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We know housing is a mess, but commercial property has been the quieter side to the real estate disaster. All across the country, pension funds invested heavily in office buildings and malls and warehouses, frequently through private-equity "opportunity funds" that employed high levels of leverage. They buy on 70% to 90% borrowed money. So with just a modest drop in values, these investments can crater. Collectively, the opportunity funds have around $200 billion in equity. How much of that is gone?
Many analysts suspect prices are down about 15% to 25% from last year. REITs, which hold another $300 billion in equity but use just 50% leverage, have already "priced in" a solid drop in values. They're down 25% from their high last year. So are the pension funds sitting on $100 billion in losses?
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The opportunity funds haven't come clean. The problem with big private funds is that so much depends on what the managers tell you. And managers are notoriously self-serving fellows.
That brings us back to Lehman. Its critics argued that its managers were taking an overly charitable view of their assets. That's what landed them where they are now. And it’s why we may all benefit from its liquidation, either in part or as a whole.
Lehman bought $12.5 billion of commercial property in 2007, more than doubling its holdings. But it refused to mark down its investments much, even though it purchased them at peak prices on high leverage. That didn't seem right.
One of its more troubling deals was struck in May 2007, when the bank agreed to put up $2.2 billion in equity plus provide debt for the purchase of a real-estate investment trust, Denver apartment landlord Archstone Communities, for $22.2 billion.
The premium Lehman agreed to, a price 18% over Archstone's closing price the previous day, ballooned to around 30% over fair market value by the time the deal neared its closing date in October. Even though Lehman had co-investors, the purchase was 75% leveraged. So didn't that mean that marked to market, the buyers were facing a total washout? Instead of paying the walk-away fee and dropping the deal, Lehman went ahead with the deal. Apartment REIT stocks have fallen even further since last October. Yet Lehman only marked its $2.2 billion stake down by 25% this past spring.
Lehman hasn't explained why it didn't write off the Archstone stake entirely. Did it sell off a few Archstone assets in the private market and were those prices used to justify its lofty value of its stake in Archstone? Had it received offers to buy the company from other private buyers? What did the bank's managers know that the rest of Wall Street didn't?
This is exactly the kind of mystery that doesn't go over well in the current environment on Wall Street. Now Lehman seems likely to bring the mystery to an end. Painfully, but quickly.
Suppose Lehman’s properties sell for rock-bottom prices, leading to massive write-offs at other investment banks and funds. Would we be better off not knowing? Japanese banks played that game for a long stretch in the 1990s. They refused to write down or unload the foolishly expensive investments they made in U.S. properties. They ended up fighting deflation and watching their stocks fall for well more than a decade.
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