What Happens When CRE Goes Bust?
The McClatchy story about the looming financing crisis in the commercial real estate market is very interesting. At the same time, the accompanying chart seems to indicate that the financial consequences, as such, of CRE-related losses will be less severe than the consequences of the collapse in the residential housing market. Not because the situation is necessarily better, but just because the scale of the loans involved is smaller.
But here’s my question. What happens to the tenants when you have CRE foreclosure? I read this:
The reality is already on display. On April 16, the nation’s second largest mall developer, General Growth Properties, filed for bankruptcy protection. The Chicago-based company owns more than 200 malls across the U.S., and was unable to renegotiate its debts as they came due.
Six days later, a 40-story office tower on New York’s Avenue of the Americas was seized by its creditor, a Canadian-owned pension fund. The tower’s owner, Macklowe Properties, couldn’t meet loan terms.
Presumably, vacancies at the General Growth malls and the office building on Sixth Avenue were part of the issue in the owners’ inability to pay their debts. But at the same time, it’s presumably not the case that all 200+ General Growth malls are uniformly empty. Same with the office building in Manhattan. So what happens to you if you’re running a store or a restaurant or a company and the owner of the office building or mall you lease from goes bankrupt?
21 Responses to “What Happens When CRE Goes Bust?”
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April 30th, 2009 at 5:03 pm
You stop paying the rent and see how long it takes someone to notice?
April 30th, 2009 at 5:07 pm
You rewire the elevators so your floor disappears from the notice of newbie landlords and rent collectors?
April 30th, 2009 at 5:10 pm
I can’t answer your question about what happens to the tenants. However, for both General Growth and Macklowe, the problem wasn’t vacancy rates but an inability to refinance existing short-term debt. Both apparently believed they could prosper by simply rolling over that debt continually. Today, not so much.
April 30th, 2009 at 5:16 pm
There were actually two scenarios being described.
One is a foreclosure, in which the mortgagee takes over the property. I believe in a majority of states, any leases subsequent to the mortgage (”junior leases”) would be terminated, and vice-versa for leases “senior” to the mortgage. The junior tenant can contract around that with the mortgagee, however, through something called a “non-disturbance agreement”.
The other is a bankruptcy. It turns out commercial leases get special treatment under bankruptcy law: the bankrupt landlord would no longer have to perform its duties under the lease, but you would have the option of remaining in the property until the end of your lease. You would pay rent to the bankrupt estate, minus any damages for non-performance by the landlord.
April 30th, 2009 at 5:17 pm
Answer is pretty complicated. Most tenants won’t be at risk of being evicted (assuming they have been paying their rent per usual), since commercial real estate contracts tend to be for many years and are binding on successors (so, whoever buys the malls can’t just jack up the rent on tenants already there). There may be issues for tenants who have leases that happen to be up for renewal, though.
The bigger issue, though, is that bankrupt landlords are usually pretty bad at maintaining facilities and making sure new tenants come in. I could imagine a lot of places that were otherwise fine falling into death spirals because no bothered to do things like pay for security or trash pickup or whatnot. This is especially problematic for malls, which can easily get a reputation for being “ghetto” and start losing tenants – once enough tenants are gone, everyone else will start leaving (since you need a certain number of stores for the mall to draw in customers) and the place just dies.
April 30th, 2009 at 5:23 pm
Oh by the way, as discussed briefly in the article, the looming problems in the CRE and contruction & development segments could cause a lot more small banks to fail going forward:
Just something to keep in mind when we argue about whether big banks are inherently riskier than small banks.
April 30th, 2009 at 5:24 pm
On December 18th, 2008, McClatchy common stock fell below $1 per share. The market capitalization of the company fell below $100 million, down over 98% since the purchase of Knight Ridder in early 2006. http://finance.yahoo.com/q/bc?s=MNI&t=5y
Nice!
April 30th, 2009 at 5:24 pm
Putting legal matters aside, I think the answer is basically “nothing.” Obviously in some cases a bankrupt landlord will behave differently from a non-bankrupt landlord, but the debtor/landlord can also choose to continue doing what it was doing pre-bankruptcy. In this case I bet that’s what happens, at least with the high-end properties like Watertower Place.
April 30th, 2009 at 5:29 pm
You take all the copper wire you can and head for the scrap yard.
April 30th, 2009 at 5:33 pm
Minderbender is right. Not much happens to commercial renters. Especially commercial renters like restaurants who typically sign very long term leases. The terms of their leases don’t change with a change in ownership, again typically. Location is a primary driver of restaurant revenues and you wouldn’t want your successful bistro to be taken out from under you by an unscrupulous landlord who could change your lease terms by changing corporate entities.
April 30th, 2009 at 5:42 pm
Most businesses that obtain a commercial mortgage are required to assign the leases over to the bank. If the bank forecloses on the property, the bank has the legal right to obtain rents directly from the tenants. No displacement would typically occur unless one of the tenants violates the terms of the lease. The bank or subsequent owner cannot alter the terms of the leases unless the language in the lease allows it. Once the leases are up, it’s time to renegotiate.
While it is true that smaller community banks are feeling pressure due to deterioration of commercial real estate quality, the risk is nowhere near that of the “big banks.” If a $500 million community bank in Tennessee fails, it won’t make a blip on the radar. Even if lots of them fail, it won’t register on a national or international scale. Go to FDIC’s website and see how many institutions have failed over the last year. It’s a lot. But you don’t hear about it very much because it doesn’t register in the stock market and therefore doesn’t affect people’s overall savings or spending patterns. Alternately, when Lehman Brothers fails, the whole system implodes. That’s why it’s called systemic risk.
In truth, most small to mid-size banks that are ready to fail are acquired by a larger, more healthy bank for pennies on the dollar.
April 30th, 2009 at 5:54 pm
Commercial real estate will almost always find a clearing price quickly. Commercial real estate is a classic investment. You know your cost, the price you pay, you know the expected rent and occupancy, with some judgments of course, and if the number meets your goal you buy. The expected return is called the cap rate, ie. the capitalization rate.
As opposed to a speculation where you buy a stock or a home or whatever, it has no cash flow, and you hope it inflates. Not to say that expected inflation of the property is not included in the calculation.
There are going to be malls, strip malls and offices all over which will not find a buyer and tennants will be forced out.
Cap rates plummeted at the end of the bubble. In one of the stupidest deals of all time Blackstone Group bought out Sam Zell’s entire commercial real estate empire. Sam Zell considered one of the greatest real estate investors of the age. They bought for what is guessed to be a 5% cap rate. A rate that is pathetic by any historic standards. A rate that is and was stupid, stupid, stupid. With commercial real estate certain to take years to reach the prices of 07 they are looking at a huge capital loss as well. Go figure.
April 30th, 2009 at 5:59 pm
Usually nothing happens because the tenant can’t use the foreclosure or bankruptcy to get out of the lease and the lenders would rather have a paying tenant than vacant space. A tenant with a substantially below market rent may be at risk. There are numerous technical caveats to the foregoing, but that’s what they pay me for in my day job.
April 30th, 2009 at 6:30 pm
Darth Cheney,
If enough small banks fail, what you get is something like the Savings and Loan Crisis. Or, for that matter, something like the bank failures during the Great Depression.
April 30th, 2009 at 7:33 pm
I like how MY says Sixth Avenue like a true New Yorker instead of Avenue of the Americas.
April 30th, 2009 at 8:38 pm
To answer the title of the post: “Suck on This”
Actually, that’s just for Tom. And we know you’re reading.
April 30th, 2009 at 8:41 pm
I like how MY says Sixth Avenue like a true New Yorker instead of Avenue of the Americas.
Yeah, seriously. Avenue of the America’s? What BS.
April 30th, 2009 at 8:49 pm
Nothing will happen.
The lease continues unless it has a term (never heard of such a thing) which terminates the lease in case of _landlord’s_ bankruptcy, inability to make mortage payments.
The idea that tenants will be forced out is totally wrong on legal and practical bases.
April 30th, 2009 at 10:18 pm
As opposed to a speculation where you buy a stock or a home or whatever, it has no cash flow, and you hope it inflates.
Surely stocks of profitable companies pay out dividends?
May 1st, 2009 at 12:38 pm
CRE debt is much shorter term than 30 year home mortgages. The key is how much needs refinancing at what interest rate.
I think Uncle Sam will be the nation’s lender for years to come.
May 1st, 2009 at 10:35 pm
DTM:
True, if THAT many small banks fail, we would be in serious trouble. I regulate small commercial banks for a living. I would wager that 80% of the banks that would have failed were saved by TARP. Some will still fail, but I don’t think it will be nearly enough to mirror the S&L crisis or the Great Depression.
Then again, I could be wrong.