Commercial Real Estate in Economic Crisis: An Interview with James O'Brien of Davis Polk & Wardwell
Kevin Viau
Yiseo Kim
Posted Saturday, September 19, 2009

Q: Please describe your commercial real estate practice.

A: We advise our clients on a variety of different transactions:  buying and selling real estate, leasing real estate, and financing real estate.  We also advise on the real estate aspects of our clients' M&A and capital markets transactions.  A company's real estate interests can be of significant value to an M&A transaction.  We conduct a due diligence investigation and ensure that the real estate interests are transferred properly.  When a REIT or other real estate company undertakes a public offering, we will assist in the due diligence investigation and the preparation of disclosure documentation.

I frequently work with real estate opportunity funds.  These funds typically buy underutilized parcels of real estate to develop and resell them.  Sometimes these parcels are vacant.  Often they are already developed, but are not being put to their highest and best use.  Our clients are expert at identifying these parcels and redeveloping them for a more desirable use - whether that be as commercial, residential or mixed use property.

I advise on these transactions from start to finish - from the acquisition and its financing, to the construction financing to the eventual sale of the improved property.

I also work with corporate clients who have real estate needs.  We represent a rail transportation company and I have assisted them in acquiring and developing distribution hubs for their rail network.

The real estate group at Davis Polk also does a considerable amount of pro bono work.  Typically we advise non-profits with regard to their leases, but recently we helped a pro bono client acquire a building in the Bronx for use as a headquarters facility.  We received a Cornerstone Award for outstanding pro bono service from the Lawyers Alliance for New York for our work on that project.

Q: How has the residential mortgage crisis affected the commercial real estate practice and the growth and development of commercial real estate?

A: The residential mortgage crisis has affected commercial real estate by making credit much more difficult to obtain.  Real estate investment is driven by leverage.  One of the great things about real estate investment is that you don't need all cash to do it.  Potential investors are either reluctant, or simply unable, to acquire and develop real estate without the aid of debt.  As a result, the demand for real estate has slowed and prices have fallen.

Many banks and other real estate lenders have taken large losses on their portfolios of mortgage backed securities and associated derivative obligations.  These losses have affected their capital reserves and have limited their ability to make loans.  Falling real estate prices have made lenders nervous about lending against real property and have led to tighter credit standards.

Even commercial projects that have little to do with residential real estate are having trouble finding financing.  As leverage dries up, the pace of deals dries up because there is less financing available to support them.

Real estate developers usually acquire real estate with short-term financing expecting to take out the initial loan with construction financing or longer term permanent financing.  Construction financing is now difficult to obtain, so development timetables have slowed.  Many developers are also faced with loans coming due that they are unable to repay.  In the usual case, a developer could sell the property to repay the loan or the developer could refinance.  Now the markets for real estate sales and financing are constrained, so developers are attempting to extend their existing loans.

There are, of course, companies that are in the business of developing real estate for residential use. Those companies are feeling the pinch because there is just not as much demand for their product and because prices are coming down.

Q: What has been the effect of the downturn on your practice in particular?

A: We have remained active, but the mix of work has shifted.  We are seeing more restructuring projects than acquisitions, for example.  We have strong clients with substantial equity and good projects in the pipeline, but the liquidity crunch has hampered their plans.

The market for construction financing is not very good right now, so instead of helping a client secure construction financing for a development project, we might restructure an existing loan on the property.  I have assisted clients in extending the terms of short-term acquisition loans in the hopes of securing construction financing down the road.  Lenders have generally been willing to restructure loans.  Banks are not in the business of managing property and would prefer not to put properties into foreclosure.  They would like to have their loans repaid and have been amenable to reasonable restructuring proposals that provide relief to the borrower and a plan for repayment.

That being said, it is not impossible to get financing right now.  We recently helped a client secure financing for horizontal infrastructure improvements for a mixed-used development in New Jersey.  The project will include retail, commercial, office and industrial space.

We have also seen some joint venture restructuring.  We have a client that formed a joint venture with a residential real estate developer.  Because of the downturn in the residential real estate market, this developer experienced economic distress that put the joint venture's investment in jeopardy.  We assisted our client in buying the residential developer's share of the joint venture so that it could take over the project on its own.

Q: Have you worked on projects lately that the general economic downturn and/or real estate crisis might have created?

A:  Yes.  The restructuring projects that I described earlier are directly attributable to the general economic downturn and the downturn in the real estate market in particular.  If the real estate market were more robust, we would be helping our clients to buy, sell and develop real estate.  Instead we have been helping them to preserve their capital and to manage their near-term loan maturities. 

Our clients have also become more interested in purchasing assets or businesses from bankrupt companies or from companies in financial distress.  Given the current economic environment, some attractive assets are available at deflated prices.  We have some clients that are considering the acquisition of buildings or other real property from distressed companies at favorable prices.  Other clients are considering the purchase of mortgages at a discount, with the expectation that they may be able to convert those mortgages to equity in the future.  If the seller is a bankrupt company, the sale is supervised by the bankruptcy court and we help our clients navigate the bankruptcy process.

More broadly speaking, Davis Polk is doing very well and has taken on a number of engagements that are at the center of the effort to mend the economy and to stem the tide of the financial crisis.  Our financial institutions group, our credit group, and our insolvency and restructuring group are all very busy on high profile matters.  We represent the Federal Reserve Bank of New York and the U.S. Treasury in the financing of AIG.  We represent Freddie Mac in connection with the U.S. government's conservatorship and financial assistance package.  We also represent the NY Federal Reserve Bank in connection with the capital injections that some banks are receiving.  Though these engagements are not being led by the real estate group, we have assisted in some of them.  Davis Polk is doing quite a bit of work that directly stems from the efforts to stabilize the economy.

Q: Given the current economic climate, what is the future of the commercial real estate practice area?

A: The future is good.  Although the economic conditions are challenging, there is still work to be done.  The mix of work may be changing, but there is work.  Our clients still need legal advice even if the focus of their activity has shifted somewhat.  Projects for which development has slowed often have existing businesses in operation.  Our clients need legal advice with respect to these businesses.  They may, for example, need assistance in negotiating a lease or a general commercial contract.

Until the credit markets open up there will be more restructuring work and ongoing maintenance work, but fewer acquisitions and development projects.  Nevertheless the long-term outlook for real estate is good.  Real Estate is not going away as an asset class in which people will want to invest.  Even residential real estate will pick-up.  As the world's population expands, there will be more need for housing.  As the economy picks up, jobs will be created and there will be more need for office space. 

Once the economy recovers, real estate lawyers will be very busy.  In fact, there will be a lot of opportunity when the credit market unlocks and more financing becomes available.  With prices coming down, there will be a lot of good deals to be had.  Many potential investors are sitting on the sidelines at the moment waiting for good deals.

The headlines we have all been reading are extreme, and the economy is experiencing a significant downturn, but there have been other down cycles in the economy since I began practicing, and we have always recovered.  We might see a change in the type of work or a slight slowdown, but the work has always picked up again and usually has been as robust, if not more robust, than it was before the downturn.

Q: How has the economic downturn and real estate crisis affected commercial leasing?

A: The economic downturn has led to some fairly large layoffs, which have in turn led to a decrease in the need for office space.  As consumer spending has slowed, the demand for retail space has also slowed.  There is more commercial space available for lease, and, as a result, rents are coming down. 

Tenants are in a better negotiating position than they were a couple of years ago.  Good tenants with strong credit are able to negotiate better terms on commercial leases now than they could have in recent years when demand for space was higher. 

For example, we recently helped one of our clients secure a lease for approximately 100,000 square feet of space in New York City on Times Square at a rental rate that was 50% lower than it would have been six months ago.  The client had been subleasing space in another building and was able to move to take advantage of the lower rental rates.

Prices are coming down.  When companies like Lehman Brothers go bankrupt, large blocks of space become available.  More space available means falling prices and more choice for tenants.

Q:  As residential real estate foreclosures have increased, has a similar increase of foreclosures in the commercial real estate market also occurred?

A: There have been some commercial mortgage foreclosures reported in the financial press, but commercial mortgage foreclosures have not increased as dramatically as residential mortgage foreclosures.  As I mentioned before, banks are not in the business of managing property.  They would prefer not to acquire property through foreclosure and would rather have their loans repaid.  Borrowers are usually in a better position to manage their properties than banks would be.  Banks are willing to restructure problem loans if they think that the borrowers will eventually be able to repay the loans.

Given the high loan to value ratios of recent years and the current declines in real property values, the real property securing a commercial mortgage may be worth less than the amount of the loan.  In this case, foreclosure is not particularly attractive.  Commercial lenders may use the threat of foreclosure as a bargaining chip in negotiations, but they are usually willing to entertain reasonable restructuring terms.

Q:  How is Davis Polk handling the economic downturn, and what effects will it have on the market in general?

A:  The economic situation is obviously challenging, but we are doing well.  As discussed earlier, we have a lot of work directly related to the economic stabilization measures being taken by the U.S. government, but there is other work as well.   We have a broad and diverse practice.  Although some areas are experiencing a down-cycle, others are busy.  We are not only working on projects related to the financial crisis.  We continue to receive high profile engagements in other areas.  For example, we advised CVS on their purchase of Longs Drugs.

Q:  So, there is M&A work actually going on now?

A:  Absolutely.  In addition to the CVS transaction, we have been representing Roche in its bid for Genentech, and we represented Citibank in its proposed rescue of Wachovia.  Some transactions, like the Citibank transaction, are directly related to the financial crisis, but many others are not.

Q: Is commercial real estate affected by the financial crisis differently in certain geographic locations?

A:  The impact is felt across the country.  We have offices in New York, California and Washington, D.C., but we work on projects all over the country.  When the economic downturn began, cities like Las Vegas and Miami and states like California were hit first by the softening of the real estate market, because prices had increased dramatically in those areas.  But now, things are slowing throughout the country.

Q:  Please describe your restructuring practice.

A:  Davis Polk has an insolvency and restructuring group that handles complex matters for both debtors and creditors.  They also advise on debtor-in-possession financings and the acquisition of distressed companies.  They have taken a lead role in some of the financial crisis related matters that I mentioned earlier, including the government's financing of AIG.

My restructuring work focuses on loans secured by real estate, but I do sometimes work on insolvency issues for real estate companies in distress.  Davis Polk is a collegial place and we often form teams across practice groups.  When we need advice on bankruptcy matters or other complex restructuring issues, we will seek assistance from lawyers in our insolvency and restructuring group.

In essence, restructuring a loan involves amending the terms of the loan in light of changed circumstances.  Each borrower and each loan are different, however, and that is what keeps the work interesting.  Some borrowers might need covenant relief to enable them to manage their businesses effectively.  Some borrowers may need to extend the terms of their loans in light of their inability to refinance.  Some projects may simply not be performing as expected given the current economic downturn, leaving their owners unable to make required interest or principal payments on the indebtedness for those projects. 

We work with our clients and their lenders to develop and document solutions that are acceptable to both of them.

Q:  Do you have final thoughts on today's discussion?

A:  It can be easy to get caught up in the relentless stream of news about the financial crisis on television, in print, and on the radio, but it's important to take that news with a grain of salt.  The economy is in recession, but it will eventually rebound.  There are many people both in government and in private industry working hard to ensure that the economy does rebound.  There will be plenty of opportunity for talented young lawyers in the next few years, and there will certainly be work for talented real estate attorneys.  When the availability of credit returns to normal levels, real estate investment activity will accelerate and so will the demand for legal services.