Orange County Register

Stan Ross is the board chairman of the USC Lusk Center for Real Estate. In a prior life, he was Vice Chairman-Real Estate Industry Services for Ernst & Young. We asked for his views of what’s happening in the beleaguered commercial development industry — beset of late by defaults and bankruptcies — and asked how some developers might survive this downturn.

Us: We’ve seen several stunning defaults in commercial properties recently as assets end up under water. The St. Regis hotel, Maguire Properties, the South Coast Home Furnishing Center and numerous housing and retail developments that are being sold for pennies on the dollar or given back to lenders. And yet brokers say that the full impact of commercial foreclosures hasn’t hit yet. What’s in store?

Stan: The commercial sector has not yet fully seen the impact of illiquidity in the capital markets. As a result, we haven’t seen the full magnitude of defaults or foreclosures yet in the marketplace.

What’s in store is that many of these companies (borrowers) will first go into covenant defaults on their bank financing. They will fail to meet certain covenants such as leverage ratios or debt service coverage as a result of market conditions and are in technical violation. While these are non-monetary defaults, it gives the lenders the option as to whether or not they will give a waiver, extension, modification or start foreclosure actions.

A lot of that is taking place quietly behind the scenes, but a number of these companies do not have the cooperation of their lenders and many of these assets will be put in “play” in the market.

In addition to the bank financing, there is a huge amount, almost $200 million of commercial mortgage backed bonds that are coming due by the end of ’09 and about $275 million going into ‘10. Since there’s no liquidity in the market, there is no known direct source of replacing those commercial mortgage backed bonds.

With many of these bonds, it’s difficult, if not impossible, to negotiate with large groups of investors and a number of different classes of their security. The servicers do not have the authority or cannot get the group together to agree on some restructure or loan modification. Many of these companies will have to find another source to refinance out and many of them will be replacing this debt with equity or new expensive debt sources. Many of the REITs have raised equity this year.

So far we haven’t seen a big dumping of commercial portfolios on the marketplace for discounts. But standby.

Us: How will all the tumult in commercial real estate impact the economy and affect the economic recovery?

Stan: Commercial real estate will affect the economy differently than residential. Many of these commercial mortgage backed securities are held by banks as well as other institutions. Those CMBS were sliced and diced into different classes and then sold into the marketplace to many different investors.

Some of these institutions that were holding or buying these securities and will run into some serious problems with respect to liquidity and capital requirements. They will either have to be restructured, taken over or look for new equity capital to continue on. The impact on the economy could be a further loss of some institutions and a continued slowdown of new development.

Us: What are commercial developers and investors doing to survive?

Stan: The commercial developers and investors have learned from previous recessions that the most effective step you could take to survive is to be transparent with your lenders and creditors, and provide them with all the information and meet with them early and frequent.

What they are doing to survive is going through a full evaluation of all costs, relooking at their business plan, looking at every development that they have, identifying which of the assets and properties they could sell, looking at alternative sources of financing, and then meeting with their banks in an attempt to come up with some kind of a restructure or modification plan, or at a minimum, getting waivers and a short term extension while they implement their new plans.

Their new job is to execute this revised plan.

Us: What opportunities are there in these distressed real estate markets? Who are the key players we’re likely to see becoming major new owners in  Southern California (particularly in Orange County)?

Stan: The opportunities in the distressed markets are going to come either from asset sales from these developers that will have to sell their assets to get the liquidity, or they’ll come from the banks and other financial institutions who have to move out so-called toxic assets, loans in default, loans that are delinquent that could be a problem in the future or actual properties that have been foreclosed and is now REO (Real Estate Owned) that they will be disposing.

In addition, you will see some asset opportunities coming from city, county and municipalities, as well as some assets that will be disposed of by the major developers that move and restructure some assets like Lennar, or some restructure opportunities coming out of bankruptcy like Empire Land.

The players that we are likely to see who will fund and acquire these properties will be some of the known and existing funds that still have capital committed. Other funds that have formed separate affiliated new distressed fund programs will be out looking for opportunities. Some of the high net worth individuals will be out in the marketplace, and finally, some of the development companies that successfully restructured early on or redesigned their business plans to move from development towards acquisition. Those with liquidity will be buyers but tough ones.

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