Real estate blues? Featured

8:00pm EDT July 26, 2007

Real estate, to a large extent, drives Orange County’s economy. It is our biggest and most valuable commodity, and it affects local businesses on many levels.

So it is not good news that real-estate-related bankruptcies have recently surged — especially among mortgage lenders who specialize in the sub-prime market.

“There is more fallout from what is happening in the real estate market every day, and it seems to be spreading through the local business landscape,” says James Bastian, partner and head of Insolvency and Reorganization Practice at Shulman Hodges & Bastian LLP.

Smart Business spoke to Bastian about what business management should do to cope with the prevailing Orange County real estate downturn.

Please explain in detail the current Orange County real estate market.

For several years, the real estate market here was booming, due in large part to the sub-prime lending market. Many people qualified for loans that were based on the value — or perceived value — of the real estate, rather than on the borrower’s ability to repay.

With property values escalating so fast, lending practices got more and more aggressive. Lenders avoided many of the normal underwriting procedures, like verifying the borrower’s income or scrutinizing tax returns. They could — and did — charge higher-than-prime interest rates. Anybody with a pulse was getting a huge mortgage, and it was sometimes even more than the value of the home.

The local real estate market, fueled at least in part by these kinds of loans, surged. Big and small mortgage companies grew. Financial institutions then paid large premiums for the loans they originated, and many people got wealthy. Everybody was happy. The brokers were getting their cut, and the banks were getting their cut.

But many homeowners soon found that they could not afford the monthly payments. When they started defaulting — sometimes in the first month — the big banks got nervous. What you have been seeing in the last several months is that the funding sources, called warehouse lenders, are demanding to be repaid from the mortgage companies, who have responded by cutting staff, shutting down or filing for bankruptcy.

The whole market was destined to eventually unravel because the loans should not have been issued in the first place. If a prospective borrower could not make the payment, he or she should not have been given a huge mortgage.

So the once-robust mortgage business in Orange County now appears to be dying. The market is tapped out. Executives are being laid off, as are loan processors, appraisers, title people — anybody associated with the chain of documenting a mortgage. As a consequence, these businesses do not need as much office space, so the commercial real estate market will suffer as well. It is a domino effect, and the first dominoes have fallen.

Why are businesses that are not related to real estate so concerned?

Anybody who watches Orange County business should be concerned. When you have a large segment of the local economy that is very frenzied and that business starts to go away, the region’s economy will be negatively affected.

Executives should be concerned because, on a personal level, their home values are going down. Their employees’ home values are going down. If their employees face foreclosure or have to go into bankruptcy, there may be potential distractions. It is all linked.

How should business executives react?

Businesses that are thinking about relocating or acquiring more commercial space should watch and wait. There might be space becoming available and deals to be had for space that was occupied by a player in the mortgage arena. In the near future, there might be opportunities to purchase commercial real estate in a somewhat distressed environment.

Right now, executives need to be concerned and sensitive to employees who may be suffering financial hardships. They need to understand the issue and figure out the impact on their business, if there is any. The problem can potentially affect virtually anyone, including friends, neighbors and colleagues.

Sure, opportunities can be found in a downturn, like purchasing investment property or a new house at lower prices. But because there is a lot happening on the national level — the war, a presidential election — I would be careful about making any immediate decisions that have an impact on your financial well-being.

This could be the beginning of a significant downturn in our local economy or just a cooling-off period, but one thing is obvious: There is more real estate development — both commercial and residential — being undertaken on a strictly speculative basis than any other time since the late ’80s and early ’90s. This may be history repeating itself or just an opportunity to enter the market before it takes off again. Either way, we are living in an interesting time.

Executives have to devise an effective strategy for protecting themselves while capitalizing on this situation. It is always easy to play Monday morning quarterback, but the focus must be on being proactive and either avoiding a problem or taking advantage of an opportunity.

JAMES BASTIAN is a named partner and head of Insolvency and Reorganization Practice at Shulman Hodges & Bastian LLP. Reach him at jbastian@shbllp.com.