COVER STORY November 5, 2009

Unrealistic assumptions, layers of investors, sky-high prices, and possible fraud will make it hard to clean up the mess in commercial real estate

by Mara Der Hovanesian and Dean Foust

When Goldman Sachs (GS) sold complex bonds backed by the Arizona Grand Resort and other commercial properties in 2006, it suggested the returns would be strong. The 164-acre luxury Arizona Grand, set against the Sonoran Desert in Phoenix, boasted an award-winning golf course, deluxe spa, and several swank restaurants. The on-site water park was named one of the best In the country by the Travel Channel. With the resort's new owners planning to refurbish hater rooms and common areas, Goldman told investors that the renovations would help boost cash flow.

As was so often the case during the real estate boom, the lofty projections didn't pan out. When the economy softened and business travel slumped, Arizona Grand*s bookings slipped to 67% from 80%. The resort defaulted on the $190 million underlying loan in 2009-a hit that alone could largely wipe out Investors who bought the riskier pieces of the Goldman mortgage-backed securities deal.

"It's one of the largest losses we have forecasted for an individual loan," says Steve Kuritz, a senior vice-president at Realpoint, an independent credit-rating agency. The property. once valued at $246 million, is now worth just $93 million. A spokesman for Goldman says the pricing on the bonds was in line with market levels at the time and not above what investors could get on similar securities. Grossman Co. Properties, which owns Arizona Grand, didn't return calls for comment.

It would be easy to write off this blowup as just another casually in the regular boom-and-bust cycle of 'the $6.4 trillion commercial real estate market. But the Goldman deal, with its unrealistic assumptions. multiple layers of investors. and stratospheric prices, helps illustrate why this downturn is more complicated than previous ones-and will turn out to be far costlier. Already, prices have plunged 41% from the peak in 2007, according to Moody's/REAL Commercial Property Price Index-worse than the 30.5% fall in the housing market from its 2006 apex "We've never seen this extreme a correction as far back as the data go, which is the late 1960s", says Neal Elkin, president of Real Estate Analytics, the research firm that created the index. Adds billionaire investor Wilbur Ross: "Commercial real estate has gone from being highly liquid at sky-high prices to being extremely illiquid at distressed prices."

To appreciate why this bust is like no other, first consider the typical! commercial real estate downturns that used to crop up every 5 or 10 years. The pattern was predictable: When prices for apartment complexes. office buildings, shopping malls, and other properties began to rise, developers sped up their projects To cash in on the bull market. Eventually, some of those developers, unable to fill all the new space, began to default on their loans, and lenders were stuck with the buildings they'd financed. The slump lasted no longer than the time it took for the property glut to he worked dawn.

TURNING A BLIND EYE

But overbuilding isn't the culprit in this bust. An oversupply of money is what pushed commercial real estate over the edge.

It turns out the same excesses that drove the housing market's crazy rise and fall were present in commercial real estate, too - but they have largely gone unnoticed until now. Bankers, in their haste to make more and bigger loans, blindly accepted borrowers' wildest growth assumptions and readily overlooked other shortcomings on loan applications. They did so in part because they could easily sell their dubious loans to investors in the form of commercial mortgage-backed securities. As the market overheated, it became a breeding ground for fraud: A flurry of new court cases reveals the disturbing extent to which commercial mortgage borrowers may have doctored loan documents.

While the housing crisis seems to be easing, the commercial storm is still gathering strength. Between now and 2012, more than $1.4 trillion worth of commercial real estate loans will come due, according to real estate investment firm ING Clarion Partners. Analysts at Deutsche Bank (DB) estimate that borrowers will have trouble rolling over as many as three-quarters of the loans they took out in 2007, the most toxic vintage.

For the banks and investors whose money fuels the economy, this presents major problems. Their losses will likely cast a shadow over lending - and, by extension, the overall economy - for years. The market won't fully recover until 2020, says Kenneth P. Riggs Jr., CEO of Real Estate Research, and in cases where "values were over the top...maybe never."

In the short term, toxic securities are creating a new problem weighing on the market: a tangle of interconnected investors fighting over the remains of the properties they own. In the past the damage was limited to a handful of lenders who invested directly in any given project. Now there can be dozens of groups of investors, each with its own agenda. The April bankruptcy of shopping mall owner General Growth, one of the largest real-estate-related bankruptcies ever, affected hundreds of parties - an unprecedented slicing and dicing of assets. These investors won't soon forget the bust and aren't likely to dive back into the market as aggressively as they once did.

And yet the securities are only a secondary problem. The main driver of the commercial real estate bust is the underlying loans. How frothy did the market get? In one notable example, New York investment fund Sterling American Property and real estate company Hines paid $281 million in 2007 for the 42-floor office building at 333 Bush St. in San Francisco. That worked out to $518 a square foot, far higher than today's price, according to Real Capital Analytics, a research firm. Less than two years later, the building's primary tenant, law firm Heller Ehrman, filed for bankruptcy and stopped making rent payments. According to Real Capital Analytics, the building's owners did not make a recent loan payment, and the lender is expected to begin foreclosure proceedings. Says a spokesman for Sterling and Hines: "[We] continue to own and operate the property."

What's striking is how quickly some big commercial deals have gone south. In April 2007, Charney FPG, a New York real estate partnership, paid about $180 million to buy a 22-story office building in Manhattan's Times Square district. It borrowed $202 million to pay for the purchase, renovations, and incidentals - 111% financing. Because the rental income didn't cover the debt payments, Comfort's lenders, Wachovia and RBS Greenwich Capital, required the firm to set aside $10 million in reserves to keep the project afloat until it got more paying tenants. Those occupants never materialized, and by July the owners had exhausted 95% of their reserves. The building is now in jeopardy of being seized by the bankers, says Real Capital Analytics' head of research, Dan Fasulo. "Everyone knows Judgment Day is coming." Says a Charney spokesman: "The owners are in the midst of restructuring the debt." Wachovia and RBS declined to comment.

Commercial lending mirrored mortgage lending in another way: Loans were made based on an unshakable belief that the market would never go down. An analysis by research firm REIS of mortgage securities created between 2005 and 2008 found that income projections for properties exceeded their historical performances by an average of 15%. "It was all based on assumption of cash flow," says Howard S. Landsberg of New York-based consultant Weiser Realty Advisors. "If you couldn't afford to pay the bank back now, in three years you could count on another $20 a square foot" in rent. When the numbers didn't add up, some lenders got imaginative. Says a banker at a large Wall Street firm: "If the cash flow wasn't there, you had to ignore it or find ways to create it."

Some lenders may have drummed up business for themselves, enticing borrowers with more money than they needed. Consider Credit Suisse's (CS) $375 million loan to the Yellowstone Club in Big Sky, Mont., one of the starkest examples of poor underwriting in recent memory. Opened in 1999 by Timothy L. Blixseth, a welfare kid turned timber magnate, the private ski and golf club catered to the ultra-wealthy crowd. Microsoft (MSFT) founder Bill Gates and Tour de France champion Greg LeMond built multimillion-dollar vacation homes there. In 2005 a Credit Suisse banker approached Blixseth about a loan, which the banker compared to "a home equity loan," according to bankruptcy court documents. Blixseth initially turned down the offer. But after several calls and a personal visit to Blixseth's home near Palm Springs, Calif., the banker persuaded Blixseth to borrow $375 million in the name of the club. According to court papers, the two decided the transaction fee by coin flip; Blixseth won, agreeing to pay 2%.

"WILD, OUT-OF-CONTROL SPENDING"

But not all of the funds were earmarked for the club. The deal allowed Blixseth to use up to $209 million of the proceeds "for his own personal benefit," according to the bankruptcy court papers. In a civil lawsuit filed by Yellowstone investors and homeowners, the plaintiffs say Blixseth used some of that money to fund a lavish lifestyle, including the purchases of a 20-seat Gulfstream corporate jet, two Rolls-Royce Phantoms, and three Land Rovers. His ex-wife, Edra Denise Blixseth, may have benefited from Credit Suisse's largesse, too. In a legal declaration filed in a Montana court, Timothy Blixseth notes her "wild, out-of-control spending." Among her extravagances, he alleges, was a "divorce celebration party" with "a voodoo doll game whereby the guests could poke pins in a life-size doll in my image to inflict pain on my various body parts." Timothy Blixseth's attorney says his client used the "vast majority" of the funds for business purposes. Blixseth, the attorney says, plowed money into an international expansion plan, including the purchase of "golf and resort properties in Mexico, the Caribbean, and elsewhere," as well as the Gulfstream jet. Edra Blixseth could not be reached for comment.

While Blixseth was busy spending the money, Yellowstone was struggling under the weight of its debt. Vendors often went unpaid for three months or longer, according to bankruptcy court testimony. In November 2008, Yellowstone filed for bankruptcy protection. "The only plausible explanation for Credit Suisse's action is that it was simply driven by the fees it was extracting from the loans it was selling and letting the chips fall where they may," said Ralph B. Kirscher, a federal bankruptcy judge in Helena, in a May court decision. Timothy Blixseth's attorney says the bankruptcy was prompted by his client's divorce proceedings. A spokesman for Credit Suisse says: "We worked on behalf of the institutions that held this loan." (The judge vacated his decision after the bank agreed to settle with Yellowstone's new owners, which include money manager Cross Harbor Capital Partners.)

RED FLAGS GALORE

The banks were hardly the only freewheeling players during the credit boom. The fast-and-easy lending environment was fertile territory for alleged fraudsters. In 2007 Prudential Financial lent $13.9 million to Namir A. Faidi, a Houston developer who planned to use the money to pay off construction loans on Piazza Blanca, a Mediterranean-themed shopping complex in Galveston, Tex. Faidi dipped into the project's reserve fund to make the first loan payment but failed to make any more. After that, Prudential concluded that some of the leases he'd submitted weren't legitimate. According to a civil suit filed in federal court by Prudential, Faidi's loan papers included a signed lease from time-share giant Bluegreen, a purported tenant that would occupy 26% of the space. But when Prudential contacted Bluegreen after the default, it learned it had backed out of talks and never signed a rental agreement.

In court proceedings, a Bluegreen employee said the signatures on the documents weren't his. Another supposed tenant, Mia Group, said in court filings that the lease on file for the restaurant company was invalid because it was signed by a business associate who didn't have authority to do so. "He was a few leases short of what he needed to get the loan," says Andrew F. Spalding, a Houston attorney who is representing Prudential. "I'm sure his thinking was just like that of most other developers: Even if the tenants were fake, he figured he could still fill that space in no time with someone else."

An attorney for Faidi, Robert A. Axelrad, says the disputed lease for Bluegreen was arranged by an outside broker. He acknowledges that the loan application included future rent payments from Bluegreen, but he says the figures were meant to be "pro forma" estimates based on the possibility of Bluegreen occupying the space. "My client says he never saw the lease and never represented there was a lease," says Axelrad. Faidi filed for personal bankruptcy in September. The civil case is ongoing.

Glaring problems that normally would have raised red flags seemed to be in plain sight of loan officers during the credit boom. Phoenix entrepreneur John J. Wanek appeared to have the right credentials when he applied for a $6.5 million loan from Merrill Lynch to buy the Ashberry Village Apartments in 2002. The sprawling ranch-style complex in Columbus, Ohio, would be the latest addition to his small, Midwestern real estate empire. He had never missed a payment on a half-dozen similar properties. And the rent rolls Wanek provided showed that more than 90% of Ashberry's units were occupied. After Wanek defaulted within six months, Merrill concluded that it had been duped. It claimed in a civil suit filed in a Franklin County (Ohio) court that Wanek had altered the rent-roll numbers to make the complex look more profitable. Merrill, which is now owned by Bank of America (BAC), contends that the complex was nearly one-third vacant at the time, and that Wanek had "grossly understated" the operating expenses. According to the suit, Wanek had inflated the numbers to get a bigger-than-necessary loan and used the extra money to cover back payments on other apartment buildings.

Even if the allegations are true, Merrill should have seen the warning signs. According to the suit, after applying for the loan, Wanek told Merrill he would transcribe data from the previous owner's supposedly illegible rent rolls into easier-to-read spreadsheets. In the process, he boosted many figures to suspiciously round numbers. Wanek also overstated his equity in the real estate he posted as collateral and listed some of his parents' assets as his own.

An attorney for Wanek, Mark C. Collins, says his client recreated the rent rolls - with Merrill's approval - only because his office had been burglarized and many records stolen 10 days before closing. "He prepared those numbers as best he could off the top of his memory," says Collins. "The proper due diligence wasn't done by anyone, but they want to make the buyer the scapegoat." Wanek, who filed for bankruptcy shortly before he lost the civil case in January 2006, now faces criminal fraud charges from the Franklin County prosecutor.

All told, Merrill and the lenders on Wanek's other properties have lost $38 million. His parents, two retired schoolteachers, had to file for bankruptcy as well. "Lenders were willing to underwrite on his record and the revenue stream of the property," says David D. Ferguson, an attorney who represented Merrill. "But it was a scheme doomed for failure."

With John Cady in New York

Der Hovanesian is Banking editor for BusinessWeek in New York. Foust is chief of BusinessWeek's Atlanta bureau.