Boston's Hancock Tower and the coming commercial real estate crisis.

Commentary about business and finance.
Sept. 5 2009 7:37 AM

The Skyscraper That Ate a Billion Dollars

Boston's Hancock Tower and the coming commercial real estate crisis.

Hancock Tower. Click image to expand.
The John Hancock Tower 

For most of its 34-year life, the Hancock Tower, which looms above its brick neighbors in Boston's Back Bay, has been the sort of place where money comes to be managed and protected. Its tenants include Ernst & Young and the investment firm Highfields Capital. The I.M. Pei-designed sliver of glass doesn't seem like a place where several hundred million dollars can vanish in a few months.

But that's exactly what happened at the 62-story building, now under its fourth owner in six years. In January, an aggressive young wheeler-dealer defaulted on a portion of the building's $1.3 billion mortgage just 24 months after buying it. In March, two firms that had purchased chunks of the tower's second mortgage for pennies on the dollar assumed control, essentially rendering up to $400 million of debt worthless. The Hancock's market value is now about $700 million—half what it appraised for less than two years ago.

Scott Lawlor, the entrepreneur who was forced to concede control of the Hancock Tower, could be called a "poster boy for everything that went wrong," as one well-placed real estate expert put it. But the trim, straightforward executive is more like a whipping boy. For the tale of the Hancock Tower isn't a morality play or an example of a bubble-era rise and fall. Rather, it's an omen. During the credit boom, the same forces that led to $600,000 subprime loans on tract houses in Modesto, Calif., spurred billions of dollars of reckless lending on urban office towers and suburban strip malls. As a result, the nation's offices, hotels, and malls now carry about $3.5 trillion in debt. Three years after the housing market peaked, falling rents and rising defaults—no surprise given the economy has lost 7 million jobs since December 2007—are posing a new threat to the still-fragile banking system and could inflict billions of dollars in fresh losses. The Hancock Tower was one of the first high-profile deals to go sour—but it won't be the last. The Blackstone Group, one of the nation's leading private-equity firms, has written down the value of its mammoth real estate portfolio by an average of 45 percent from the original cost. General Growth Properties, a pioneer of the shopping mall that carried $27 billion in debt, filed for Chapter 11 in April.

From its completion in 1975 until 2003, the Hancock Tower was owned by life-insurer John Hancock. In September 2003, local developer Alan Leventhal paid the then-stunning price of $910 million for the Hancock complex, which included two adjacent buildings and a parking garage. While the price was rich, the deal was structured conservatively. Leventhal put down about one-third of the purchase price—$300 million in cash—and borrowed about $620 million, a standard mix for 2003.

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But the climate quickly changed, as the low interest rates and rising prices that fueled the housing boom crossed over into commercial properties. The shadow banking system—unregulated financial institutions like Wall Street banks, hedge funds, and private-equity firms—flooded into the sector. Just as residential mortgages were gathered together, chopped up, and sold to investors, so, too, were commercial mortgages. The easy money allowed investors to buy buildings with less money down—borrowing 80 percent for a first mortgage instead of 65 percent, and perhaps tacking on a second mortgage. Newly minted "opportunity funds" began prowling the landscape for deals; their assets rose from $100 billion in 2004 to nearly $300 billion by mid-2008, according to Townsend Group. One of the newly prominent operators riding the rising debt wave was Scott Lawlor. The Queens, N.Y.-raised son of a cab driver, Lawlor got an MBA from Columbia University in 1993 and worked in the investment industry for several years, including a stint at Fortress Investment Group, a large hedge fund. In 2000, he was a successful, yet anonymous, finance jockey.

That year, Lawlor struck out on his own. His first deal was the 2000 acquisition of a $4.8 million office building in Westchester County, N.Y.—tiny and irrelevant by industry standards. Just as many shows debut in regional theater before moving to Broadway, Lawlor worked in the suburbs before assuming a more prominent role. In 2005 Lawlor formed a fund—Broadway Partners—and began buying larger properties in major cities. Between 2000 and 2007, Lawlor's firm bought $15 billion in real estate, and he began to amass the trappings of a real estate mogul: Lucite tombstones memorializing consummated deals lined shelves in his office in the Seagram Building, the Mies van der Rohe office tower on Park Avenue that is one of Manhattan's original trophy office buildings. Lawlor's deals made money, producing returns of more than 40 percent a year for investors from 2000 to 2007. In 2003, to take one example, Broadway Partners purchased an office building in hedge-fund haven Greenwich, Conn.; brought in tenants at higher rents; and sold it for twice the purchase price in 2006. Such deals led industry veterans to dismiss Lawlor as a flipper.

Everybody was doing it, though. Rising rents alone didn't explain the boom in commercial-real-estate values. In the Alan Greenspan-inspired period of low rates and nonexistent inflation, investors became more willing to accept lower rates of return on all assets, including real estate. Increasingly, owners weren't interested in the rents that buildings would produce. Rather, like those speculating in housing, they'd make their money by flipping the property to a new owner or by refinancing on favorable terms. Between 2005 and 2007, $1.15 trillion in commercial property traded hands. The volume of sales soared from $78 billion in 2001 to $498 billion in 2007. Between 2005 and 2008, nearly three-quarters of San Francisco's top downtown office buildings were bought and sold.

Broadway bid aggressively on many properties. But Lawlor almost always lost out to players with deeper pockets. On one building—350 Park Ave., an office tower that the savvy giant Vornado bought for $542 million in 2006—Lawlor's bid was the lowest.

Even though Broadway Partners was making good money, its founder longed to bag a career-defining, home-run deal.

It would come in December 2006. By then, financing was becoming available for ever-larger leveraged buyouts—$20 billion, $30 billion—and rather than buy individual buildings, investors began scooping up huge collections of properties and swiftly selling off pieces of the deal. In the fall of 2006, Sam Zell, the Chicago-based investor whose reputation would take a nick with his disastrous ownership of the Tribune Co., agreed to sell his collection of 543 buildings to the Blackstone Group for $39 billion, including the value of assumed debt. Blackstone began flipping the properties immediately.

Broadway Partners sought to pull off a similar feat—buying a portfolio wholesale and selling it into a hot retail market—by agreeing to pay $3.3 billion for nine properties offered by Beacon Properties, including the Hancock Tower. Lawlor immediately sold three of the buildings for a profit of $180 million and took possession of six properties valued at $2.5 billion. By the time Lawlor became its owner, the Hancock Tower was effectively saddled with two mortgages totaling $1.36 billion.

Lawlor rejected several unsolicited offers for the remaining buildings, figuring he could either sell at higher prices down the road, or do better by managing the properties and raising rents. The office markets in downtown cities were white hot, and Lawlor believed the Hancock Tower's top floors could command rents of $70 per square foot, up from the $50 or so paid by existing tenants. The price hikes would help generate enough cash to pay off—or refinance—the second mortgage, known as a mezzanine loan, when it came due in January 2009.

Throughout 2007, as subprime lenders failed and housing tanked, commercial real estate held up remarkably well. In the summer of 2007, Broadway was negotiating with a blue-chip Wall Street firm to sell a huge chunk of its holdings in a deal that would have valued the Hancock Tower at $1.7 billion and given Broadway Partners a profit of several hundred million dollars. But in late July, when credit markets seized up in the wake of subprime losses, the buyer disappeared. And then a strange thing happened. Throughout 2007 and most of 2008, as job losses mounted and the world's financial house of cards crumbled, commercial real estate hung in there. "The commercial property market is a lagging indicator," said Jim Costello, principal with Torto Wheaton Research, based in Boston. That's because companies tend to lay off employees only after suffering a few quarters of losses, and it takes them even longer to cut back on their office space.

Over the course of 2008, however, the three interlocking forces that drove real estate prices up—cheap credit, strong fundamentals, and exuberant sentiment—weakened. The tipping point came in September 2008 with the failure of Lehman Bros. Lehman had been both a prolific lender to and purchaser of commercial real estate, with some $43 billion of real estate assets on its books. With Lehman gone and banks in free-fall, the commercial market collapsed. Tenants began to expect lower rents. Lenders and investors began to expect lower prices and to demand tougher credit terms. Instantly, the investment thesis behind so many bubble-era deals changed. And the financial-services companies that had been the mainstay of Boston's—and the nation's—high-end office market began to contract. The advertising agency Hill Holliday, balking at higher rents, had vacated its four floors at the Hancock Tower in March 2008.

Pivoting quickly from an offensive to a defensive posture, Broadway Partners began to market other buildings in its portfolio, aiming to raise money to pay off the $733 million mezzanine loan tied to the Hancock Tower that would come due in January 2009. The Hancock Tower had been appraised at $1.4 billion in June 2008, but now prices were falling. "Since September 2008, sales prices of office buildings fell at least 30 percent," said John Powers of CB Richard Ellis. And there were no buyers. According to research outfit Real Capital Analytics, commercial property sales slumped to $9.8 billion in the first quarter of 2009, from $120 billion in the fourth quarter of 2007.

As prices fell, two investors—Normandy Real Estate Partners, a New Jersey-based landlord, and Connecticut-based Five Mile Capital—began buying up chunks of the Hancock mezzanine loan, at a sharp discount, eventually amassing enough to put them in the driver's seat if Broadway were to default. In January 2009, with the loan balance paid down to $525 million, Broadway Partners defaulted.

On the morning of March 31, a few dozen people showed up at an anti-climactic foreclosure auction staged in a large conference room at the New York law firm Skadden, Arps, Slate, Meagher & Flom. While several parties had expressed an interest in the Hancock Tower, only a single bid was offered—by Normandy and Five Mile. The new owners formally took control of the property, largely by agreeing to assume the existing mortgage. People familiar with the situation believe that somewhere between $350 million and $400 million of the building's debt was written off. By this spring, the building's market value had fallen to about $700 million, losing about half its value in a year.

The saga of the Hancock Tower may seem like a classic case of the difference between genius and idiocy being a matter of luck and timing when you're using lots of debt. Highly leveraged bull-market traders always get caught out when there's a swift correction. But among property magnates, Lawlor was merely the first—and he wasn't doing anything the lions of the industry weren't. Goldman Sachs, long considered the sharpest operator on Wall Street, has taken big losses in its real estate-heavy Whitehall Funds. Macroeconomic changes have upset the thesis of pretty much every purchaser of office space in the last few years. In June, according to CB Richard Ellis, the average asking rent in Midtown Manhattan was off 30 percent from a year earlier—to $60.45 per square foot from $86.57. With job losses continuing, nearly 15 percent of the nation's offices are vacant today, and Jim Costello of Torto Research believes the vacancy rate will rise to nearly 20 percent through 2011—the highest level since 1991, "Even when we start to get some job growth, occupancy levels won't pick up right away."

All of which means more building owners will face the same dilemma that Broadway Partners did earlier this year. In the next few years, nearly $1 trillion in acquisitions concluded between 2005 and 2007, mostly with short-term debt, will have to be refinanced. But owners won't be able to refinance or flip their way out of trouble. The nation's banks, for their part, have about $1.5 trillion of commercial real estate loans on their books. According to the Federal Deposit Insurance Corp., whose troubled bank list has expanded to 416 from 90 in March 2008, the value of real estate loans on which borrowers were more than 90 days or more past due spiked to $67.3 billion in the first quarter of 2009 from about $13 billion in the second quarter of 2007. In the coming months, the recovering banking industry will probably report billions of dollars in losses tied to commercial real estate loans. In the case of the Hancock Tower, the damage has already been done. Investors have written down the value of their holdings, and Scott Lawlor has shored up his operations. In July, he reached an agreement with lenders to cede control of a portion of Broadway Partners' remaining office buildings in exchange for restructuring debt. In Boston, the new owners are seeking tenants to occupy the Hancock Tower's eight empty floors.

This spring Michael Loughlin, the new manager, was learning his way around the building, He led a visitor past the coffee station near the entrance, through the marble lobby, and up to the vacant 39th floor. Free of desks, cubicles, and partitions, the floor offers stunning 360-degree views of Boston Harbor to the east and the State House and Beacon Hill to the northeast. "There's the Citgo sign," Loughlin noted reverentially, pointing to the billboard that looms over Fenway Park. Without tenants to block the sightlines, the views are priceless. Visitors could be enjoying these vistas for some time.

Newsweek's Stuart Johnson contributed to the reporting for this story, which also appears in this week's issue of Newsweek.

Daniel Gross is a longtime Slate contributor. His most recent book is Better, Stronger, Faster. Follow him on Twitter.

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