatedanddated

infinishandamenities.Thequalityofanassethasadirectimpactonhowmuchalandlord

canchargeinrent.ClassApropertiescanobviouslychargemorepersquarefootthanClass

BorClassCproperties.

5. TenantMix

All tenantsmay prefer Class A buildings, but not all tenants can afford to locate

there. Commercial real estate owners value a predictable, secure income streamandall

ownersprefertenantswithgoodcreditandahistoryofprofitability.TheownersofClassA

buildingsaregenerallyinabetterpositiontosecuretheso-called“credittenants,”whoare

valuedfortheirdemonstratedabilitytopayrent.Attheotherendofthespectrumareso-

called “mom and pop” tenants, small businesses that either have a limited history of

operationsorlackofgoodcreditstandingbehindtheleaseobligations.

It has been observed that in an environment inwhich vacancy rates are rising,

tenantswillattempttomovefromClassCtoClassB,andfromClassBtoClassAbecause

reduced rental rates allow increases in standards at little or no cost. This phenomena

104GrantS.Nelson,DaleA.Whitman,AnnM.Burkhart,R.WilsonFreyermuth,RealEstateTransfer,FinanceandDevelopment(8thed.2009)at1193.

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resultsingenerallylowervacancyratesforClassAbuildings,comparedtotheirlower-class

competitors.

6. TypeofOwner

Anyone can own commercial real estate. This Article classifies the universe of

commercial real estate owners into three broad categories. “High Capital” owners are

definedaslarge,super-regional,national,andinternationalcompaniesandinstitutionswith

readyaccesstocapitalandsophisticatedadvisors.HighCapitalownersincludepublicreal

estate investment trusts105 (REITs), private REITs, investment managers, insurance

companies, pension funds, equity funds, andnational private real estate and investment

companies.“MediumCapital”ownersaredefinedasregionalcompaniesandinstitutions

withlessrobustaccesstocapitalandamorelimitedreach.MediumCapitalownersinclude

some corporations, educational institutions, hospitals, banks, and regional private real

estateand investment companies. “LimitedCapital”owners are individuals. Individuals

may own one commercial real estate asset for investment purposes, or they may own

several,buttheyarenotreallyinthebusinessofcommercialrealestate.

Itappears that noempirical work hasbeendoneto quantifythe distribution of

commercial real estate between these threeclasses of owners. However, ananalysisof

commercialrealestatetransactionsthatoccurredin2010providesasnapshot.

Table5.Analysisof2010CommercialRealEstateTransactionsbyBuyerType(U.S.)106

ClassofBuyer Percentage of Total

SalesTransactionsin2010

Percentage of TotalSalesVolumein2010

AverageSalesPrice

HighCapital 12.4% 57.6% $8,850,351

MediumCapital 42.4% 32.3% $1,451,431

LimitedCapital 45.2% 9.4% $396,232

105“[A]REITisacorporationorbusinesstrust(taxableasacorporation)formedtogenerateincomefromtheleasingofrealestate…TheREIT’sprincipleadvantageoverotherpublicly-tradedentitiesisthatitmayavoidpayingfederal(andinmanyinstancesstate)incometaxasaresultofdeductingdividendspaidtoshareholdersfrompre-taxincome.”)Nelson,etal,supranote___at1202-03.

106ThisdatawasderivedfromtheCoStarGroup’sCoStarPropertyProfessionaldatabase.AlltransactionscompletedbetweenJanuary1,2010andDecember31,2010intheUnitedStatesforwhichabuyertypewasidentifiedwereanalyzedandcategorized.Thespreadsheetsandoriginalcalculationsareintheauthor’sfiles.

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Onaroughbasis,thisdatademonstratesthatwhileHighCapitalbuyersareinvolvedinonly

12.4%oftransactions,thosetransactionshaveahighaveragevalue,whichresultsinHigh

Capital control of nearly 60% of total sales volume. At the other end of the spectrum,

Limited Capital buyers (individuals) were responsible for purchasing nearly half of the

commercial realestateassetssoldin2010,buttheaveragetransactionsizewaslessthan

$400,000,whichresultedinlessthan10%oftotalsalesvolume.

Thesedifferences areevenmoresignificant when thesecondcriteria, location of

asset, is added to the analysis. Compare the distribution of transactions onManhattan

island in2010, versus the transactions inthe10smallest states intheUnited States, by

population.107

Table6.Analysisof2010CommercialRealEstateTransactionsbyBuyerType(Manhattan)108

ClassofBuyer Percentage of TotalSalesTransactionsin2010


AverageSalesPrice

HighCapital 22.2% 52.7% $42,061,876

MediumCapital 39.6% 39.5% $17,673,921

LimitedCapital 38.2% 7.8% $3,617,947

It is somewhat surprising that nearly 40% of commercial real estate transactions in

ManhattaninvolvedaLimitedCapitalbuyer,buttheaveragesizeofthosetransactionswas

stillsmallbyManhattanstandardsandresultedinlessthan8%oftotalsalesvolume.High

Capitalbuyers,onceagain,werethemostdominantgroup,althoughMediumCapitalbuyers

controlled a larger share of the total sales volume in Manhattan compared to the U.S.

average.Thepictureinthetensmalleststatesisverydifferent.

107AccordingtoU.S.Censusdata,the10smalleststatesbypopulationare:Alaska,Delaware,Hawaii,Maine,Montana,NorthDakota,RhodeIsland,SouthDakota,Vermont,andWyoming.

108ThisdatawasderivedfromtheCoStarGroup’sCoStarPropertyProfessionaldatabase.AlltransactionscompletedbetweenJanuary1,2010andDecember31,2010intheManhattansubmarketforwhichabuyertypewasidentifiedwereanalyzedandcategorized.Thespreadsheetsandoriginalcalculationsareintheauthor’sfiles.

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Table7.Analysisof2010CommercialRealEstateTransactionsbyBuyerType(10smalleststates)109

ClassofBuyer Percentage of TotalSalesTransactionsin2010


AverageSalesPrice

HighCapital 4.5% 36.4% $6,406,228

MediumCapital 43.7% 46.5% $842,723

LimitedCapital 51.8% 16.2% $247,684

HighCapitalbuyersareveryselectiveintertiarymarkets.Theywereinvolvedinlessthan

5% of total transactions, but given the relatively large size of those transactions, still

acquiredover1/3oftotalsalesvolume.Ontheotherhand,LimitedCapitalbuyerswere

evenmore active inthese areasthanthenational average,anddespite the even smaller

averagetransactionsize,managedtoacquire16%oftotalsalesvolume.

Whilethereareoutliertransactionsineachcategory,thisdataconfirmsanintuitive

alignment between different criteria and suggests the contours of the three separate

commercialrealestatemarkets.Thecommercialrealestatemarketcanberoughlybroken

intothreesegments:(1)theInvestment-Gradesegment;(2)theRegionalsegment;and(3)

theLocalsegment.

The Investment-Grade segment ispopulated byHigh Capital owners and ClassA

buildings.110 The Investment-Grade segment includes “trophy properties” and other

desirablepropertiesinprimarymarkets.111Asoneanalystputit,

Many secondary cities and most tertiary markets just do not appear oninvestorradarscreens.“Youseenodemand,nocapitalandnointerest.”112

109ThisdatawasderivedfromtheCoStarGroup’sCoStarPropertyProfessionaldatabase.AlltransactionscompletedbetweenJanuary1,2010andDecember31,2010inAlaska,Delaware,Hawaii,Maine,Montana,NorthDakota,RhodeIsland,SouthDakota,Vermont,andWyomingforwhichabuyertypewasidentifiedwereanalyzedandcategorized.Thespreadsheetsandoriginalcalculationsareintheauthor’sfiles.

110

EmergingTrends2011,supranote___at12.(“PremierdowntownbuildingsremaininvestorsmainstaysinNewYorkCity,Washington,D.C.,andtheselectfew24-hourmarketssituatedalongglobalpathways.”)

111AccordingtoastudybyPriceWaterhouseCoopers,“Manysecondarycitiesandmosttertiarymarketsjustdonotappearoninvestorradarscreens.”BrianLouisandDavidM.Levitt,U.S.CommercialPropertyRecoverySparesEconomy,Bloomberg(February4,2011)http://www.businessweek.com/news/2011-02-04/u-s-commercial-property-recovery-spares-economy.html.112EmergingTrends2011,supranote__at29.

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TheRegionalsegmentispopulatedbyHighCapitalandMediumCapitalownerswho

ownmainlyClassAandsomeClassBbuildings. TheRegionalsegmentincludesdesirable

propertiesinsecondaryandtertiarymarkets,andsomepropertiesinprimarymarkets.

TheLocal segmentcontains everything else. MediumCapitalandLimitedCapital

owners own the majorityofClassB and C buildings inprimary, secondary, and tertiary

markets.OnlyafewofthebestpropertiesintertiarymarketsriseoutoftheLocalsegment

toahighersegmentofthemarket. TheLocalsegmentofthemarketrepresentsthelion’s

shareofcommercialrealestateintheUnitedStates.

This fragmentation into market segments is rough, but the significance of this

alignmenttothecommercialrealestatedebtcrisisbecomesclearwhenthefinalcriteriais

addedtothemix:typeoflender.

7. TypeofLender

Threecategoriesoflenderaremainlyinterestedincommercialrealestate:banks,

insurancecompanies,andissuersofcommercialmortgagebackedsecurities(CMBS). 113 A

fourthtypeoflender,government-sponsoredentities(GSEs),representsnearly15%oftotal

commercial real estatedebt outstanding,but that debt is limited toa singleasset class –

multi-familyhousing.GSEsarenotinvolvedinlendingtoanyotherassetclass.

Asthefollowingtableillustrates,themajorityofcommercialrealestatedebtisheld

bybanks.114 Aswill bediscussed shortly,nearly40% ofthisexposure isto commercial

construction loans,115 which are significantly riskier than permanent commercial loans.

Insurance companiesholdapproximately 20%of commercial real estate debt, andasset

backed securities (ABS) or commercial mortgage backed securities (CMBS) hold

approximately20%.

113SeeBiancaA.Russo,CommercialMortgageSecuritization,930PLI/Comm1013(December2010).

114COP,supranote__at37.

115ParkusTestimonyat34.ThedelinquencyrateforconstructionloansasofSeptember30,2010was19.5%,comparedtoanaveragedelinquencyrateof5.6%forpermanentcommercialloans.ForesightAnalytics,Advance3Q2010DelinquencyRateEstimates(2010)(privateresearchreportinfilesofauthor).

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Table8.LenderGroupsforCommercialMortgageDebt 116Billionsofdollars;amountsoutstandingasofJune30,2010

LenderGroup CommercialMortgageDebt 117

%ofTotalCommercialMortgageDebt

Banks118 $1,638.1 50.5%

Insurancecompanies119 $322.5 9.9%

Government-sponsoredentities120

$478.7 14.8%

Assetbackedsecuritiesissuers

$651.7 20.1%

Other121 $152.1 4.7%

Total $3,243.1 100%

It appears that no empirical research has been done regarding the alignment

between segments of the market and types of lenders. However, anecdotal evidence

suggests that strong alignment exists,122 a conclusion that is supportedbycircumstantial

data.

Traditionally,allcommercialrealestatemortgagelendingwastheprovinceoflocal

banks.AprimefictionalexampleistheBaileyBuildingandLoanAssociationofBedford

Falls.123 This concentrationofcommercialreal estate debtatthelocal levelwas likely a

resultofthethinkingthat“allrealestateislocal”andthelackofafederalagencytocreatea

nationalmarket forcommercial real estatedebt, like FannieMaeorFreddieMacdid for

116AlldatatakenfromTablesL.218,L.219,L.220inFederalReserveFlowofFunds2Q10.

117CommercialmortgagedebtfiguresweredeterminedbycombiningthedatafromTableL.219(multifamilyresidential)andTableL.220(commercial).

118Thiscategoryincludescommercialbanking,savingsinstitutions,andcreditunions.

119Thiscategoryincludescasualtyinsurancecompanies,lifeinsurancecompanies,privatepensionfunds,andstateandlocalgovernmentretirementfunds.

120Thiscategoryincludesgovernment-sponsoredenterprises,agency-andGSE-backedmortgagepools,stateandlocalgovernments,andthefederalgovernment.

121Thiscategoryincludeshouseholdsector,nonfinancialcorporatebusiness,nonfarmcorporate

business,financecompanies,andREITs.

122See,e.g.JoanH.Story,Lending:MortgagesandBeyond,582PLI/Real413(November2010).

123It’saWonderfulLife.NoteGeorgeBailey’sspeechtothecustomersofthebankwhentheydemandedtheirdepositsback:“No,butyou…you…you'rethinkingofthisplaceallwrong.AsifIhadthemoneybackinasafe.The,themoney'snothere.Well,yourmoney'sinJoe'shouse...that'srightnexttoyours.AndintheKennedyHouse,andMrs.Macklin'shouse,and,andahundredothers.Why,you'relendingthemthemoneytobuild,andthen,they'regoingtopayitbacktoyouasbesttheycan.”

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residentialrealestatedebt. Thecommercialrealestate financingmarketopenedupwith

the advent of commercial mortgage securitization in themid-1980s,which dramatically

acceleratedattheendofthe1990sandbeginningofthe2000s,peakingin2007. 124Bythe

height of the market, CMBS loans constituted fully 25% of the dollar volume of new

originations.

ButthestrongemergenceoftheCMBSmarketdidnotimpactallsegmentsofthe

marketequally.Instead,CMBSoriginatorshaveastrongpreferencefornewer,largeoffice

andretailassets125inprimaryandsecondarymarkets,withHighCapitalowners. 126Inthe

fourth quarterof 2006, thequarterwith thehighestorigination level, theaverageCMBS

loanwas$21.1 million.127 From the firstquarterof 2004 through the fourth quarter of

2007,theaverageCMBSloan,averagedonaquarterlybasis,rangedfrom$11.9millionto

$52.9million.128CMBSoriginatorshadstronggeographicalpreferences,with50%ofCMBS

debt on properties located in just five states: California,New York,Texas, Florida, and

Illinois.129Incontrast,thetensmalleststatesbypopulationcollectivelyrepresented1.7%

of total CMBS debt outstanding as of December 31, 2010. This circumstantial data is

consistentwiththeconclusionthatCMBSdebtislimitedtotheInvestment-Gradesegment.

Insurancecompanieshave historicallybeenconservativein their commercial real

estate lending, preferring high quality operating properties with good credit tenants.130

InsurancecompaniesnormallylimittheirlendingtotheInvestment-Gradesegmentandthe

verybestpropertiesandborrowersintheRegionalsegment.131

124CREFinanceCouncilCompendiumofStatisticsatAppendixA2.

125CREFinanceCouncilCompendiumofStatisticsatExhibit11:CMBSBreakdownsbyDealandPropertyType(December30,2010)

126Officeandretailassetsconstitutenearly60%ofCMBSloans.COP,supranote___at55.

127MortgageBankersAssociation,QuarterlySurveyofCommercial/MultifamilyMortgageBankersOriginations(FirstQuarter2009).

128

MBA,QuarterlySurvey(FirstQuarter2009);Misonzhnik,supranote__.(“CMBSlendershaveuppedtheaveragedollaramountofeachindividualloanthatgoesintotheissue…[because]withfewersmallerloansintheissueinvestorsfeelmorecomfortablewiththeirabilitytoanalyzeeveryloan.Theynolongerblindlytrustissuerstodotheduediligenceforthem.”)

129See,JoanH.Story,Lending:MortgagesandBeyond,582PLI/Real413,415-16(November2010).

130See,Story,supranote___at415.

131EmergingTrends2011,supranote__at18(describing“loansontrophyassetsinlargermarkets”asthe“breadandbutter”forlifeinsurancecompanycommercialrealestatelending.)

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Bankshaveprovidedtheremainderofthecommercialmortgagelending.Although

bankssometimesmakeloansintheInvestment-Gradesegment,theymakenearlyallofthe

loansintheLocalsegmentandmostoftheloansintheRegionalsegment. 132

C. TheProblemwithCommercialRealEstateValuations

The commercial real estate industry is fairly insular and uses a specialized

vocabulary.133Fewpublicationsaimedatageneralaudienceexplaintheindustryindetail,

whichresultsinasignificantknowledgegapbetweeninsidersandoutsiders.Inparticular,

theartandscienceofrealestateappraisalappearstomostoutsiderstobeoccurringina

black box. The mystery surrounding real estate appraisal is compounded by the

confidentialitythatsurroundstheappraisalsthemselves.Thisunderstandablymyopicview

ofcommercialrealestatevaluationprocesshinderspolicymakersfromunderstandingthe

corecausesof thecommercial real estatedebt crisis andcrafting appropriate responses.

ThisArticleseeksto curethatknowledgegapwitha detailedexplanationofthevaluation

process.

Thevalueofcommercialrealestateisrootedinitsabilitytogenerateincomeand

the price that investors are willing topay for that income. Objective attributes such as

location,conveniencetopopulationcentersandmajorthoroughfares,accesstoutilities,and

ageandqualityoftheimprovementsareimportant,butprimarilyinthattheyimpactthe

rentsthatmaybechargedandtheinvestors’perceptionoftheriskincollectingthatincome

stream.Forexample,theaverageaskingrentfornon-anchorretailspaceinMiami,Florida

iscurrently$23.82persquarefoot,134butonly$12.35persquarefootinColumbus,Ohio.135

Rents inMidtownManhattan office buildings average $55.27 per square foot,136 but the

landlord ofa ClassAhigh-rise office buildingin Kansas City can only charge $19.72 per

132AlternativesforPromotingLiquidityintheCommercialRealEstateMarkets,supranote___at20(TestimonyofToddLindsey)(“AmajorityofthesmallerbalancecommercialrealestateloansareonthebalancesheetsofourNation’scommunitybanks.”)

133SeeJoshuaSteinandObianujuA.Enendu,TheLanguageofCommercialRealEstateFinance,23-APRProb.&Prop.59(March/April2009).

134REIS,MetroTrendsRetail3rdQuarter2010–Metro:Miami(non-publicresearchreportinfilesofauthor).

135REIS,MetroTrendsRetail3rdQuarter2010–Metro:Columbus(non-publicresearchreportinfilesofauthor).

136AFewBrightSpotsinOfficeMarket,TheWallStreetJournal,November22,2010.

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squarefoot.137Partoftheselargespreadscanbeexplainedbythecostsofconstruction.It

ismore expensive to build commercial real estate in somemarkets due to higher land

prices,developmentcontrols,complicatedprocessesforgovernmentalapprovals,andcost

ofmaterialsandlabor.Thosehighercoststranslateintohigherrents.Butretailandoffice

tenants,forexample,arealsowillingtopayhigheraveragerentsinManhattanandMiami

than Kansas City and Columbus because of demographic characteristics such as higher

populationdensities,whichmaytranslateintomoresignificantreturnsfordevelopersand

owners.

Inadditionto thesemarketdisparities, investorsgenerallyvalueeach$1of rental

rent inprimarymarketslikeMidtownManhattanmorehighlythan$1ofrentalincomein

tertiarymarketslikeKansasCityorColumbusforavarietyofreasons.

Three appraisal methods are generally used to determine the market value of

commercialrealestate:(1) thecostapproach;(2)thesalescomparisonapproach;and(3)

theincomecapitalizationapproach.138 Sinceeachofthethreevaluationtechniqueshavea

differentperspective, theynormally arriveatdifferent estimates ofmarket value. These

threevaluesarethenreconciledforasubjectpropertybasedontheappropriatenessofeach

methodforthepropertygivenmarketconditionsandotherconsiderations.

Forexample,considerthevaluationofasmallMidwesternretailshoppingcenter

namedBlackacrePlaza.139The58,029squarefeetretailcenterwasconstructedbyprivate

developersin2005adjacenttoagrocerystoreowneddirectlybyitsoperator.Blackacre

Plazawasdesignedtoholdupto24“smallshop”retailtenantsinunitsrangingfrom728to

6,435squarefeet.140Smallshoptenantsnormallyincludelocalnailsalons,drycleaners,

localandnationalrestaurants,videostores,coffeeshops,andbeautysalons.InJune2008,

Blackacre Plazawasappraisedusing the costapproach,sales comparisonapproach,and

incomecapitalizationapproach.

137CBRichardEllis,OfficeOutlookKansasCity,Spring2010(non-publicresearchreportinfilesofauthor).

138

Standard1-4,UniformStandardsofProfessionalAppraisalPractice,2010-2011edition.(onlineathttp://netforum.avectra.com/eweb/DynamicPage.aspx?Site=TAF&WebCode=USPAP)

[citeTheDictionaryofRealEstateAppraisal,ThirdEdition,AppraisalInstitute,Chicago,IL(1993).]

139ThevaluationofBlackacrePlazaisbasedonthenon-publicappraisalofarealshoppingcenter.Thenameandlocationofthepropertyhavebeenchangedbutallotherdataisconsistentwiththeactualappraisal.Appraisalof[BlackacrePlaza]by[AppraisalCompany]datedJune1,2008(hereinafter,the“Appraisal”).

140Appraisal,supranote___at3.

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1. TheCostApproach

The costapproach assumesthata purchaserwould paynomorethan the costof

producinga substitutepropertywith thesame utility. Thisapproachis usefulwhen the

improvements being appraised are relatively new, orwhen the property has unique or

specialized improvements for which there is little or no sales data from comparable

properties.141 The cost approach is normally the least useful valuation method for

commercialrealestate.142Inaddition,whilethecostapproachisbasedonsolidtheory,that

is,thataninformedpurchaserwouldnotdesiretopaymoreforapropertythanitwould

pay to construct a substitute propertywith the same utility, the cost approach is rarely

considered by potential purchasers except for new construction because purchasers

acquirecommercialrealestatenotfortheunderlyingvalueofthelandandimprovements,

butfortheincomegeneratedbytheleasesinplace.

2. TheSalesComparisonApproach

Thesalescomparisonapproachassumesthatapurchaserwouldpaynomorefora

propertythanthecostofacquiringanotherexistingpropertywiththesameutility.Datais

gathered fromrecent sales of properties comparable to thesubject property in terms of

propertytype,size,location,age,andqualityofimprovements.Thosecomparablesalesare

141Inthecostapproach,thereplacementcostofthesubjectimprovementsisestimatedbyapplyingcurrentconstructioncoststothevariousbuildingcomponents.Anestimateofaccrueddepreciationtothesubjectpropertyisthenmade.Thisestimateofaccrueddepreciationisthendeductedfrom

thereplacementcost.Finally,themarketvalueoftheunderlyinglandisaddedtothedepreciatedcostoftheimprovementstoarriveatafinalestimateofmarketvalue.Forthecostapproach,theappraiserofBlackacrePlazaestimatedthreesums:thereplacementcostofthecenter,theaccrueddepreciation,andthemarketvalueoftheunderlyingland.Afteranalyzingcomparablesalesoflandthatinthearea,therealestateunderBlackacrePlazawasassignedavalueof$2,160,000.Appraisal,supranote___at74.Thereplacementcostofthebuildings,thatis,theamountthattheappraiserestimatedthatitwouldcosttoreconstructtheimprovements,wasestimatedat$92.73persquarefoot.(ThisestimatewasbasedondatapublishedbyMarshallSwiftValuationService,whichtheappraiserdescribedasa“nationallyacceptedsourceforconstructioncostdata.”Appraisal,supranote___at75.)Theestimatedreplacementcostofthe58,029squarefootbuildingwastherefore$5,325,953andtheestimatedreplacementcostofthesiteimprovements,suchastheparkinglotandlandscaping,was$765,000.Theimprovementswerethendepreciatedinaccordancewiththeirageandeconomiclifeexpectancy.Retailbuildingshaveanexpectedeconomiclifeexpectancyof45years

andsiteimprovementshaveanestimatedeconomiclifeexpectancyof20years.Therefore,thebuildingimprovementsweredepreciatedby11.67%(5.25/45)andthesiteimprovementsweredepreciatedby26.25%(5.25/20).Sothereplacementcost,minustheappropriatedepreciation,was$6,585,829.Addinginthevalueoftheunderlyingland,thecostapproachvaluedBlackacrePlazaat$8,750,000.Appraisal,supranote___at79.Itisimportanttonotethatthissumdoesnotreflectreplacementcostsinceitincludesdepreciation.

142Thisisparticularlytrueifthepropertyisolder,whichmakesitmoredifficulttoestimatedaccrueddepreciation,oriftherearelimitedlandtransactionsinthemarketareaofthesubjectproperty,whichmakesestimatesofthevalueoftheunderlyinglanddifficulttoachieve.

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analyzed for material differences compared with the subject and then a valuation is

reached.

Thevalidityofthesalescomparisonapproachisdependentonanactivemarketfor

thesameproducttypeinthegeographicareainwhichthesubjectpropertyislocated.The

salescomparisonmethodislessreliableinaninactivemarket,orwhenestimatingthevalue

ofpropertiesforwhichnodirectlycomparablesalesdataisavailable.

InJune2008,theappraiserofBlackacrePlazafoundsixcomparablesalesofsmall

retailcenters in themarket area that tookplacebetweenAugust2005andMarch 2008.

Aftermakingadjustmentsforfeatureslikelocation,ageandcondition,occupancy,andland-

to-buildingratio,theappraiserarrivedatadjustedpricespersquarefootrangingfrom$109

to$204withameanof$166.143Thisfairlywiderangeisnotatypical.Afterafewmore

adjustments,theappraiserconcludedamarketvalueof$160persquarefootforBlackacre

Plaza,whichresultedinavalueof$9,500,000throughthesalescomparisonapproach.144

Asthiscursorysummarysuggests,theappraiserhasawiderangeofdiscretionin

determiningwhich sales arecomparable,how to adjust thepurchaseprices, andhow to

apply that data toa valuation. Anotherappraisermighthavereasonablyusedthemean

pricepersquarefootfromthecomparables–$166.That$6increasewouldhaveincreased

thevaluation ofBlackacre Plaza bynearly $350,000. For largerproperties, theeffect of

slightchangesisevenmoresignificant.

3. TheIncomeCapitalizationApproach

Theincomecapitalizationapproachassumesthatapurchaserwouldpaynomore

for a propertythanthe cost ofacquiring the same income stream from anequally risky

investment. This approach converts the anticipated net income from ownership of a

propertyintoamarketvalueindicationthroughcapitalization.145Thevalidityofavalue

estimate under the income capitalization approach is dependant upon: (a) accurate

calculations or estimates of net operating income; and (b) selection of an appropriate

capitalizationrate.

The first step in the direct capitalization approach to income capitalization is to

estimatethepotentialincomestreamfromthepropertyinasingleyearbyanalyzingleases



145Therearetwomethodsofincomecapitalization:directcapitalizationanddiscountedcashflowanalysis.Sincetheyaresimilar,onlydirectcapitalizationisusedinthisexample.

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inplaceandcomparingactualrenttomarketrent.Thissumisreferredtoasthe“gross

income.”Thesecondstepistoestimateappropriateallowancesforvacancy,collectionloss,

andoperatingexpenses.Thenetoperatingincomeor“NOI”ofthepropertyforthatyearis

calculatedbydeductingexpensesandallowancesfromthegrossincome.TheNOIisthen

dividedbyacapitalizationrate146toarriveatavalueestimate.

Theincomecapitalizationapproachisconsideredtobethemostreliablevaluation

method for an operating commercial real estate asset because it reflects the valuation

criteria used bymost buyers – the income generating potential of the propertyand the

anticipatedrateofreturn.

When analyzing thevalueofBlackacrePlaza viathe direct capitalizationmethod,

theappraiserestimatedthegrossincomeofthepropertybasedonactualleasesandmarket

rents. Itthencalculated,basedonactualBlackacrePlazadataplusdatafromcomparable

properties in the area, a vacancy rate, collection risk, and operating expenses. Those

estimatedexpensesweresubtractedfromthegrossincometoarriveatanestimatednet

operating incomeof$771,665 for “Year1.” Theappraiserdrewuponseveral sourcesof

datatoarriveatanappropriatecapitalizationrate,includinganindustrysurveythatstated

theaverageoverallcapitalizationratefornationalstripshoppingcenterswas7.32%,andan

industry survey that stated the average overall rate for retail neighborhood commercial

centers in the local market was 8.6%. Therefore, concluded the appraiser, “an overall

capitalizationratebetween7.32and8.6%wouldbereasonable.” 147Thecomparablesales

were again analyzedtodeterminethe capitalization rates atwhich theytraded. Thesix

salesusedin thesales comparisonapproachwere found tohavetradedat capitalization

ratesrangingfrom6.56%to8.71%withanaverageat7.78%.Giventhisdata,theappraiser

selecteda capitalizationrateof8.5%forBlackacrePlaza,nearthetopof itscontemplated

range. Dividing the net operating income by the designated capitalization rate led to a

valuationof$9,080,000.148

146Thecapitalizationrateisanattempttoquantifythemarketinfluencesthatimpactcashflow,

whichcouldincludemacroeconomicfactorslikecapitalliquidityandtaxpolicy,andlocalfactorslikethesupply/demandrelationshipfortheparticularassettype.Capitalizationratesaremarket-driven,particulartoaspecificgeographicareaandaspecifictypeofproperty,andcanvarywidelyovertime.Forexample,inthespringof2010,capitalizationratesforofficebuildingslocatedincentralbusinessdistrictsaveraged8.0%whileofficebuildingslocatedinsuburbanareasaveraged8.8%.146Asmallchangeinthecapitalizationratecanhaveasignificantimpactonthevalueoftheproperty.Thateffectisamplifiedasthenetoperatingincomerises.



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Theselection of a capitalization rate ishighly significant. Consider the following

table,whichillustratestheimpactonthevaluationofBlackacrePlazathroughtheselection

ofadifferentcapitalizationrate.

Table9:ValuationofBlackacrePlazaThroughDirectCapitalizationMethod

SourceofInformation NOI CapRate Value

Real Estate Research Corporation, Spring2008 (local average for neighborhoodshoppingcenters)

$771,665 8.6% $8,972,849

Appraiser-selected $771,665 8.5% $9,080,000

AverageofsixcomparableProperties

$771,665 7.78% $9,918,573

KorpaczPriceWaterhouseCoopers,SecondQuarter, 2008 (national average for retailcenters)

$771,665 7.32% $10,541,872

Withintherangeofcapitalizationratesdeemed“reasonable”bytheappraiser,the

valueofBlackacrePlazabythedirectcapitalizationmethodvariesfrom$9millionto$10.5

million,aswingofover$1.5million,or17%.Aswiththesalescomparisonmethod,the

income capitalization approach is dependent upon recent robust market data and an

appraiser’sselectionof“appropriate”metrics.

AfteranalyzingthevalueofBlackacrePlazathroughthethreemethodsofappraisal,theresultswerecomparedandafinal“marketvalue”wasdetermined.TheJune2008value

estimatesforBlackacrePlazaareasfollows:

Table10:ComparisonofValues

CostApproach: $8,750,000

SalesComparisonApproach: $9,500,000

IncomeCapitalizationApproach: $9,080,000

After considering the various approaches, the appraiser decided that the income

capitalization approach was the most reliable and concluded that the market value of

BlackacrePlazawas$9,000,000.

Acentralassumptionofpolicymakersisthatthevaluationmethodologiesdescribed

abovereliablygeneratemeaningfulconclusions.Thisassumptionisfundamentallyflawed

in a distressed commercial real estate market in which liquidity was essentially non-

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existent foran extendedperiod of time. Appraisers will caution that all three valuation

methodologiesaredependentupondatafromafullyfunctioninglocal market.Blackacre

Plazais located inaMidwestern community near a largecity. Although therearemany

comparablepropertiesinthearea,eveninJune2008therewerefewcomparablesalesand

those varied widely in valuation. The commercial real estate market, particular in the

RegionalandLocalsegments,hasnotbeenfullyfunctioningsincetheendof2007.

TheimpactofadistressedmarketonvaluationisfurtherapparentwhentheJune

2008 appraisal ofBlackacre Plazais compared toa second appraisal ofBlackacre Plaza,

conductedlessthantwelvemonthslater,inMay2009.Atthetimeofthe2008appraisal,

BlackacrePlazawasonly55%leasedwithanin-placenetoperatingincomeof$530,081.

Theappraiser usedthe actual in-placeincomeandassumedamarket rent of$17.50per

squarefootfor theremainingvacantspace. Theappraiserfurtherassumed,basedonthe

vacancyrates incomparable properties, that thevacancywould be leased-up overa 24-

monthperiod. Finally,a vacancy and collectionlosswas estimated at12% of the gross

potentialincomeofBlackacrePlaza.

InMay2009,BlackacrePlazawas72%leasedwithanin-placenetoperatingincome

of$578,949.However,themarketrentsestimatedbytheappraiserdropped14%inthe

year,from$17.50to$15.00.Thisissignificantbecausemostofthetenantshadstandard

five-yearleasesthatwerescheduledtoexpirein2010or2011.Therefore,theappraiser

adjusted the in-place net operating income to take into account the likelihood that the

landlordwouldbe requiredtoadjustrent tomarketratesinorder toretain tenantsupon

lease expiration. Again, the appraiser assumed a 24-month lease-up and a vacancy and

collectionlossof12%.SodespitethesignificantincreaseinoccupancyfromJune2008to

May2009,thedropinmarketrentledtoa28.8%decreaseintheestimatednetoperating

incomeforBlackacrePlaza.

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Table11:ComparisonofAppraisalsofBlackacrePlaza

June2008Appraisal

May2009Appraisal

Difference

CostApproach: $8,750,000 $8,470,000 (3.2%)149

SalesComparisonApproach: $9,500,000 $7,300,000 (23.1%)

EstimatedNOI: $771,665 $549,713 (28.8%)

CapitalizationRate: 8.5% 8.75% 2.5%

IncomeCapitalizationApproach:(directcapitalization)

$9,080,000 $6,300,000 (30.62%)

FinalValuation $9,000,000 $6,800,000 (24.44%)

The six comparable sales used by the May 2009 appraiser, which took place

between January 2007 and September 2008, resulted in a range of capitalization rates

between7.56%and9.70%,withameanof8.67%.Thisrepresentsa11.4%increaseover

the mean market capitalization rate determined by the appraiser a year earlier. The

followingtablesummarizesthecomparisonofcapitalizationratescitedbytheappraiserin

thetwoappraisals.

Table12:ComparisonofCapitalizationRates

SourceofInformation June2008CapRates May2009CapRates Difference

RealEstateResearchCorporation(localaverageforneighborhoodshoppingcenters)

8.6% 8.9% 3.5%

AverageofsixcomparableProperties

7.78% 8.67% 11.4%

KorpaczPriceWaterhouseCoopers(nationalaverageforretailcenters)

7.32% 7.63% 4.2%

Despite the improved actual performance of Blackacre Plaza during the year, thecombination of the decreased estimated net operating income and the increased

capitalization rate led to a 30.6% drop in the value of Blackacre Plaza via the income

capitalizationapproach.

149Thisreductioninvalueisprimarilyduetoanadditionalyearofdepreciation.

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ThelackofafunctioningmarketalsoimpactedthevaluationofBlackacrePlazavia

thesalescomparisonapproach.ThesixcomparablesalesusedbytheMay2009appraiser

ofBlackacrePlazayieldedpurchaseprices between$82 and $158 per square foot. The

meanpriceof $124per square foot represented a25% decline from the six comparable

salesuseda year earlier. The appraiser concluded amarket valueof Blackacre Plazaat

$130persquarefoot,resultinginalossinvaluationviathesalescomparisonapproachof

23.1%overtheyear.

Althoughitistruethatcapitalwillflowtowardsthehighestreturnsrelativetothe

perceivedrisks,itisalsotruethatrealestatemarketsareofteninformationallyinefficient,

suchthatthepartiesmaynotaccuratelyperceiverisk.150Thatinformationalinefficiencyis

particularly relevant in today’s disrupted market. As the Blackacre Plaza example

demonstrates,arangeofcapitalizationratesmaybedeemedreasonableatanygivenpoint

in time, and two experts may widely disagree about which is appropriate for a given

property. Aswe have seen,small changes inthe selectedcapitalization rate can have a

significantimpactonvaluation.

III. THEINEVITABLERESULTSOFTHEGOVERNMENT’SPOLICY

Given the structure and customs of the commercial real estate industry, the

government’s current policy will lead to some fairly predictable results. First, debt and

equityhavealreadybeguntoflowintothe InvestmentGradesegmentofthemarketfirst.

Asaresult,theHighCapitalbuyerswillincreasetheirconsolidationoftheprimarymarkets

and the best properties in secondary and tertiary markets. Second, small banks with

concentrations incommercialrealestatelendingwill continueto failundertheweightof

non-performing commercial real estate loans, particularly those heldby Limited Capital

borrowers. Third, the combination of a sluggish lending environment, depressed

valuations, and the failure of their primary lenders will contribute to stress and failure

150Forexample,capitalizationratesaresubjecttomarketforces,oneofwhichisliquidity.Ifcapitalisscarce,thereislessdemandtopurchasecommercialrealestateassets,whichraisescapitalizationrates(thusloweringvalue).Ifcapitalflowsfreelyandinterestratesarelow,theenvironmentduringthemid-2000s,thereisincreaseddemandforcommercialrealestateassetsandcapitalizationratesdecline,whichinturnreducesinvestmentreturnforbuyersbyincreasingthevalueofcommercialrealestate.Sothesamefundamentaleconomiceffectcanbeobservedintheresidentialrealestatemarketandthecommercialrealestatemarket.Buttheroleofcapitalizationratesissignificantbecauseitcancreateanegativefeedbackloopwherethelackofliquidityraisescapitalizationrates,whichmakesitmoredifficulttoownerstorefinanceduetotheequitygap.

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among Medium and Limited Capital commercial real estate owners in secondary and

tertiarymarkets.

A. IncreasedConsolidationattheTopofMarket

Althoughallsegmentsofthecommercialrealestatemarketinitiallysufferedasa

resultof therecessionandthe relatedcredit crunch, the Investment Grade segment has

begunrecoveringand,insomelimitedpartsofthemarket,mayhaveregainedmostorallof

the ground lost inthe past threeyears. Given the low interestrateenvironment,many

investorsareinterestedinacquiringhigh-qualitycommercialrealestate,particularlyifitis

availableatasignificantdiscount.151Asaresult,severalinterrelatedtrendshaveemerged.

First,thepublicrealestateinvestmenttrustisprovingtobeanownershipvehiclecapable

of thriving in this market and increasing market share. Second, investors have shown

increasedappetiteforpurchasingCMBSfacilities,whichtranslatesintorisingoriginations.

The renewed enthusiasm of buyers like REITs and lenders in the CMBS market are

beginning to support increased deal volume and rising prices. Although all of these

developmentsarepositiveforthecommercialrealestatemarket,itisimportanttonotethat

theirimpactisfeltonlyinparticularproducttypes(notably,office)intheupperechelonsof

theInvestmentGradesegmentlocatedinprimarymarkets.

1. RealEstateInvestmentTrusts

Activity in thepublic REITmarket demonstrates investor interest inhigh-quality

commercialrealestate.AsofDecember31,2010,approximately170REITswerelistedon

theAmericanstockexchanges. NineREITswentpublicin2010,raisingapproximately$2

billion.152 As of January 10, 2011, about a dozenREIT IPOs were “on file or waiting to

launch.”153 One of those, American Assets Trust, an office REIT based in San Diego,

151See,e.g.UrbanLandInstituteandPriceWaterhouseCoopersLLP,EmergingTrendsinRealEstate2011.Washington,D.C.:UrbanLandInstitute,2010.atp.3(“Thesmartinvestorswhosoldnearmarkettops,avoidedoverleveraging,andkeptpowderdryareextremelywellpositionedtotake

advantageoflegionsofcredit-starvedcompetitorswhooverborrowedandoverpaid.Now,thehavescanattractnewcapital,poachtenants,andluretalentawayfromthehave-nots.Cash-flushinvestorsandrevivinglendersshouldhaveplentyofopportunitiestorecapitalizedebt-starved,have-notplayersandtakepreferredinvestmentorloan-to-ownpositionsinassetcapitalstacks,eventuallyreapingexcellentrisk-adjustedreturns.”)

152ElaineMisonzhnik,ClimateImprovesforPotentialRetailREITIPOs,RetailTraffic,January19,2011,http://retailtrafficmag.com/finance/reits/climate_improves_retail_reit_ipos/

153Id.

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California, raised $564million in its January2011 IPO,exceeding expectations.154 More

REIT IPOs are expected throughout 2011 from well-known private owners like

Schottenstein Realty Trust and Eola Property Trust. Schottenstein, based in Columbus,

Ohio,operates109shoppingcenterstotaling11millionsquarefeetofretailspace. 155Eola

PropertyTrust,basedinOrlando,Florida,isoneofthelargestprivatelyheldcommercial

real estate companies in the Eastern United States with 47 office properties totaling

approximately9.9millionsquarefeet.156

The private companies contemplating REIT IPOs are uniformly focused on

improvingtheiraccesstocapitalandtakingadvantageofacquisitionopportunitiescaused

by the equity gap. For example, Hudson Capital, LLC, a private real estate investment

companybasedinLosAngeles,transformedintoHudsonPacificProperties,apublicREIT,

ina$218millioninitialpublicofferinginJune2010. 157HudsonPacificspecializesinoffice

buildings and sound stages in California. Its strategy is focused on acquiring “office

properties located in submarkets with growth potential, aswell as on underperforming

properties that provide opportunities to implement a value-add strategy to increase

occupancy rates andcash flow.”158 Hudson Pacific emphasizes that it views the current

marketasa“favorableacquisitionenvironment”andthatitsaccesstocapitalhelpsposition

ittotakeadvantageofemergingopportunities.159

2. CMBSOriginations

Well-capitalizedborrowerslikeREITs,investmentmanagers,andpensionfundsare

inagoodpositiontotakeadvantageofthedistressedcommercialrealestatemarketand

purchasevalueatadiscount.Theirsuccess,however,dependsinpartontheavailabilityof

154RandylDrummer,UPDATED:FirstREITIPOof2011PricesThisWeek,WhileAnotherFizzles(January13,2011)http://www.costar.com/News/Article/UPDATED-First-REIT-IPO-of-2011-Prices-This-Week-While-Another-Fizzles/125668

155ElaineMisonzhnik,ClimateImprovesforPotentialRetailREITIPOs,RetailTraffic,January19,2011,http://retailtrafficmag.com/finance/reits/climate_improves_retail_reit_ipos/

156EolaPropertyTrust,AmendmentNo.2toFormS-11(January6,2011)http://secwatch.com/eola-

property-trust/s11/a/registration-statement-for-sec/2011/1/6/7506744#cu43201_management_s_discussion_and_an__man03466

157KristenScholerandInyoungHwang,HudsonPacificRaises$218MillioninOfficeREITIPO,BloombergBusinessweek(June24,2010)http://www.businessweek.com/news/2010-06-24/hudson-pacific-raises-218-million-in-office-reit-ipo.html158HudsonPacificProperties,Strategy.http://www.hudsonpacificproperties.com/about/strategy

159HudsonPacificProperties,MarketOpportunity.http://www.hudsonpacificproperties.com/about/market

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debt.AsHighCapitalborrowerscomebackintothemarket,CMBSisalsoshowingsignsof

rebirth. In2007, $230 billion inCMBS debt was originated.160 In the third and fourth

quarters of 2008, the CMBS machine ground to a complete stop.161 There were a few

issuancesinlate2009thatresultedin$3billionin2009originations,and$12.3billionin

2010.162 Moody’s projects that CMBS issuance will more than triple, to $37 billion, in

2011.163

IncreasingtheliquidityofCMBShelpsshoreupcentralbusinessdistrictsandlarger

assets. There is evidencethat thehigherechelonsof themarketarealreadyresponding

well.Forexample,a10-storyofficebuildinglocatedat1331LStreetNWinWashington,

D.C. waspurchasedby theMortgageBankersAssociation in2007 for$79million.164 By

February2010,theAssociationwasunderwateronits$75millionmortgageandsoldthe

buildingto theCoStarGroup, Inc. for$41.3million.165 Less thantwelvemonths later, in

January2011,theCoStarGroupsoldthebuildingtoGLLRealEstatePartners,aGermanreal

estateinvestmentfundfor$101million. 166 Thesedramaticshiftsinvaluewerearesultof

twofactors:(1)increasednetoperatingincomein2011basedonalong-termleasewith

CoStar;and (2) fallingcapitalization rates in theWashington, D.C. officemarket. Jochen

Schnier,theChiefOperatingOfficerofGLL,explainedtotheWallStreetJournalthatinalow

interestrateenvironment,commercialrealestateisanattractiveoptioncomparedtolow

bondyieldrates.“Thisisaveryhigh-profile,low-riskinvestment,”Mr.Schniersaid.“The

alternative investments to these investments don’t really look more promising.”167

Transactionslike1331LStreetNWdroveuptotalcommercialrealestatedealvolumein

160CREFinanceCouncil,CompendiumofStatistics(lastupdatedFebruary11,2011),Exhibit1:CMBSIssuancebyMonth(2008-2011).

161Id.

162Id.

163Commercial/MultifamilyMortgageOriginationsJump36%in2010,MBASurveyShows,NationalRealEstateInvestor(February9,2011)http://nreionline.com/property/multifamily/multifamily_mortgage_originations_0209/

164JamesHagerty,MortgageBankersAssociationSellsHeadquartersatBigLoss,WallStreetJournal(February6,2010).

165Id.

166CoStarSellsWashington,D.C.BuildinginSignofCommercialRebound,TheWallStreetJournal(February3,2011).ThebuildingwasabletoreboundinvaluesoquicklyinpartbecausetheCoStarGroupoccupiesmostofthespaceonalong-termlease.

167Id.

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2010 to $____, an increase of _____ over 2009.168 The number of transactions involving

propertiesvaluedat$100millionorgreaterincreasedfrom59in2009to195in2010.169

Thiscontributedtotheincreaseinaveragedealsizefrom$11millionin2009to$18million

in2010.170

Thisconsolidationisnotinherentlyproblematic.HighCapitalownersaretypically

well-managedandprovidelendersandtenantswithstability.Thisincreasingconsolidation

willposefewanti-competitiveproblemsfortworeasons.First,HighCapitalownerstendto

focusonlargerassetsinprimarymarkets,centralbusinessdistricts,andsuburbanareas

with strong demographics, a profile that is inherently limited. Second, because the

commercial real estate market ishighly fragmented,High Capitalowners control only a

smallpercentageofassets.

TheeffortsofHighCapitalbuyersgeneratedpositivenewsin2010onseveralfronts

–increaseddealflowandlending,significantcapitalraisesbypublicrealestateinvestment

trusts,and indicationsof improvingvaluations. Thisincreasedtransactionalactivitywas

matched byanincrease in lendingactivity. In2010,mortgagebankers originated $110

billion of commercial real estate loans, an increase of 36% over 2009 lending levels.171

Thesestatisticsdemonstratepositiveactivityin2010andsuggestthatvaluationsarerising

andliquidityisre-enteringthemarket. Butthesestatisticscanonlybemeaningfulifthey

reflectbroadeconomicactivity,orifonepresumesthatthereisasinglecommercialreal

estatemarket inwhich buyers, sellers, and lendersfreely interact. That is certainly the

implicitassumptionbeingmadebypolicymakers.Itisalsofundamentallyflawed.

Althoughitislikelythatpolicymakersviewedincreasedmarketactivityin2010as

evidencethattheirlaissezfaireapproachwasworking,acloserlookatthedatarevealsthat

a recovery isunderwayonly in the InvestmentGrade segment of the market,while the

Regional andLocal segmentscontinueto suffer. Forexample,the prices of “investment-

grade” commercial real estate increased by8% in2010,whilepricingof “general grade”

commercial real estateprices declined8.2%in the fourth quarterof 2010.172Thesame

168RealCapitalAnalytics,supranote__at2.

169Id.

170Id.

171MortgageBankersAssociation,QuarterlySurveyofCommercial/MultifamilyMortgageBankersOriginationsQ42010(2011).

172Id.

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phenomenacanbeseeninthepositivelendingstatistics.Overall,commercialrealestate

lendingincreasedby36%in2010over2009,butthatgrowthwasdrivenalmostexclusively

bytheincreaseinCMBSoriginations,whichsawa6110%increasefromthefourthquarter

of2009tothefourthquarterof2010. 173Lendingbycommercialbanksactuallydeclined

25%duringthesametimeperiod.174Inthefourthquarterof2010,theaverageCMBSloan

was$69.6million,comparedto$7.6millionforthecommercialbankloans.175Clearly,data

that attempts to describe the entire market is skewed by a small number of large

transactionsintheInvestmentGradesegment,whichmasksthecontinuinglackofactivity

orvalueappreciationintheRegionalandLocalsegments.176

Whilerecovery in the Investment Grade segmentis good newsforthe economy,

combinedwith anassumption that there is a single commercial real estate market, this

increasedactivitycanleadtotheerroneousimpressionthatstabilityisreturningacrossthe

board.Infact,thereisnoindicationthatconditionsintheRegionalandLocalsegmentsof

the market have substantially improved. Several respected analysts have opined that

commercialrealestatevalueshavenotyethitbottomandlikelywillnotdosountillaterin

2011or2012.177Asoneanalystbluntlyputit:

The capital flight to quality … has produced a “deep canyon” separating“trophy” and “trash” assets, “witha lot more trash.” … Investors have…learned from recent cycles that prime properties hold value better indownturns and appreciate more in good times. As a result, pent-up,sidelined capitalswarmsapartments andofficebuildings ingatewaycities

andmostlyignoresjustabouteverythingelse.178

173QuarterlySurveyofCommercial/MultifamilyMortgageBankersOriginationsQ42010,supranote___.LifeInsurancecompaniesalsoincreasedtheircommercialrealestatelending170%fromthefourthquarterof2009tothefourthquarterof2010.

174Id.

175Id.

176Commercialrealestatetransactionactivityincreasedsignificantlyin2010,drivenlargelybythere-emergenceofportfoliotransactionsandlargeindividualdeals.RealCapitalAnalytics,supranote__at2.

177[citetoParkusoraltestimonyintranscriptofFebruary4thmeetingwhenreleased.];MarkHeschmeyeroftheCoStarGroupexplainsthat“[w]hileinvestment-grade‘trophy’buildingsarecommandinghigherprices,pricesforthemajorityof‘ordinary’officeproperty,shoppingcentersandwarehousebuildingscontinuetosearchforabottom.”Heschmeyer,supranote___.

178EmergingTrends2011,supranote___at6.

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B. BankFailures

Oneofthemostsignificantimpactsofthecommercialrealestatedebtcrisistodate

hasoccurredveryquietly.FromJanuary1,2000toDecember31,2007,theFederalDeposit

InsuranceCorporationclosed26Americanbanks.179FromJanuary1,2008toDecember31,

2010,theFDICclosed322banks. 180 In2010 alone,157banksfailed, the highestannual

totalsince1992.181

Despitetheattentionpaidtothosefinancialinstitutionsthatare“toobigtofail,”the

realityisthatmostAmericanbanksaresmallenoughtofailwithoutattractingmuchnotice.

Therearenearly7,000communitybanks intheUnitedStates,constitutingapproximately

97%ofallbanks.182Ninety-onepercentofallbanksintheUnitedStateshaveassetsofless

than $1billion and 36% have assets less than $100million.183 Community banks are a

major sourceofcreditfor smallbusinesses,includingsmallbusinesses inthecommercial

realestateindustry.184Communitybankswithassetsoflessthan$10billionrepresent23%

ofthebanking industry, asmeasured bytotal assets, yet theymade56% ofoutstanding

bank loans to small businesses. 185 Randall Compton, the CEO of Pioneer Trust Bank in

Salem,Oregonexplainedtheroleofcommunitybanks:

We encourage people to deposit their funds with the community banks,becauseweturnaroundandrelenditwithinthecommunity.Atleastthat'swhatwedo,because,youknow,whereelsearewegoingtogo?We'renotinNewYork.We'renotinWashington.We'renotinCalifornia.We'rejustinSalem.186

179FederalDepositInsuranceCorporation,FailedBankList(lastvisited:February17,2011)http://www.fdic.gov/bank/individual/failed/banklist.html.

180Id.

181TestimonyofSandraThompson,Director,DivisionofSupervisionandConsumerProtection,FederalDepositInsuranceCorporationonTheCurrentStateofCommercialRealEstateFinanceandItsRelationshiptotheOverallStabilityoftheFinancialSystem,CongressionalOversightPanel,Washington,D.C.(February4,2011)at9.

182IndependentCommunityBankersofAmerica,CommunityBankingFacts(November2010)http://www.icba.org/aboutICBA/index.cfm?ItemNumber=527

183Id.

184AlternativesforPromotingLiquidityintheCommercialRealEstateMarkets,SupportingSmallBusinesses,andIncreasingJobGrowth,HearingoftheU.S.HouseofRepresentatives,CommitteeonFinancialServices(July29,2010)TestimonyofRep.SuzanneKosmasatp.4(“[C]ommunitybanksarethelifebloodofourcommunitiesand…wehavetoensuretheircontinuedviability.”)

185Id.

186TheStateoftheSmallBusinessEconomyandIdentifyingPoliciestoPromoteEconomicRecoveryBeforeH.Comm.OnSmallBus.,111thCong.(2009)(statementofRandyCompton,CEO,PioneerTrustBank,Salem,OR).

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Commercial real estate lending played a key role in the collapse of a significant

numberofthe322banksthathavefailedinthepast36months. 187FDICanalysisindicates

that of the 322 banks, more than 86% exceeded the commercial real estate lending

concentrationsguidancepromulgatedbybankregulatorsinDecember2006.188

Representatives of the FDIC have testified that while bank failures in 2011 will

remainhigh,2010representedthepeakofthecurrentcycle. 189Whilethatpredictionmay

beaccurate, commercial real estatedebt continues to force bank closures.190 In January

2011,11banksclosedtheirdoors,mostlyduetonon-performingcommercialrealestate

loans.191The11failedbanksreported$732millioninnonperformingloans.Approximately

$600millionofthatpool,or82%,werecommercialconstructionloansorcommercialreal

estatemortgages.Only$90millionwereresidentialrealestateloans.

Manymore small banks remain atrisk. AsofSeptember 2010,860 bankswere

designated by the FDIC as “problem institutions.”192 Many of these banks have high

concentrations of construction loans and commercial real estate loans. For example,

IntegraBank ofEvansville,Indianaposted a loss of$35million in the fourth quarter of

2010, due in large part to the “persistentweakness in commercial real estate markets.”

IntegraBankstatedthata“plunge”inthevalueofcommercialrealestatehasresultedin

187Itisimportanttonotethatregulatorsincludeloansforthedevelopmentofsingle-family

subdivisionsin“commercialconstructionloans”althoughthatproducttypeisnototherwiseincludedinthedefinitionofcommercialrealestateusedinthisArticleorbyotherdataproviders.PatrickParkinson,COPFeb4,2011hearingatp.1(“LossesassociatedwithCRE,particularlyresidentialconstructionandlanddevelopmentlending,werethedominantreasonforthehighnumberofbankfailuressincethebeginningof2008,andfurtherCRE-relatedbankfailuresareexpectedoverthenextfewyears.”);JonPrior,CommercialRealEstateProblemsLeadtoLatestBankFailures:Trepp,HousingWire(September20,2010)http://www.housingwire.com/2010/09/20/commercial-real-estate-problems-lead-to-latest-bank-failures-trepp(InthesecondweekofSeptember2010,theFDICclosedsixbanks.Accordingtoindustryanalysts,commercialrealestateloansmadeup82%ofthe$152millioninnonperformingloansheldbythesixbanks.)

188TheJointGuidanceonCRELendingdatedDecember12,2006definedacommercialrealestateconcentrationasloanswhichexceeded300%oftotalcapital.See:FIL104-2006,http://www.fdic.gov/news/news/press/2006/pr06114.html

189Id.

190StatementofPatrickParkinsonatp.9(“WeexpectthatbankswillcontinuetoincursubstantialadditionalCRElossesoverthenexttwoyearsandthatmanybankswithCREconcentrationswillcontinuetobeunderstress.”)

191JacobGaffney,CRE“extendandpretend”reachingbreakingpoint,HousingWire(January31,2011)(www.housingwire.com/2011/01/31/cre-extend-and-pretend)

192Thompsontestimony,supranote___at8.

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capitalratioslowerthanlevelsrequiredbytheOfficeoftheComptrolleroftheCurrency.193

CommunitybankslikeIntegra,withahighconcentrationofcommercialrealestateloansin

tertiarymarkets,areintheweakestpositionforashort-termrecovery.Withoutsignificant,

widespread job growth, capitalization rates will be unlikely to fall in the markets they

serve.194 Therefore, despite the success of their “core community banking business,”

depressedcommercial real estatevalueswill cause thedemise ofmanymore banks like

Integra.

Ifinterestratesrise,thestressonbankswilllikelysignificantlyincrease.195More

thanhalfofbankloansarefloatinginterestratedebt.Risinginterestrateswillincreasethe

paymentburdensonborrowers,sendingmoreproperties into foreclosureandincreasing

lossesbybanks.196Oneanalystdescribedthecurrentenvironmentas“low-interest-ratelife

support”forregionalandlocalbanks:197

Either theirbalance sheets improve or regulators take them over. “It’safailed business model,” says a big banker. “Where do they get themoney?”198

Regulators appear willing to allow these bank closings for atleast two reasons.

First, theyhave adopted a narrative borrowed from thesubprimeresidential real estate

crisis,thatpoorunderwritingcontributedtothecrisis.Second,“whileproblemsintheCRE

193IntegraBank’sauditorsayssituationmaybedire,IndianapolisBusinessJournal(February1,

2011).194EmergingTrends2011,supranote___at7-8(“Morethananyotherissue,thesputteringU.S.jobsenginecompromisessustainedrecoveryandgrowthinrealestatemarkets.Peopleneedtheconfidenceprovidedbyasteadypaychecktoresumespendinginshoppingcenters,lookfornewhousing,andtakevacationsatresortsandhotels,whilemorehiringwouldhelpfillemptyofficespace.”)

195EmergingTrends2011,supranote___at9.(“Record-lowinterestrates(‘essentiallyzero’)havebeenalife-linetobothrealestatelendersandborrowers.”);KevinJ.Thorpe,ImplicationsofRisingInterestRatesonCRERecovery,CassidyTurley(December2010).

196CBREReport,supranote___at16(“[Thedefaultrateforconstructionloans]couldhavebeenhigherhaditnotbeenforthehistoricallylowLIBOR-basedrates(LondonInterbankOfferedRate)onfloatingratedealsthathaveoccurred[in2009].Withdebtservicerequirementslowerduetolow

LIBOR-basedrates,higherdebtservicereserveshaveeffectivelylengthenedthetermofnumerousconstructiondeals,andthiseffecthasgrantedmanypermanentdealsanenhancedabilitytocoverdebtservice.Somesmallerbanks,whichgenerallyhavemuchhigher-than-averageexposuretocommercialrealestateanddevelopmentdeals,couldfaceconservatorshipthroughtheFDIC,possiblyresultinginafurtherdeclineinliquidityforcertaincommercialrealestatemarketsegments.”)

197EmergingTrends2011,supranote__at16.

198Id.

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marketwillbeanongoingconcernforanumberofbankingorganizationsandanegative

factor ineconomicgrowth andlending, [regulators]do notseeCRE losses asa threat to

systemicallyimportantfinancialinstitutions.”199

From the regulators’ perspective, bank failures are a necessary, if painful,

componentofthecommercialrealestatemarkethittingbottomandbeginningtorecover.

Butthisviewisdependentupontheassumptionthatthereisasinglecommercialrealestate

market, and that if a bank fails, other capital sources will be available to that bank’s

previouscustomers.However,thedatasuggestsotherwise.Overall,commercialrealestate

lendingby bankswas down 25% in the fourth quarter 2010, compared to the already-

depressed2009levels.CommunitybankslendtoborrowersintheLocalsegment,whichis

populatedbyolderandsmallerpropertiesintertiarymarkets.IfIntegraBankinEvansville,

Indianaclosesitsdoorsduetoitsnonperformingcommercialrealestateloanportfolio,the

FDIC will bundle the loans and sell them for 25-40 cents on the dollar to High Capital

investors, who have the capital and patience to wait for the potential upside.200 That

resolutiondoesnothingtostabilizethevalueoftheunderlyingcommercialrealestate,and

doesnothingforthecommunityservedbyIntegraBank.Iftheregulators’narrativeofthe

commercial real estate debt crisis is correct, and the banks brought this problem upon

themselvesbyaggressiveunderwritingtoborrowerswithinsufficientcredit,thenallowing

IntegraBank toclosemay bea reasonableoutcome for bad behavior. But thereis little

evidence that community banks caused the commercial real estate debt crisis. If

underwritingstandardswererelaxedduringthemid-2000s,itwasbecauseofcompetitive

pressuresduetorisingvaluationsandinvestorseagertoputtheirmoneyincommercial

realestate.Thereissimplynosubprimeaspecttocommercialrealestate.201Therewasno

199TestimonyofPatrickParkinson,Director,DivisionofBankingSupervisionandRegulation,BoardofGovernorsoftheFederalReserveatCongressionalOversightPanelhearingonFebruary4,2011atp9.

200MarkHeschmeyer,RealMoney:ColonyCapitalAcquires$817MilinLoansfromFDIC,CoStarAdvisorNewsletter(February2,2011)(reportingthataconsortiumofinvestorsorganizedby

ColonyCapital,LLCacquiredtwoportfoliosof1,505loanswithanaggregatebalanceof$817million.Thepurchasepricewas$192.8million,or23.6centsonthedollar.TheFDICretaineda50%equityinterestintheportfolios.);MarkHeschmeyer,RealMoney:StarwoodPays40CentsontheDollarfor137CommercialLoans,CoStarAdvisorNewsletter(January12,2011)(reportingthatStarwoodCapitalGroupacquireda“non-performingcommercialloanportfoliowithanoutstandingprincipalbalanceof$157fromamajorMidwestregionalbank”for“40centsonthedollar.”ThisacquisitionincreasedtheholdingsoftheStarwoodGlobalOpportunityFundVIIItonon-performingcommercialrealestateloanswithanoutstandingbalanceof$537million,allacquiredin2010.)

201Parkustestimony,February4,2011.

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systemic fraud. Therewas,certainly, anultimately irrationalbelief that propertyvalues

wouldcontinue toincrease,butthatwas adelusionsharedbynearlyeveryparticipantin

theAmericaneconomy.Toallowcommunitybanksto failduetocircumstancesthatwere

ultimately beyond their control, particularly after stepping in to stabilize “systemically

important”financialinstitutionslikeCitigroupandBankofAmerica,seemsfundamentally

unfair.202

Butbeyondfairness,therearecompellingeconomicreasonswhyitisbadpolicyto

allow community banks to fail due to the commercial real estate debt crisis. The most

significant is that the key to economic recovery in secondary and tertiary markets is

investment.203Leverageisanecessaryrequirementforeconomicinvestment,andsmall

businesses, including LimitedCapitalowners of commercial real estate,will find itmore

difficult toobtain loansbecauseof the lackof intervention bypolicymakers. Thereis a

fundamentalandtroublinginconsistencyinthemessagefrompolicymakerstolenders.On

theonehand,policymakersandregulatorsactivelyencouragebankstobegintolendagain,

particularly by extending credit to small businesses and commercial real estate

borrowers.204 On the other hand, some in the banking community charge that field

examinersare“overzealousandundulyoverreachingand… demandingoverlyaggressive

write-downs and reclassifications of viable commercial real estate loans and other

assets.”205 Cleary,regulatorsandpolicymakershavedemonstrated thattheyareperfectly

202See,e.g.AlternativesforPromotingLiquidityintheCommercialRealEstateMarkets,supranote___at27(TestimonyofRep.SpencerBachus)(“Manyofourprogramstodatehavebeen,Ithink,designedtohelpthelargerinstitutions.Andthatisasignificantfailurethatwehavehadoverthepast2or3years;wehaveneglectedthesmallerinstitutions.…Ithasalsocreatedaperception,whichIthinkistrue,inthegeneralpublicthatourlargerinstitutions,bothbytheregulatorsandbytheresponse,havebeenprotectedandinsulated,when,really,alotoftherisk-takingandwhathappenedwasadirectresultofsomeoftheiractivities,andthatoursmallerbanksandourbusinessesandcommercialrealestateismoreofavictimofwhattheydid.Anditisreallynotafairapproachthathasbeentaken.”)

203TestimonyofSandraThompsonatp.3(Feb.42011)(“Banklendingisanessentialaspectofeconomicgrowthandwillbevitaltofacilitatingarecovery.”)

204InteragencyStatementonMeetingtheNeedsofCreditworthyBorrowers(November12,2008)

(“Theagenciesexpectallbankingorganizationstofulfilltheirfundamentalroleintheeconomyasintermediariesofcredittobusinesses,consumers,andothercreditworthyborrowers.”);SandraThompson,atp.12(“TheFDICunderstandsthatbusinessesrelyonbankstoprovidecreditfortheiroperations,andthatextensionsofcreditfrombankinginstitutionswillbeessentialinsupportingeconomicgrowth.Accordingly,wehavenotinstructedbankstocurtailprudentlymanagedlendingactivities,restrictlinesofcredittostrongborrowers,ordenyarefinancerequestsolelybecauseofweakenedcollateralvalue.”)

205TestimonyofR.MichaelS.Menzies,Sr.onbehalfofIndependentCommunityBankersofAmerica,HouseofRepresentatives,CommitteeonFinancialServices,HearingonExploringtheBalance

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willingtoallowbanksto failbecausetheywereoverexposedto commercialrealestate.206

Asa result of thesemixedmessages, one representativeof the Independent Community

BankersofAmericatestifiedthat:

[Currentregulatory]practicesnotonlyundermine thefundamentalgoalof

[encouraging the extension of credit], they are costing community banksmoney, leading to a contraction of credit, and forcing many of them torethink their credit policies. Under thisclimate, communitybankersmayavoidmaking good loans for fear of examinercriticism, write-downs, andtheresultinglossofincomeandcapital.207

C. MarginalizationofLimitedCapitalOwnersandTertiaryMarkets

Mostcommercialrealestateisownedbyprivately-heldMediumandLimitedCapital

owners.Someprivateborrowersaresurelylargeanddiverseenoughtofindtheresources

necessarytofilltheequitygaporpostadditionalcollateralfortheloan.Butmanyprivate

borrowerssurelycannot.AnalystshavebluntlysummarizedthepositionofLimitedCapital

borrowersintertiarymarkets:“Thecashrichandwellcapitalizedshouldfeastoffthecash

poorandunderleveraged.…Smallerplayersmorethanlikelygetleftoutinthecold.” 208

If the borrower lacks the funds to fill the equity gapand finance, it could seek

additionalequityfromamezzaninelenderorapartnerwillingtocontributethenecessary

betweenIncreasedCreditAvailabilityandPrudentLendingStandards(March25,2009)atp.3.

(“[Some]bankersarecomplainingthatotherwisesolidloansarebeingdowngradedsimplybecausetheyarelocatedinastatewithahighmortgageforeclosurerate.Thisformofstereotypingistantamounttostatewideredliningthatisunjustifiedintoday’sworldandcouldultimatelyleadtocapitalproblemsatotherwisehealthybanks.Otherreportsfromcommunitybankerscitedexaminersrequiringwrite-downsorclassificationofperformingloansduetothevalueofcollateralirrespectiveoftheincomeorcashflowoftheborrowers;placingloansonnon-accrualeventhoughtheborroweriscurrentonpayments;discountingentirelythevalueofguarantors;criticizinglong-standingpracticesandprocessesthathavenotbeencriticizedbefore;andsubstitutingtheirjudgmentforthatoftheappraiser.”)

206SandraThompson,atp.12(“[W]eexpectthatbankswillcontinuetoaccuratelyrecognizelossesinatimelymannerinaccordancewithaccountingandfinancialreportingstandards.”

207Menzies,supranote___at4-5;GregM.Ohlendorf,onbehalfoftheIndependentCommunity

BankersofAmerica,HouseofRepresentativesCommitteeonFinancialServices,FieldHearingonCommercialRealEstate:AChicagoPerspectiveonCurrentMarketChallengesandPossibleResponses(May17,2010)(“WhileWashingtonpolicymakersexhortcommunitybankstolendtobusinessesandconsumers,bankingregulators…placerestrictionsonbankswellbeyondwhatisrequiredtoprotectbanksafetyandsoundness.Thebankingagencieshavemovedtheregulatorypendulumtoofarinthedirectionofoverregulationattheexpenseoflending.Weneedtoreturntoamorebalancedapproachthatpromoteslendingandeconomicrecoveryinadditiontobanksafetyandsoundness.”)

208EmergingTrends2011,supranote___at15.

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equityinexchangeforapreferredreturnandownershipinterestintheasset.209Duringthe

2000s,manysmall real estatedevelopers relieduponthiskind of financing to fuel their

growth.Butsincetheinterestsacquiredbutsuchintermediateinvestorsaresubordinateto

the first lienholder, they are risky and therefore expensive. Mezzanine financing could

easily cost 10%-15% in interest per annum. It is unlikely that a distressed asset has

sufficientcashflowtosupportthisadditionalexpense.

Evenifalenderagreestoaworkoutthatinvolvespartialforgivenessofdebt,asmall

borrowermay beunable to accept that arrangement given the tax consequences. As a

generalrule,anyreductioninoutstandingindebtednessduetoaworkoutwillrequirethe

borrowertorecognizetaxablecancellationofindebtednessincome.210Thereare,however,

exceptionstothisgeneralrule.Perhapsthemostapplicableexceptionistherulethatno

cancellation of indebtedness income arises if thetaxpayer is “insolvent”both beforeand

after cancellation of the debt.211 “Insolvency” is defined as the “excess of liabilities

immediatelybeforethedischargeoverthefairmarketvalueofassetsimmediatelybefore

thedischarge.212

Inreactiontothedilemmafacingsmallownersofcommercialrealestatewhoneed

aworkoutbutcannotaffordtopayincometaxesonforgivendebt,theAmericanRecovery

andReinvestmentActof2009includedaprovisionthatallowedcertaintaxpayerstodefer

the taxation of cancellation of indebtedness income related to certain modifications of

outstandingdebtin2009and2010.TheActaddedSection108(i)totheInternalRevenue

Code,which set forth fairly complex rules thatwould permit restructuringborrowers to

irrevocablyelecttodefer taxationoverfiveyears,formodificationsoccurringin2009,or

fouryears,formodificationsoccurringin2010.213Theforgivendebtwasstilltaxableas

income,butborrowersweresimplygivenmoretimetomeettheirobligationstopay.Itis

209See,generallyAndrewR.Berman,“OnceaMortgage,AlwaysaMortgage”–TheUse(andMisuseof)MezzanineLoansandPreferredEquityInvestments,11Stan.J.L.Bus.&Fin.76(2005).

210

Minefields,supranote___at30;RobertF.Reilly,IncomeTaxImplicationsofIndustrialandCommercialPropertyMortgageDebtRestructuring,29-MARAm.Bankr.Inst.J.56(March2010).

211InternalRevenueCodeSection108(a)(1)(B)

212InternalRevenueCodeSection108(d)(3).Aborrowercouldhavethefundstocontributetoaworkouteventhoughitisinsolventbecauseofthewidespreadpracticeofsegregatingindividualcommercialrealestateassetsin“specialpurposeentities,”usuallylimitedliabilitycompaniesorlimitedpartnerships.

213InternalRevenueCode,Section108(i)

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unclearhowmanytaxpayerstookadvantageofthisprovision,whichexpiredDecember31,

2010.

Smallprivateborrowersfaceseveralchallengesinthecommercialrealestatedebt

crisis.Theyhaveseenthemarketvaluationsoftheirassetsfall,perhapsbyasmuchas40-

50% since 2007. They have experienced reductions in market rent, increased tenant

defaultsandslowpays.Theircashflowsaresuffering.Iftheirlenderiswillingtonegotiate

aworkout,theywillberequiredtocontributeadditionalequityand/orprovideorenhance

apersonalguarantee.Iftheyareluckyenoughtoreceivepartialdebtforgiveness,theyare

requiredtopaytaxon theresultingcancellationof indebtednessincome. Formanysmall

borrowers,alternativecapitalsourcesareunavailableduetothesizeandlocationoftheir

properties. Ifcommunitybanks,aprimarysourceof supportforsmallprivateborrowers,

curtaincommercialrealestatelending,theiroptionsareseverelylimited.

Itisnotonlysmallbusinessesinthecommercialrealestateindustrythatwillsuffer.

Fromtheperspectiveoftenants,thecommercialrealestatesectorisafinancingmechanism

ofequalimportancetoalineofcredit.214Businessesthatchoosetoleasethepremisesthat

theyoperatefromhavetheflexibilitytoemploycapitalintheacquisitionofequipment,or

payroll.Ifthecommercialrealestatesectordidnotexist,manyothersmallbusinessesthat

couldnotaffordtopurchasetheirownbuildingwouldalsonotexist.Thestabilityofthe

commercialrealestatesectorthereforehasanimpactontenants.Forexample,aborrower

strugglingtomakeloanpaymentsmayskimponmaintenanceobligationsorotherfunctions

necessary for a tenant to run their own business. Representative Shuler explained the

broaderimplicationsofthecommercialrealestatecrisisinvulnerablecommunities:

Thisproblem startswith commercial real estatebutdoesn’t end there.…What starts with commercial real estate stretches from local communitybankstooursmallbusinesses,decreasingtheamountofjobopportunitiesand stunting job growth. If community banks can’t lend, and they can’trefinancetheloansontheirbooks,theywillbeseizedbytheFDIC.Oncethathappens,smallbusinesslendingandjobgrowtharedoomed.215

Finally,municipalitiesandstateswillsufferifborrowersandlendersareforcedto

tradeondepressedvaluations.Propertytaxrevenuesaretiedtotheappraisedvalueofreal

estate,usuallybasedonthemostrecenttransactionprice.Astheappraisedvalueofthetax

214SeeSandraThompson,Feb.42011testimonytoCOP,at14(“Smallbusinessesrelyheavilyoncommercialrealestatetocollateralizeborrowingsforworkingcapitalandotherneeds.”)

215AlternativesforPromotingLiquidityintheCommercialRealEstateMarkets,supranote___at9(TestimonyofRep.Shuler)

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base decreases, the revenues generated by that tax base will similarly decrease. There

appearstobenoempiricalresearchmeasuringtheimpactofthisphenomenon.Thereis

anecdotalevidence,however.Forexample,ElPasoCounty,Colorado,thehomeofColorado

Springs,sufferedanearlyhalf-billiondollar,or6.8%decline, intheaggregatecommercial

realestatevaluationfrom2009to2010.216Itwasthefirstdecreaseinthecommercialreal

estatetaxbaseinElPasoCountysincetheearly1990s.

CONCLUSION

In the current economic crisis, much attention has been paid to the financial

institutionsdeemed“toobigtofail.”Attheotherendofthespectrumarethesmallbanks

thatpolicymakersviewas“notsystemicallyimportant”andwhosefailure,therefore,istoo

minor to attract notice. In the aggregate, however, those small banks are incredibly

importanttothestabilityofthecommercialrealestatemarket,particularlyinsecondary

andtertiarymarkets, andparticularlyin classesof commercial real estateleasedto small

businesses. As one lawmaker put it, “freemarkets,when allowed to function properly,

aren’t kind, but they are very efficient.”217 While that may be true, it is also true that

allowingthefreemarketstosolvethisparticularproblemwillinevitablyresultinincreased

stressonsmallbusinesses,smallbanks,andsmallcommercialrealestateowners,andthat

thefalloutfromthatincreasedstressmayhampereconomicrecoveryefforts.Policymakers

shouldthereforeabandontheircurrentapproachoftreatingthefailureofsmallbanksand

small commercial real estate owners as regrettablebut systemically irrelevant. Instead,

they should recognize that although the commercial real estate debt crisis hasattracted

littleattention,addressingitiscriticaltothebroadereconomicrecovery.

Athoroughdiscussionofpoliciesthatcouldbeadoptedtoaddressthecommercial

real estate debt crisis will be the focusof future work. Briefly, the federal government

shouldconsiderfourpositiveinterventions.

First,Congresscouldpasslegislation to temporarily stabilize thecommercial real

estate market by guaranteeing or purchasing certain loans.218 In 2010, Representative

216RichLaden,Commercialrealestatevaluesplungeforfirsttimein20years,newreappraisalsays,TheGazette(ColoradoSprings)(February19,2011)http://www.gazette.com/articles/first-113121-commercial-time.html

217Id.at8(TestimonyofRep.Neugebauer)

218Forexample,theSmallBusinessAdministrationannouncedaprograminFebruary2011toallowsmallbusinessestorefinancematuringcommercialrealestateloansbeforeDecember31,2012.

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Walter Minnick ofIdaho introduced such legislationin the form ofthe CommercialReal

Estate Stabilization Act. The House Committee on Financial Services held hearings to

discuss the proposal, but the bill failed to make it out of committee before Congress

adjourned. Representative Minnick’s bill would have focused on smaller banks and

permitted themtosell certainperformingcommercialrealestateloanstolargerfinancial

institutions,whichwouldpackagetheloansintoinstitutional-sizedportfoliosandsecuritize

them.219 This proposal would solveone of the fundamental disparitiesbetween lending

sources for tertiary and primarymarkets and allow small banks to clear their booksof

many commercial real estate loans.220 Although RepresentativeMinnick’s proposalwas

designedtosunsetwithinthreeyears,thiskindofprogramwouldhavemoreofanimpactif

itwerelonger-term.

Second,bankregulatoryagenciesneedtoensurethattheyareconveyingaclearand

consistentmessageto banks regardingcommunitylending. Communitybankshavebeen

encouragedbyregulatorsforyearstoinvestinthecommunitiestheyserve,particularlyby

makingloanstosmallbusinessesandincommercialrealestate.Topunishthemnowfor

pursuing the goals set by regulators will discourage further lending in the future. If

policymakersonbothsidesoftheaislebelieve thatsmallbusinesseswillprovidemostof

the new jobs in the economic recovery, they should be focused on supporting the

institutionsthatsupportsmallbusinesses,includingsmallcommercialrealestateowners,

particularlyintertiarymarkets,andsmallbanks.

Theguidanceonworkoutsissuedbytheregulatorsin2009isconsistentwiththe

directive forbankstoextendloansto creditworthysmallbusinessesandcommercialreal

estateborrowers. Butempiricalworkshouldbedoneto evaluatetheeffectivenessof the

guidance. Inotherwords,dobanksbelievetheguidanceandisitmakingadifferencefor

lenders and borrowers? Anecdotal evidence suggests that small banks still believe that

regulatorsaresendingmixedmessages,andthatindividualbankexaminerscriticizebanks

CongressauthorizedtheSBAtoapproveupto$15billioninloans.SeeMarkHeschmeyer,Real

Money:SBAComingtotheRescueofSmallMaturingCRELoans,CoStarAdvisorNewsletter(February21,2011).

219AlternativesforPromotingLiquidityintheCommercialRealEstateMarkets,supranote___at2(TestimonyofRep.WalterMinnick)

220OneofthereasonsthatsmallloansarenotpackagedintoCMBSisbecausethehightransactioncostsofeachindividualloanclosingareprohibitive.Itismuchcheapertocreatea$500millionCMBSpoolfrom25$20millionloansthanfrom100$500,000loans.Federallegislationcouldhelpsubsidizesomeofthecosttoencouragecreationofthesenewsecurities.

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60

for lending decisions that the guidance endorses. A meaningful regulatory approach is

dependantupongoodinformationaboutthesuccessorfailureofcurrentpolicies.

Third, several accounting rules play a role in valuation methodologies and bank

regulatoryissues.221 Afull discussionof the accounting rulesisbeyondthescopeofthis

Article, but policymakers need to be aware of the impact of these rules and exercise

discretioninadoptingorextendingthem.Theaccountingrulechangethathasgarneredthe

mostattentionistheadoptioninNovember2007of“mark-to-market”accountingbythe

Financial Accounting Standards Board (FASB) for the first time since 1938.222 Some

economists view theapplicationofmark-to-market accounting to commercial real estate

loanstobeaprimarycauseofthedevastatinglossesinvaluesufferedsincelate2007. In

thewordsofBrianWesburyandRobertStein:“Simply,mark-to-marketaccountingneedsto

die.Itshouldbestabbedintheheartwithacedarstake,shotwithasilverbullet,andthen

buriedundersixfeetofgarlicpowder.Liketheevilkillerinahorrorflick,weneedtomake

sureitnevergetsupofftheflooragain.” 223

Finally, accuratedata is key tounderstanding thepolicy challengesposed by the

commercialrealestatedebtcrisissothatappropriateresponsescanbecrafted.Weneeda

farbetterpictureofseveralkeymetrics:theequitygapofcommercialrealestateloansheld

by banks; statistics on technical and maturity defaults; and, as discussed above, data

regarding the banks’ responses to regulator guidance encouraging workout. At the

Congressional Oversight Panel hearing on February 4, 2011, Patrick Parkinson of the

Federal Reserve announced that his institution was working with the Office of the

ComptrolleroftheCurrencyandtheFederalDepositInsuranceCorporationtocollect“loan-

level”datafromnationalandregionalbanksinordertobetterunderstandthecreditquality

221Seegenerally PriceWaterhouseCoopers,FairvaluereportingforinvestmentpropertiesunderUSGAAP(August2010)(discussingtheproposedAccountingStandardsUpdatethatwouldrequireinvestmentpropertytobemeasuredat“fairvalue”);FinancialAccountingStandardsBoard,

ProposedAccountingStandardsUpdate:Leases(Topic840)(August17,2010)(proposingthatlandlordsandtenantsshouldapplya“right-to-usemodel”inaccountingforallrealestateleases,whichessentiallywouldrequiretenantstorecognizethecontractedrentasaliabilityonthebalancesheetandwouldrequirelandlordstorecognizeleasesasareceivablefortherighttoreceivefuturerentpaymentsatthediscountedvalueoftheexpectedfuturerentstream.)

222BrianS.WesburyandRobertStein,BernankeFinallyFingersMarktoMarket,NationalReviewOnline(March8,2010)(onlineathttp://www.nationalreview.com/articles/print/229276)

223Id.

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andperformanceofthoseportfolios.224Thisannouncementisagoodsteptowardcapturing

thedatathatwillallowregulatorsandscholarstoassessthecharacteristicsofcommercial

realestateloansheldbybankstounderstandtheimportanceofhistorictrendsandcraft

appropriatepoliciesgoingforward.

Thefirststep tosolving anyproblemis recognizingthat theproblemexists. The

purposeofthisArticlehasbeentodescribethecommercialrealestatedebtcrisisandthe

dangersposedbythegovernment’spolicyofinaction.ThenextArticlewillexpandupon

the four proposals briefly mentioned above and provide more concrete policy

recommendationstoresolvethecurrentcrisisand,perhapsmoreimportantly,preventit

fromoccurringagain.

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