Despite slightly improving economic conditions, Nevada’s commercial real estate market continues to face downward pressure as a result of poorly underwritten and grossly overleveraged legacy deals from 2005 to 2007, which are now coming to maturity. This same scenario is playing out in virtually every region across the country. According to data service provider Trepp LLC, U.S. commercial real estate loans totaling more than $1.73 trillion will mature from 2012 through 2016. Two-thirds of this maturing debt is currently underwater or close to it, with 56 percent of the 2016 maturities underwater by more than 10 percent. Over the past 12 months, only 42.8 percent of the commercial mortgage-backed securities with balloon loans were paid off on their maturity date.
Underwater loans that have hit maturity and/or don’t generate enough cash to cover debt service cannot be refinanced without new equity, lender write-offs or, in some instances, both. As underwater properties go through voluntary or involuntary restructurings, they often drag down other, currently financially stable, buildings by negatively impacting rents in the region. This downward valuation spiral will create the most stress on properties located in secondary markets such as Las Vegas and negatively influence properties currently thought to be relatively safe and stable.
Many of the reasons for the particularly difficult conditions in Nevada’s commercial real estate market have been widely discussed: overbuilding was rife, and local lenders were wildly aggressive on their underwriting criteria, with the effects of both exacerbated by the recessionary pressures on gaming and hospitality. One other contributing factor has not received much attention, however: the disproportionate number of properties in Nevada that were purchased through tenant-in-common (TIC) syndications.
TIC syndications gained popularity in the early-to-mid 2000s as a way for up to 35 small “mom-and-pop” investors to pool their money and purchase large-scale commercial properties, opportunities which previously had been largely unavailable to them. Additionally, the TIC structure allowed these same investors to leverage a TIC-specific 1031 like-kind tax deferral ruling by the Internal Revenue Service in 2002. Some of the TIC transactions in Las Vegas involved properties with values in excess of $80 million.
Enticed by sponsors with the promise of compelling yields, these TIC investors, many of them senior citizens, could not foresee the potential pitfalls associated with the transactions. These deals were often loaded with excessive fees. There have been some types of troubled loans with “loads,” or upfront fees, of up to 27 percent. Such a fee would mean that for every dollar used to acquire the property, only 73 cents actually went to work in the investment.
Most of these TIC investments were made between 2005 and 2007, at the absolute top of the real estate market. A number of investors allege some Las Vegas TIC deals included blatant fraud. The investors of one TIC property in Henderson claim the deal’s sponsor didn’t tell them that the property was part of an infamous Ponzi scheme. In another deal located in Downtown Las Vegas, the sponsor allegedly claimed that the building’s mechanical systems were brand new, but the investors say the systems were about 40 years old. Naturally, the adversely affected TIC investors are incensed by what they believe are unscrupulous practices by these sponsors.
For these reasons, TIC deals often end up in court, congesting securities fraud, litigation and bankruptcy dockets. The Clark County Superior Court is overwhelmed with civil litigation as it plows through years of backlog to get through discovery and into trial. The federal court is understaffed, and the bankruptcy court is swamped. In the meantime, the commercial real estate market can’t reach equilibrium until the borrowers and lenders complete the debt resolution process and remove this impediment to economic recovery.
As property values continue to decline, one can see a long stream of underwater Nevada loans facing either maturity defaults or payment defaults as a result of decreased rental income. This overhang will prolong the market malaise and contribute to under-investment as borrowers facing default will resist putting money back into the under-performing properties. Ultimately, the community suffers as maintenance is ignored, capital improvements are deferred, and scarce resources are expended on litigation and bankruptcy.
The market will improve more quickly if borrowers, lenders, the courts and the community began acting in such a way as to accelerate the debt restructuring process. While this process may be painful in the short term, everyone ultimately benefits when the market regains its footing.
Phil Jemmett is CEO of Breakwater Equity Partners.
