The $3.5 Trillion RE Collapse

The $3.5 Trillion RE Collapse NEW YORK, NY - Losses at the police and firefighters' pension fund have thrown this Ozark city into its worst budget crisis in decades. The city wants to slash spending on health care, parks and roads. Skunk trapping may have to go, too. One of the pension fund's problems: It's an investor in a $1.1 billion speculative office skyscraper rising in New York's Times Square in the middle of a commercial-property bust.

That folks in places like Springfield wound up owning a piece of one of the biggest real-estate gambles in America is indicative of how widely today's commercial-property collapse has spread. Some in the industry believe the damage will be deeper than the previous crash of the early 1990s.

The sector's woes are considered a major threat to economic recovery. There is some $3.5 trillion in commercial-real-estate debt outstanding - more than the amount for auto loans, credit cards and student loans combined. And the default rate is rising sharply.

Over the past decade, Wall Street unleashed a wave of "securitized" commercial-real-estate debt, just as it did in residential mortgages. Some $700 billion worth of commercial-real-estate mortgages were sliced up, packaged into securities and sold to a wide range of investors - meaning that this time, the pain will be felt by many more players beyond banks and thrifts.

Pension funds, foundations and college endowments became more active players in real estate. Real estate as a percentage of the average portfolio for such institutions doubled in the past 10 years to close to 11%, according to Institutional Real Estate Inc. and Kingsley Associates, two real-estate consulting companies. Between 2000 and 2007, these institutions sank more than $355 billion into real estate.

Some pension plans bought real estate directly. Others invested through funds managed by Wall Street firms and insurance companies such as Prudential Financial Inc.

The police and firefighters of Springfield are one of 272 pension funds, foundations and endowments that invested in a pooled real-estate fund managed by Prudential Real Estate Investors, a unit of Prudential. The insurance giant's fund is the major backer of a Manhattan office building called 11 Times Square. That building is the largest of $2.6 billion in commercial projects across the U.S. that the Prudential fund has committed to pay for over the next three years.

In May 2007, Prudential predicted average rents of $110 a square foot for the 1.1-million-square-foot Times Square edifice, and that it would be fully leased by June 2011, according to documents reviewed by The Wall Street Journal. By October 2008, Prudential was saying the building wouldn't be fully leased until June 2012 and would garner rent of $99 a square foot. The New York office market has fallen since then; rents in 11 Times Square's neighborhood were about $69 a square foot in the first quarter of this year, down nearly 9% from $76 a year earlier, according to research firm Reis Inc.

A pension fund in Springfield, Mo., with an investment in New York City real estate has suffered so severely that the city is considering service cutbacks. WSJ's Anton Troianovski reports.

"Given the deterioration in the midtown Manhattan office market, the financial performance of 11 Times Square will not be what we expected," said Kevin R. Smith, who manages the Prudential fund, known as PRISA, in a statement. "We continue to believe tenants will demand state-of-the-art office space, so we are confident the property is a good investment for PRISA over the long term."

Losses for many such funds are now mounting. Some, including more highly leveraged funds run by Goldman Sachs Group Inc. and Morgan Stanley, have written down more than half their equity value.

Prudential has marked down the $12.4 billion fund backing 11 Times Square by 32% from one year ago. Fund managers are telling investors to expect as much as 20% in further write-downs this year, according to documents reviewed by the Journal. Investors have lined up to take $1.5 billion out of the fund, but Prudential has stopped funding redemption requests, according to fund documents.

Comparable funds have been written down 27% for the past year, according to the National Council of Real Estate Investment Fiduciaries, an institutional real-estate-investment trade group, and many have also stopped funding redemptions.

"We wanted a small portion of our portfolio in real estate, but we also wanted something that was as safe as possible in terms of the investment risk," says Evelyn Honea, president of the Springfield pension board, explaining its January 2007 decision to invest with Prudential.

Ms. Honea says the investment is a long-term one. "Would they have invested in a building of that size in New York if they had seen this coming? Probably not," she says of 11 Times Square. "But hindsight's 20-20 vision, unfortunately."

Steven Pozycki, the New Jersey developer of 11 Times Square, limited his own risk in the project: PRISA provided nearly all of the equity. He had reason to be cautious. Mr. Pozycki says he put up millions of dollars of his own money after one of his speculative real-estate projects soured in the 1990s recession, though eventually the building was leased and delivered a profit.

"Every day I learn something about how to position ourselves and not take a risk," he says.

Prudential had tried development in Times Square before. Two decades ago, the Newark, N.J., company spent hundreds of millions of dollars of its own on an ill-fated effort to redevelop Times Square, then a seedy area of peep shows and vacant buildings. By the mid-1990s, with office towers still on the drawing board after recession and legal battles, Prudential started selling off its sites, some at big discounts. At the time, Prudential was selling much of the real estate on its balance sheet to reduce risk.

But years later, as Times Square became a thriving business center, Prudential executives who managed PRISA saw an opportunity. To boost returns and put to work money that pension funds were depositing at record levels, PRISA was funding an increasing amount of development. During the boom years, developments helped PRISA scoop up investments and fees. In 2005, PRISA's annual return was close to 25%. The next year, investors deposited $2.5 billion into the fund. Last year, when PRISA posted a 13% loss, the fund generated $89 million in management fees for Prudential, according to fund documents.

To sign up new investors, PRISA executives made calls on places such as Springfield, a city of about 150,000. In 2007, at a fire station community room known locally as an affordable venue for birthday parties, the Prudential managers handed out a brochure saying they would aim to put more vacant space on the market, allowing them to "increase income as the economy strengthens and market rents rise." The brochure said PRISA consistently outperformed the overall commercial-real-estate market, with a return of 19% in the year that ended Sept. 30, 2006.

The Springfield fund's board members in attendance - one policeman, two firemen, one retired fireman, three citizens and two City Hall officials - were generally impressed, meeting minutes show. Ron Hoffman, the retiree, noted Prudential's decades of experience: "The more history you have, the smarter you are going to be," he said, according to the minutes. By a vote of 6-2, with one not voting, the board chose to invest its entire real-estate allocation - $12 million - with Prudential.

The long-underfunded pension fund was under pressure to boost returns at the time, Ms. Honea says. To avoid asking taxpayers for a greater contribution, actuaries were telling City Hall it had to boost the annual rate of return on the fund's investments to 7.5% from about 5% to meet future obligations to retirees. Real estate seemed to be an answer. [commercial real estate debt]

With bigger pools of money from clients seeking to invest, Prudential needed bigger deals. To do this, the insurer stuck with a partner it knew well: Mr. Pozycki, whose development firm, SJP Properties, had been doing deals with Prudential since 1996. Most of those were suburban office buildings. But in 2005, Prudential said it was interested in a Manhattan office tower.

Soon, Mr. Pozycki approached Howard Milstein, a New York billionaire whose family controlled Emigrant Savings Bank - and the last open plot of land in Times Square. The Milsteins had owned the site on 42nd Street and Eighth Avenue since 1983, when they bought it for $5 million and planned to develop it. They had broken ground for a 35-story tower on the site in 2002, but never built anything.

At a meeting in his Madison Avenue office, Mr. Milstein said he was willing to consider Mr. Pozycki's offer for the site, but required a $50 million nonrefundable deposit, according to Mr. Pozycki. Mr. Pozycki and Prudential came up with the money. In May 2006, the $332 million deal was done.

Mr. Pozycki would get the recognition of developing a New York skyscraper - and developers' fees - in exchange for putting up 4% of the equity in the project, roughly $15 million, according to a December credit report on PRISA by the Standard & Poor's rating agency. Mr. Pozycki confirms the $15 million number, but says his exposure in the deal is bigger than that because he guarantees the building's budget, among other things.

Success depended on the continued strength of the Manhattan real-estate market, which at the time was on a tear. Between 2004 and 2007, Manhattan rents rose 36% to $56.33 a square foot, according to research firm Reis. Prudential and Mr. Pozycki banked on this continuing.

"The attractiveness of the investment had to do with what at the time was a very tight and quickly improving office-rental market in Midtown," Mr. Smith, the PRISA portfolio manager, said in an interview.

Just as the building's sloping facade rose into the Midtown skyline, the market reversed. Reis now predicts that rents in the neighborhood of 11 Times Square will fall to about $64 a square foot by the end of this year, from a high of $76 in early 2008.

Struggling banks and other companies have put huge blocks of space on the market in Manhattan's most desirable neighborhoods, to the east of Times Square or closer to Central Park. Mr. Pozycki's building is a block west of the center of Times Square, across the street from the city's huge Port Authority Bus Terminal.

Eleven Times Square hasn't landed a tenant yet. Mr. Pozycki's broker, Stephen Siegel of commercial brokerage CB Richard Ellis Group Inc., says there's a 60% to 70% chance the building will have at least one tenant by the time it's finished around the end of this year. "Luck has a lot to do with it," he says. SJP and PRISA executives say they're optimistic the development will be successful and say that as one of Manhattan's few speculative office buildings, it will be well positioned if the economy bounces back soon.

So far, Prudential has written down the value of 11 Times Square to 20% less than the building's cost, fund documents show.

In Springfield, meanwhile, the pension fund's market value was down to $91 million at the end of March, from $131 million a year before. Nearly 10% of that was tied up with PRISA.

The fund's board in December applied to withdraw $5 million, but it may not get the money for years because of PRISA's freeze on redemption requests.

A referendum in Springfield for a sales-tax increase to keep the pension fund afloat failed in February, forcing cuts in the city budget. A proposed budget would reduce how often park lawns are mowed and roads are maintained. It would eliminate the city's summer concert series, its multifamily-housing inspections and a service to trap skunks and feral cats.

Mr. Hoffman, the retired fireman, says when PRISA managers visited Springfield about a month ago, they "didn't try to paint some kind of rosy picture." He says, "We were pretty comfortable with them, as comfortable as we could have been with any commercial real estate right now."

"No one - again, no one - could have anticipated what happened in the economy as quickly as it happened," said Mr. Siegel, Mr. Pozycki's broker. "That's where the expression caveat emptor came from - let the buyer beware."
Source: Wall Street Journal

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