Cautionary Tale

Wall Street Journal

Small Investors Lost It All in Memphis

By LINGLING WEI

The commercial real-estate mess is clobbering lots of investors. Few of them are reeling as much as the 27 owners of 1023 Cherry Road in Memphis, Tenn.

The office complex about five miles east of downtown tumbled into foreclosure last fall because the owners couldn't refinance the $14 million loan used to buy the two glass-and-steel buildings in 2004. They also lost all $7.1 million they invested.

Cherry Road's collapse is an ominous sign for thousands of other commercial real-estate deals in which mom-and-pop investors pooled their money to get a tiny piece of the action. As unemployment and fallout from the credit crunch fuel rising vacancies and declining rents, a growing number of small investors are getting wiped out.

"We ended up all losing collectively $7 million of lifetime savings," says Lynn Rogoff, a New York artist who put $213,000 into the Cherry Road deal. Individual losses range from about $100,000 to $700,000, according to Cherry Road investors.

Many such deals were structured as so-called "tenant-in-common" ventures, known by the acronym TIC. Often, the TICs took out commercial mortgages that were packaged into commercial-mortgage-backed securities.

"Now, they're starting to experience problems on the property levels," says Marc Perusse, principal at RSS Advisors, a Denver firm that works with troubled TIC investors. "With the majority of TIC investments being syndicated from 2005 to 2007, the future of many of these assets is extremely bleak."

CMBS delinquencies climbed to about 6.5% this month, an all-time high, according to Trepp, a New York company that tracks the commercial property market. More trouble is looming for small-time property owners because much of the $223 billion of CMBS debt coming due between now and 2013 is in the form of mortgages of less than $50 million.

TICs surged in popularity after the Internal Revenue Service said in 2002 that they could be used by investors to defer capital-gains taxes from the sale of "like kind" properties. More than $14 billion in TIC equity is outstanding, according to Omni Real Estate Services, a TIC brokerage and research firm in Salt Lake City. Unlike deals where large developers overloaded acquisitions with debt, many of the mom-and-pop deals were conservatively underwritten. For example, the Cherry Road group put up a third of the purchase price in equity, and the buildings generated more than enough cash to service the debt.

If the $14 million mortgage had been held by a bank, it might have been refinanced or modified because the owners were current on their payments when it came due.

But the Cherry Road loan, made by KeyCorp, was sold off as CMBS to investors by Merrill Lynch & Co., now part of Bank of America Corp. When the loan matured in April, the owners couldn't refinance the debt, since the CMBS market has essentially been shut down for more than a year. The owners also reached out to about 40 banks, but were rejected by all of them because the property's value had declined.

One problem: The lone tenant, Harrah's Entertainment Inc., moved its back-office operations out of Cherry Road even though its two leases are in effect until 2012 and 2017 and the company has continued to pay rent. The move by the tenant has caused a significant drop in the property's value.

Cherry Road property's manager, TIC Properties Management LLC, contacted the "master servicer" about a loan extension, according to Paul Aiesi, the company's chief investment officer. But the servicer, KeyCorp, was only in charge of passing along interest payments to the CMBS investors every month. According to CMBS rules, a master servicer has no power to modify loans before they go into default. A KeyCorp representative declined to comment.

After the mortgage wasn't paid off when it came due in April 2009, it was transferred to a specialist in troubled loans.

"We put some strong proposals in front of the special servicer, but they showed very little willingness to negotiate at all and seemed content to foreclose and keep the property" in its real-estate-owned portfolio, Mr. Aiesi says.

A spokeswoman at the servicer, ING Clarion, declined to comment.

Mr. Aiesi says the servicer offered to extend the loan if the investors would contribute another $2 million in equity. He recommended against that move.

"The property is worth significantly less than the debt on it," he explains.

Cherry Road investors say they are innocent bystanders who are paying a painful price for the credit crunch.

"We're not going out to fancy dinners and we're not taking vacations or major trips," says Steve Harris, a retired television-advertising executive who lives in Valley Center, Calif. He declined to say how much he invested in the Cherry Road building.