Phase One: Initiation - How the Commercial Real Estate Crisis Started (2005-2007)
This is Part 2 of our retelling of The Commercial Real Estate Tsunami: A Survival Guide for Lenders, Owners, Buyers, and Brokers by Tony Wood (ISBN: 978-0-470-63637-4, John Wiley & Sons, 2010). We’re covering Chapter 1: Phase One: Initiation (2005-2007).
The Wave Nobody Saw
Tony Wood borrowed his framework from actual tsunami science. A real tsunami has stages. The first one is called Initiation. It’s what happens deep underwater when something shifts. You can’t see it. You can’t hear it. But it sets everything in motion.
For commercial real estate, the Initiation phase was 2005 through 2007. The economy was booming. Rents were going up. Property values were climbing. And lenders were happy to keep writing checks.
Here’s the thing. The same exuberance that blew up the residential housing market was happening in commercial real estate. Ownership fever. Optimistic underwriting. And Wall Street creating new ways to securitize and profit from commercial loans through CMBS (commercial mortgage-backed securities).
The CMBS Machine
CMBS worked a lot like the mortgage-backed securities (MBS) that wrecked the residential market. Banks would make commercial loans, bundle them together, and sell them as securities to investors. This created a loop: more investor demand meant more available financing, which meant more loans, which meant more securities to sell.
During the mid-2000s, CMBS fueled a massive expansion of commercial real estate lending across the country. And for a while, it seemed fine. Most experts at the time believed lending practices stayed relatively conservative through the boom.
But nobody predicted the free fall that was coming. By 2009, new CMBS origination had basically stopped. And it wasn’t coming back anytime soon.
Where CMBS left off, regular banks picked up the slack. Big ones, small ones, community banks. They kept making commercial real estate loans. And many of those loans would later cost them everything.
The Numbers That Should Scare You
Wood lays out the data pretty clearly, and it’s ugly.
Over $1 trillion in commercial real estate loans were set to mature between 2010 and 2013. These loans were originally written at 70 to 80 percent loan-to-value ratios, based on valuations from the boom years. But values had dropped. In some cases by more than 50 percent.
So you’ve got a building that was worth $10 million in 2007. The owner borrowed $7 million against it. By 2009, that building might be worth $5 million. The loan is now bigger than the property’s value. And it’s about to come due.
Here’s what the Wall Street Journal reported in March 2009: the delinquency rate on about $700 billion in securitized commercial loans had more than doubled since September 2008.
Foresight Analytics estimated that $814 billion in commercial and multifamily mortgages would mature between 2009 and 2011. About two-thirds of the $700 billion in CMBS maturities wouldn’t qualify for refinancing.
And then there were the $500 billion in commercial loans held by smaller community banks. A huge percentage couldn’t be refinanced under current conditions. The U.S. banking sector was looking at potential losses ten times what happened during the S&L crisis. Possibly 700 or more bank failures.
These weren’t small numbers tossed around casually. Wood quotes directly from the Foresight Analytics report: “The commercial real estate market faces demand for mortgage financing, at a time when credit is very tight.”
Everyone Was Warning. Nobody Was Listening.
What struck me about this chapter is how many people were sounding the alarm. The Wall Street Journal. Bloomberg. Fox Business. McClatchy. Intelligent Investing. Industry leaders and economists. All saying the same thing: this is coming, it’s going to be bad, and we need to act.
General Growth Properties, which owned more than 200 malls across the U.S., filed for bankruptcy in April 2009. They simply couldn’t renegotiate their debts as they came due.
Even the President got briefed. In October 2009, Fox Business reported that Obama’s economic team presented the “looming issue” of commercial real estate to him. Many believed it could trigger the next banking crisis.
But here’s what’s frustrating. Everyone was talking about the problem. Almost nobody was proposing solutions.
The ATM Effect
Wood explains a pattern that connects the residential and commercial markets in a way that’s easy to understand.
During the boom, homeowners used their homes like ATMs. Home equity lines, cash-out refinances, spending beyond their means. This consumer spending drove demand for retail space. More retail space meant more commercial real estate development. More development meant more commercial loans.
It was a spiral. Consumer overleveraging led to inflated sales projections, which led to inflated expectations for commercial real estate demand. Retail, office, industrial, all of it was being built based on a level of economic activity that was artificially pumped up.
When the residential market collapsed and consumers stopped spending, the demand for commercial space evaporated. But the loans were already made. The buildings were already built. And the debt was still there.
Mac McClure: The FASB 157 Problem
One of the best parts of this chapter is Wood’s interview with Charles A. “Mac” McClure, the 2009 president of CCIM Institute. Mac had been in commercial real estate since 1975 and had closed over $1 billion in transactions.
Mac pointed to something most people weren’t talking about: FASB 157.
In 2007, the Financial Accounting Standards Board passed rule 157, which changed how mortgage investments and securities were valued. Under FASB 157, accountants had to use “fair value accounting,” and they defaulted to the sales comparison approach. Basically, they looked at what similar assets were trading for in the market.
The problem? There was no active trading market in 2008. So accountants looked at the few deeply discounted distress sales happening and used those as comparables. This meant perfectly good loan portfolios, ones that were still generating cash flow, got written down by 40, 50, or 60 percent on paper.
Mac gave a specific example. A medium-sized police and fire pension fund had $50 million in triple-A rated CMBS. Still generating $3.5 million in annual cash flow. The auditor wrote it down to $22 million because there were no active market comparables. Now the fund had to reserve for $30 million in “losses” that weren’t really losses. The buildings were still there. The tenants were still paying rent. But on paper, the fund was suddenly undercapitalized.
This cascaded through the entire system. Banks, pension funds, insurance companies. Everyone’s balance sheets got wrecked by an accounting rule that forced them to value assets based on a panicked market with no buyers.
My Take On This
Here’s what I think about after reading this chapter.
The commercial real estate crisis of 2008-2013 wasn’t caused by one thing. It was a pile-up. CMBS created a lending machine that ran too hot. The residential boom inflated commercial demand beyond what was real. FASB 157 turned paper losses into actual capital problems. And the economic collapse took away the floor.
But the pattern that sticks with me most is the gap between awareness and action. By the time Wood wrote this book, everyone knew the problem existed. Industry leaders, government officials, media outlets. The data was clear. But the response was slow.
Mac McClure told Wood he was lobbying Congress and couldn’t get anyone to listen. Congress spent the summer and fall of 2009 focused on healthcare while, in Mac’s words, “the rest of the world falls down on top of its head.”
And there’s the smaller story buried in the data: the big pension funds and REITs would probably figure it out. They had resources and lawyers and capital reserves. But the small investors with $1 million, $3 million, $5 million properties? The owner-users who put 40 to 50 percent down and did everything right? They were the ones who’d get crushed. Many of them couldn’t refinance even if their properties were fully occupied, because the loan-to-value math just didn’t work anymore.
That’s the real cost of a financial crisis. It’s not the big institutions. It’s the regular people who followed the rules and still got caught.
Next: Phase Two: Amplification - When the Commercial Real Estate Market Froze