The New York Times

Wall Street Tumult Casts Pall on Manhattan Real Estate

October 1, 2008

By Terry Pristin

As the financial services industry expanded rapidly in mid-decade, Manhattan office rents skyrocketed, investors competed furiously for buildings and developers planned huge trading floors to lure tenants. As recently as last year, large blocks of space were scarce, and landlords had the upper hand.

These days, however, confidence and optimism have given way to fear, uncertainty and gloom. Wall Street is expected to shrink significantly, and the market for commercial real estate has ground to a virtual standstill (though many investors are hopeful of profiting handsomely by choosing the right time to get back in).

“The speed at which this has flip-flopped has been stunning,” said Mike Kirby, a principal of Green Street Advisors, a Newport Beach, Calif., research company that analyzes real estate investment trusts. The company follows the Manhattan market closely because one-third of the nation’s public office sector, in terms of its value, is in New York.

Green Street has predicted that the city will lose 60,000 financial jobs before the economic crisis is over and that the Manhattan availability rate could exceed 13 percent (though that is far less than the Manhattan availability rate of 19.8 percent in the third quarter of 1991, the nadir of the last prolonged downturn). The proportion of office space that is empty now, or will be available within a year, rose to 8.9 percent in the third quarter, from 7.2 percent in the second quarter, according to Studley, a brokerage firm that represents tenants.

Most of the increase, however, was attributed to 11 Times Square, a 40-story office tower being built on speculation at Eighth Avenue between 41st and 42nd Street. The building is scheduled to be completed next September, but no tenants have been announced.
At the moment, asking rents in Manhattan are flat, according to Studley, but they are expected to decline as companies seeking to shed excess space sublease it at a discount.

Three of the biggest players caught up in the economic crisis — Lehman Brothers, which is seeking bankruptcy protection; Merrill Lynch, which was acquired by Bank of America; and the insurance giant American International Group, which received an $85 billion bailout from the government — occupy 9.2 million square feet in Manhattan. No one knows how much of this space will be put on the sublease market, or when.

The financial turmoil has prompted some large law firms and other tenants to angle for a better deal in leases.
“They all start by saying that the deal is off,” said a leasing broker who asked not to be named because he was not authorized to discuss his firm’s negotiations. “For some, it really is off. Others are using this as leverage.” Tenants that are not under pressure to make leasing decisions are waiting, he said.

Also waiting are dozens of investors who have amassed billions of dollars of capital but are not ready to spend it because no one knows how much values have dropped. “More money is sitting on the sidelines now than ever before in my lifetime, but nobody wants to risk it,” said Jules Demchick, the chairman of J. D. Carlisle, a New York developer.

The default rate for commercial mortgage-backed securities — bonds backed by loans that are pooled and sliced according to varying levels of risk — is less than half a percent. But real estate professionals say defaults are likely to spike in two or three years when many loans that originated in 2006 and 2007, when the market was at its frothiest, need to be refinanced. The income from these highly leveraged properties is expected to fall short of the robust projections of rental growth that were made when the buildings changed hands.

The collapse of Lehman Brothers will also have repercussions for operators of a number of Midtown office buildings.

In addition to originating loans, selling these loans in commercial mortgage-backed securities and providing “mezzanine” loans at higher interest rates than the senior loans, Lehman was also an aggressive supplier of bridge equity. These were infusions of cash that enabled deals to close quickly, thereby giving its partners a competitive edge. An operating partner might have put up 5 percent of the equity, or even less, with Lehman putting up the balance in the expectation of selling its position to its investors. Often, Lehman played several roles in a given deal.

Lehman frequently provided financing for Broadway Partners, the once aggressive investor in office towers that is now facing a mountain of short-term debt. One of Lehman’s biggest deals in New York involved $1.2 billion in financing for 237 Park Avenue, a 21-story tower that Broadway Partners acquired in May 2007, said Orest Mandzy, the managing editor of Commercial Real Estate Direct, a news and information service. Lehman’s equity positions in Manhattan include the office towers at 1745 Broadway and 545 Madison Avenue, in which it has a minority stake.

In May 2007, Lehman put up most of the $480 million that was used to buy 200 Fifth Avenue, the former International Toy Center, which L & L Holding is turning into a prime office building. Lehman had to keep its interest because the credit squeeze was beginning and no buyers emerged. L & L, which formed a $500 million partnership with Prudential Real Estate Investors in June, hopes eventually to buy Lehman’s stake at a discount. Half of the 15-story building is leased to the Grey Group, a global communications company; the remainder has not been spoken for. A consortium of foreign banks provided a construction loan.

“We are the likely buyer,” said David W. Levinson, chief executive of L & L Holding. He added that the building itself, to be completed in January, will not be affected by Lehman’s demise.

Because he has ready access to cash, Mr. Levinson is in an unusual position, said Robert J. Ivanhoe, chairman of the real estate practice for the law firm of Greenberg Traurig. Some of Lehman Brothers’ other partners are likely to lose control of their buildings. “The typical sponsor is going to have to go out and raise the money,” Mr. Ivanhoe said. “The likelihood of success in this marketplace is remote.”

Anyone who bought a building when the market was red-hot is likely to see an erosion of equity, said Paul M. Fried, a principal of AFC Realty Capital, a mortgage brokerage based in New York. “If you’ve acquired property with highly leveraged capital, you’ve got a problem,” he said. “New York or Washington assets may hold their value better than assets in other markets, but they still may take some hit. And when they take a hit, then your equity has just been devalued.”

But just how deep will that hit be?

The Real Estate Roundtable, which represents the nation’s largest real estate companies, successfully lobbied for commercial real estate debt to be included in the proposed $700 billion government bailout to help establish a fair price for the assets. Jon Southard, a principal at Torto Wheaton Research, an arm of CB Richard Ellis, the brokerage firm, said that under a well-run government auction, sellers would be penalized for overpaying for their buildings because of poor underwriting. But unjustifiably low prices based on panic over the economy would be avoided.

But Mr. Kirby of Green Street Advisors said New York real estate players were perfectly capable of figuring out how much an office building is worth. “Why the government has to play a role there, I don’t know,” he said.