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Why the U.S. Commercial Real Estate Market Will Collapse, and What Could Save It

From NYC real estate attorney Stuart Saft in this week’s Forbes:

Between now and 2013, at least $1.3 trillion of financing on commercial real estate comes due; $160 billion was the result of securitizations.

Less than $80 billion can be refinanced because of all of the following factors:

1) banks are too weak to refinance
2) the secondary market has disappeared
3) pension funds and insurance companies have too much debt already

Saft’s prescription for fixing the problem:

1) Provide a credit facility via the Federal Reserve to commercial real estate owners as a lender of last resort. The government would retain an equity interest (but not control) over the real estate in order to avoid the real estate from being dumped on the market.
2) Reduce real estate tax assessments, and thus lower taxes for owners
3) Rescind building requirements that require large capital outlays unrelated to safety
4) Suspend the IRS’ passive activity rules
5) Reduce the depreciation period for real estate acquired between 2010 and 2013
6) Reduce the negative tax implications for foreign investors in purchasing and holding US real estate (this is a 10% penalty tax imposed on non-citizens under FIRPTA)

Suggestions 2 through 6 are eminently reasonable. Suggestion 1 sounds analogous to Marty Feldstein’s proposal for Uncle Sam to directly refinance primary residences across the board at 1-2% interest. The difference here is only in degree, not kind.

Saft’s prescriptions specifically avoid marking assets to market, as that, according to Saft, would do far more harm.

I think that any harm done by marking to market, or MTM, would be offset by the benefits that follow: The market would then have a sense of what properties are worth. Other banks could then lend based on comparable values. Right now, banks aren’t lending because they are hoarding money to cover these loans that are not marked to market. Moreover, banks aren’t lending based on LTV because too few sales fail to provide an accurate picture of what constitutes value.

Right now, banks are the problem.

While everyone agrees that banks are in a far more precarious position now than they were in, say, 2001, the banks’ accounting practices suggest otherwise.

A recent in-depth analysis by economists Harry Huizinga and Luc Laeven revealed that while only 8% of banks at the end of 2001 had a market-to-book value of assets ratio of less than one, by the end of 2008, more than 60% of US bank holding companies made that claim.

Over the same period, the average ratio of Tier 1 capital to bank assets stayed constant at about 11%. The market value of bank equity thus dropped precipitously against a backdrop of virtually constant book capital. In other words, if the bank has the same amount of assets to protect itself from a default, and the assets have clearly dropped in value, then their cushion is woefully insufficient.

1. Banks’ balance sheets overvalue real-estate-related assets compared to the market value of these assets.

2. Banks with large exposure to MBS (mortgage backed securities) experience large excess returns when fair-value accounting rules are relaxed. On April 9, 2009, The Financial Accounting Standards Board (FASB) granted banks wide latitude in determining the value of their assets. With this great power, came great irresponsibility.

3. Banks use accounting discretion regarding loan losses and the classification of assets to preserve book capital. Banks have considerable discretion in the timing of their loan loss provisioning for bad loans and in the realisation of loan losses in the form of charge-offs. This gives otherwise zombie banks (dead by any clinical definition) a new lease on life.

Until Uncle Sam forces the banks to come clean upon threat of charter revocation, commercial real estate prices, including the multifamily asset class, will continue to stall.

Saft’s suggestions are insightful, but they do not go far enough.

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