The Storm Warning
Will commercial real estate be the next crisis?
“There’s an old adage,” says Steve Sofos. “Pigs get fat; hogs get slaughtered.”
Sofos, president of Sofos Realty, Hawaii’s largest independent commercial real estate brokerage, is discussing the possibility of a collapse in the rents and prices for Hawaii’s stores, offices, hotels and warehouses. In his metaphor, the hogs are landlords who haven’t grasped that times have changed and demand has plunged; investors who leapt into the commercial real estate market, thinking prices and rents would always go up; and lenders who failed to underwrite loans prudently. For now, Sofos explains, the hogs are snuffling around in an empty trough. But the recession is sharpening its knives.
Prices and rents are tumbling on the Mainland — in some markets they’re already down 40 percent or more — and many involved in Hawaii’s commercial real estate market believe the same will happen here. Others say the local market is resistant to collapse. Prominent brokers such as Joe Leonardo and Jamie Brown point out that some sectors of commercial real estate — notably offices — are relatively healthy, and that problems will mostly affect the Mainland investors. The outcome probably depends on how local players respond to the same forces that buffet markets elsewhere.
On the Mainland, the problems are well documented. Commercial real estate in the United States is worth at least $6 trillion. More than $3 trillion of that is mortgaged — at least $700 billion of it through commercial mortgage-backed securities. Unlike residential loans, most of this debt is short term — three- to ten-year notes. Over the next three years, hundreds of billions of dollars of these loans will come due, but the combination of rising vacancies, declining incomes and falling property values make it increasingly difficult to qualify for new loans.
Many properties depended on rising values or increasing rents and they are now upside-down. And, because of the credit crisis, fewer lenders and more stringent underwriting portend an explosion of defaults. In March, Deutsche Bank reported that of the nearly $154 billion in CMBS debt due in the next three years, about two-thirds will not qualify for refinancing. Many of those properties will eventually default. If that’s a collapse, Hawaii’s not immune.
“We believe that the Hawaii market really hasn’t been affected yet,” Sofos says. “But somewhere between the middle of this year and the end of next year, you’ll see the commercial real estate market take a hit.” And when it does, he’s sure it will be exacerbated by the hubris of Hawaii landlords.
“I’ll give you an example,” he says. “We saw a flyer recently for warehouse space in the Kalihi area. It said $1.25 a square foot. And I said, ‘Wow!’ Because the market’s really at $0.85 to $1 a foot right now, depending on the location and the condition of the building.” Since the market’s peak a couple of years ago, there has been consistent downward pressure on real estate prices: The end of the construction boom undercut the need for warehouses; plummeting visitor counts and rising unemployment pummeled retail; and stagnation in the professions affected offices. But landlords haven’t adjusted their expectations, Sofos says.
Others also see a gap between the expectations of landlords and tenants, or buyers and sellers. Although brokers are reluctant to speak publicly, privately they share many of Sofos’ concerns. They’ve seen the near collapse in credit options — particularly for larger deals that rely on Mainland lenders. They remark on the reluctance, or sometimes the inability, of landlords to lower prices. And they say the market won’t reach bottom until there are realistic expectations.
Sofos points out what he calls unrealistic expectations throughout the market. “If you go out to Kapolei, you’ll see some landlords asking $1.35 a square foot, and you’ll see other landlords asking $0.85. The landlord who has a $1.35 expectation in mind, he’s going to take a tremendous hit. … Until he gets realistic, he’s just not going to get a tenant.”
Another example, according to Sofos, is a property called Kapolei Spectrum, which the lender recently foreclosed on, and then put on the market for $52 million. “Let me tell you, it’s not going to sell for even half that price,” Sofos says. “So, that’s an unrealistic sale. They say, ‘We’re asking $52 million because it’s a great piece of property’ and this and that. But you’ve got 221,000 square feet and it’s all vacant. In this market, it’s going to take you three years to lease it all.”
Sofos reserves especially harsh criticism for the big landlords, like Kamehameha Schools, Queen Emma Foundation and HRPT Properties Trust. All too often, he says, they seem unconcerned with whether the property can support unrealistic ground rents. This is a perspective shared by many brokers. Matthew Bittick, executive vice president of PM Realty Group, notes that net income from these properties often won’t cover ground rent, yet prices seem poised to increase. In the case of the HRPT properties in Mapunapuna, for example, current appraisals are based on recent comps, which reflect rents at the height of the boom. “Those guys are all pretty much screwed,” Bittick says.
To Sofos, it’s not always clear that landlords want to rent the properties at all — as if they wanted to redevelop many properties themselves. “The landlords who are realistic, they’re going to do fine,” Sofos says, but others don’t understand the importance of cooperating with tenants. “You’ve got to see blood running in the streets before you see landlords changing their attitudes.”
Kirk Belsby, vice president of the endowment for Kamehameha Schools, says Sofos probably overestimates the effect ground-rent renegotiations will have on the near-term market. “As far as Kamehameha Schools goes, we got through the majority of our renegotiations a few years ago,” he says. “We don’t have any large renegotiations in the near future. But I think it’s fair to say, for any negotiations coming up, both parties are going to have to come to the table and have open and transparent dialog.”
Belsby also has a rosier outlook on the commercial real estate market in Hawaii, and others in the community are closer to his view than Sofos’. Most bankers, for example, point out that the conservative underwriting standards of local banks mean their loans are in much better shape than those of Mainland lenders. And Bittick says most of the troublesome CMBS loans do not pose an immediate threat. “The largest percentage of them really don’t come up until 2015, 2016, 2017 and 2018,” he says. “They really don’t matter for six to seven years.”
But the scariest part of Sofos’ scenario is that it doesn’t take a catastrophic increase in vacancies to undermine the commercial real estate market. Consider a recent report produced for Bank of Hawaii by real estate appraiser and consultant Steven Chee. This report — with the disturbing title, “Illustration of the Potential Order of Magnitude of Value Correction” — indicates what effects current conditions might have on the refinancing of property purchased in 2007, at the height of the last cycle.
For example, Chee found that the hypothetical value of a hotel bought in 2007, with a capitalization rate of 8.22 percent and an income of $1 million, was $12.2 million ($1 million divided by 0.0822). However, the same hotel bought or refinanced in the first quarter of 2009 has a lower value. The assumed income is down to $750,000, representing a 25 percent decrease in tourism; and the capitalization rate has risen to 9.29 percent, reflecting the higher risk and cost of capital. The hotel is now only worth $8.1 million, a drop of 34 percent. Worse still, the new capitalization rate also assumes a 70 percent loan to value rate compared to 80 percent in 2007. This means the lender may re-margin the loan, requiring at least an additional 10 percent equity investment from the owner.
“You’ve got to see blood running in the streets before you see landlords changing their attitudes.”
– Steven Sofos
But for most Hawaii borrowers, the nuances of capitalization rates and credit spreads are beside the point — for most borrowers, there’s no one left to borrow from. Two years ago, most of the large deals in Hawaii were financed by wheeler-dealer Mainland and foreign lenders: companies like Lehman Brothers, the Royal Bank of Scotland and Fremont Bank. Now, they’re gone, many of them bankrupted by the credit meltdown. Gone, too, is the frenetic market for commercial mortgage-backed securities that was the ultimate destination for more than 60 percent of Hawaii’s commercial real estate paper. As those loans come due, where does the borrower turn to refinance?
It’s almost certainly not the local banks. Hawaii’s community banks have always been relatively conservative when it comes to commercial real estate loans. That’s especially true for large loans, according to Ralph Mesick, executive vice president for wholesale credit at Bank of Hawaii. “If you come to a local bank,” he says, “if you go above about $15 million, we’re probably not going to look at it.” In addition, even when they do make commercial real estate loans, most of the local banks prefer to work with existing customers. That doesn’t mean they’re not making loans — First Hawaiian financed more than $1.5 billion in commercial real estate last year — it just means that the local banks aren’t much of an option for refinancing.
Mesick points out an exception: “If you borrowed from a bank, then you do have a lender — whether he wants to or not.” That’s because, since there’s no real market for distressed properties, foreclosure frequently isn’t an attractive option for the bank. That’s been the case for Central Pacific Bank, which has long been the most aggressive commercial lender among the major local banks.
Ryan Harada, executive vice president of CPB’s commercial real estate loan division, explains: “I’m just guessing, but I would say about a third of my portfolio will come up for maturity in the next year or so. The reason why that number seems a little large is that CPB has always been a big construction lender. As these construction projects finish, a lot of them we were already targeted to get off through the conduit of a life (insurance) company. And, because that market disappeared on us, it’s not that we’re ‘stuck’, but we’re having to mini-perm them for two or three years.”
Mini-permanent loans are an unusual intermediate step between a construction loan and more traditional long-term lending — and, given the shortage of other lenders, they may be the only thing preventing a foreclosure or a deed-in-lieu. “I’ll give you an example,” Harada says. “We’ve been very active in the self-storage market, and we have a bunch of them that are built. They’re cash flowing, so, although they’re not quite at stabilization, we’re getting principal and interest payments. Those were the ideal candidates for the secondary market, being that the developer could go in there and not only get our loan refinanced, but he could pull out his own equity and get a nice 10-year, fixed-rate loan — non-recourse, usually. Perfect for him. But not anymore.” Mini-permanent loans are likely to become a popular tool.
Perhaps there is hope for borrowers. But conversations with people in commercial real estate always seem to turn to the idea of people with money waiting in the wings for bargains. And hidden in the margins of Chee’s report, there are other troubling notes: a developer who “will not consider anything that is not reflecting a heavy price discount”; and a consultant who indicates that buyers are looking for “discounts as much as 30-plus percent.” Clearly there are scavengers in the barnyard.
And if Steve Sofos is right, there will be plenty of ham and bacon to go around.