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Tranche Warfare

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War is hell.

Just ask the investors, creditors and bankers facing off against each other in the growing clash over commercial real estate.

At first there were selected skirmishes. There were hints of hostilities in Las Vegas, Chicago and L.A. where investors had poured billions into luxury complexes. It was a sideshow to the greater conflagration – the struggle to prevent mass foreclosures among individual homeowners.

When a group led by Tishman Speyer Properties and BlackRock, Inc. defaulted this morning on the $4.4 billion note they were holding on the Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan, the conflict over commercial real estate became the latest front in the battle over bank solvency.

Originally purchased during the height of the real estate boom in 2006, the $5.4 billion for the 56-building, 11,000 unit complex, was the most ever paid for residential property in the U.S. The joint venture between real estate giant Tishman – also owner of Rockefeller Plaza – and the private equity group BlackRock, has been struggling for months to restructure its debt. With the New York economy still sputtering, the two partners finally capitulated by turning the massive property back to the banks.

In Los Angeles, at least eight residential projects and one hotel have fallen into bankruptcy. Some of those projects, along with others in the area, have also faced foreclosure — an equally complex process with just as many possible endings.

Sputter Multiplied by $8 Billion

When Lightstone Group bought Extended Stay Hotels Inc. in June 2007, it relied on more than $7 billion in debt financing to complete the $8 billion deal just weeks before the leveraged-buyout market imploded.

Today, Extended Stay’s creditors are battling each other after the company filed the largest bankruptcy case by a U.S. hotel owner. A company reorganization plan, which includes financing from Centerbridge Partners LP and Paulson & Co., may be challenged by a proposal from Starwood Capital Group LLC that is backed by some so-called mezzanine lenders.

Infighting among lenders with different classes of debt, called tranches, is on the rise in the hotel industry and throughout the $3.5 trillion market for commercial real estate loans after property prices fell more than 40 percent from their peak in 2007. Commercial mortgage defaults more than doubled to 3.4 percent in last year’s third quarter from a year earlier.

The key question now is, eventually what happens to the buildings once the lenders take over. Will there be a swift turnaround that adds to the residential momentum? Or will the lenders sit on the properties, waiting for values to increase, even if it means structures remain empty for months or years?

In sharp contrast to the millions of individual homes that remain at risk, only a select group of buyers is interested in operating such properties let alone those who have the financial strength to purchase them.

One well-known property on the block for a fraction of its last sale price is the Campus at Playa Vista. The 56-acre site near Marina del Rey is one of the most desirable parcels in the country for developers because it's near the ocean and comes with approval for the construction of more than 500,000 square feet of office and retail buildings.

It Is Available for the Asking

The parcel, where Steven Spielberg and his DreamWorks’ partners once planned to build a major film studio, includes the enormous hangar where aviator and business mogul Howard Hughes built his infamous Spruce Goose airplane in the 1940s. The hangar is now frequently used as sound stages for making movies and television shows.

New York developer Tishman Speyer and its financial partner, Walton Street Capital, paid $200 million for the sprawling coastal campus 2 1/2 years ago during the real estate boom and built four office buildings before defaulting on a $155 million loan last summer. Now the one-time hot property is back on the auction block.

As the rate of commercial real estate defaults heats up, many analysts are predicting that the Federal Reserve, along with the U.S. Treasury, may be forced to step in and further prop up the banks holding the paper on these properties.

With the President and Fed Chair Ben Bernanke already facing criticism for their continued support of the taxpayer-based bailout of the nation’s banks, it’s tough to imagine either will be able to secure Congressional backing to help the banks out of this jam, especially after the election debacle in Massachusetts.

John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com