Lehman: Real estate’s day of reckoning

A decade after the largest financial bankruptcy in US history, the private real estate industry has been reshaped by tough lessons learnt. In this first of a series of features, we examine the impact of the collapse of Lehman Brothers on global real estate.

Few recent financial events are considered as singular as Lehman Brothers Holdings’ bankruptcy filing on 15 September, 2008. The largest financial bankruptcy in US history was named by the US Fiduciary Deposit Insurance Corporation as “one of the signal events of the financial crisis”.

But while the impact of Lehman’s demise was far-reaching, it was particularly acute in private real estate, where, until 2007, the bank had been considered “the bluest of blue-chip places”, according to one industry observer.

Many executives in the sector vividly recall the chaotic days immediately after Lehman’s collapse – and the painful months that followed.

“When they filed, the world stopped,” recalls Alan Kava, co-head of real estate at Goldman Sachs’ merchant banking division. Kava, who was then chief financial officer of Goldman’s Whitehall real estate funds, was called in from a weekend in the Hamptons to help assess Lehman’s portfolio as Goldman and other banks participated in an emergency effort by the federal government to orchestrate a private sale of the bank. The effort failed. Lehman filed that Monday morning.

The value of global real estate fell by $605 billion in the 15 months following Lehman’s collapse, according to an estimate from commercial real estate services firm CBRE.

Kava: wrote down RE portfolio significantly

“We all thought there would be a day of reckoning,” says Kava. “I think pretty much everybody in the industry, when they got themselves off the floor and came to their senses, were all thinking, ‘we need to start addressing the problems sooner rather than later’.”

Immediately after the filing, Goldman wrote down its real estate portfolio significantly, reporting losses from real estate principal investments totalling $2.1 billion from the fourth quarter of 2008 to the second quarter of 2009, according to the firm’s earnings reports at the time. At its worst, the firm’s last opportunistic real estate fund, Whitehall 2007, was understood to have been marked down to 19 cents on the dollar.

“Obviously it turned out we bought at the high point of the cycle,” Kava says. “We had a lot of leverage, and we knew, quite frankly, our assets were worth less than our debt balances.”

Over in Sacramento, Mike DiRe, director of real estate at the California State Teachers’ Retirement System, watched with his public equities colleagues as stock markets plummeted – the Dow dropped more 500 points on 15 September alone – discussing with them what to do next.

“The immediate effect that we felt was the lack of credit in the marketplace,” he recalls. “If you were in the process of refinancing or needing capital in any way, whether it be equity or debt, those markets dried up fairly quickly.”

At the time, CalSTRS’ holdings were more than 50 percent public equities and approximately 20 percent fixed income, which took a hit in the stock market crash and led the valuation of the overall portfolio to drop significantly. The pension fund’s property portfolio fell by 40 percent over the next 12 to 18 months.

DiRe: saw credit markets dry up quickly

Against this backdrop, “hard choices had to be made with our available limited capital”, he says. “We were forced to stop, or eliminate, some development transactions, including letting assets go back to the banks.”

Those with the capability, however, strived to hold on to their assets. After writing down its property holdings, Goldman restructured the debt on each of its real estate investments to extend their maturity dates. “We needed more time,” says Kava. “If maturity was a year out, we needed another four or five years. The only way we thought we would recover was by having more time for the market to come back.” Whitehall 2007 is now understood to be on track to recover 75 to 80 cents on the dollar.

“In the confusion that often accompanies this type of situation, it really becomes important to take a deep breath and try to see your way clear,” says Jerry Pietroforte, who served as Lehman’s co-head of real estate during its first year of bankruptcy, as part of a team at turnaround management firm Alvarez and Marsal.

Charged with winding down Lehman Brothers’ property portfolio and maximising the value of the underlying assets and interests, Pietroforte says his team followed the advice he received during a similar market crash in the 1980s: don’t sell any assets for at least six months to see if the markets would recover.

“During the first six months after the bankruptcy, we didn’t experience a complete recovery, but I believe that close to half of the total value of the portfolio was regained,” he says. “That near-term recovery makes a strong statement about the gradual improvement of markets during that time and about the emotional factor within markets to overreact to bad news, particularly severely bad news.”

Shadow of their former selves

A decade later, the longer-term effects of Lehman’s collapse can be seen everywhere in private real estate. Chief among them is the impact on bank-sponsored real estate platforms, powerhouses in the industry prior to the financial crisis.

Indeed, in our sister publication PERE’s inaugural PERE 30 ranking in 2008, five of the largest firms by equity raised over a five-year period were banks. Three were in the top 10: Morgan Stanley Real Estate Investing at two, Goldman Sachs Real Estate Principal Investment Area at four, and Lehman Brothers Real Estate at six.

In contrast, just one bank-sponsored platform made the cut in this year’s PERE 50 ranking: MSREI, now coming in at 20.

One key reason for the banks’ diminished presence was the resultant introduction of the Volcker Rule of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It required banks to put a higher risk rating on real estate debt and equity and thus retain greater capital to support investments, which reduced the profitability of allocating capital to the sector.

“The aftermath of the GFC and Volcker rule is, for a lot of the big players, like Lehman, Citi, Goldman, Deutsche, they’re either no longer around or more modest in terms of their involvement,” says Joseph Azrack, who led Citi Property Investors, the real estate arm of Citigroup, from 2004 to 2008. “Those guys, with very few exceptions, are a shadow of their former selves.”

Some bank-sponsored real estate investment platforms have gone entirely. The platform of Merrill Lynch was wound down following the 2010 sale of the company to Bank of America, which responded to the crisis and ensuing regulation by opting out of the market completely. Citigroup sold Citi Property Investors to Apollo Global Management in 2010, although it continues to have a small presence in the sector today.

The bank-sponsored platforms that continued to do business, such as Goldman Sachs and Morgan Stanley, meanwhile underwent a challenging transition period.

“Ultimately, if you look at how banks changed for those who stayed investing, it was a sobering period,” says one former executive at a bank-sponsored real estate business. In addition to their capital becoming more expensive to invest, banks’ property platforms also suffered from an exodus of talent – which became less well-compensated post-crisis – and investors’ anger and distrust, he said.

MSREI grappled with both the poor performance of its largest opportunistic real estate fund, the $8 billion Morgan Stanley Real Estate Fund VI Global, as well as turnover among its senior executives. The firm raised just $4.7 billion for the successor vehicle, G7, and ultimately returned $700 million in commitments to investors. MSREI went on to amass $1.7 billion for G8 and $2.7 billion for G9 – a far cry from the mammoth G6, but still sizable enough to remain a relevant force in private real estate.

Meanwhile, Goldman Sachs, no stranger to a poorly performing 2007-vintage fund itself, shifted to investing in property using the bank’s balance-sheet capital rather than through funds. Today, it raises and invests third-party capital through its real estate debt funds platform. It closed on $4.2 billion in equity for its latest of these, Broad Street Real Estate Credit Partners III, in January. The fund is Goldman’s second-largest property vehicle to date after the $4.8 billion Whitehall 2007.

Lessons learnt

Across the industry, many institutions have dramatically changed the way they invest, particularly in terms of leverage and risk.

Goldman, for example, used 80 to 85 percent leverage on its property deals prior to 2008. Today, that leverage is 35 to 40 percent for its overall real estate portfolio; half of its holdings – its European investments – are not levered at all, given the firm’s cost of funding in the region is cheaper than securing debt from external sources, according to Kava. “Our equity business is on the balance sheet of Goldman Sachs. As such we don’t have to do deals to try to generate 15 to 18 percent returns that investors would demand.”

Meanwhile, CalSTRS learnt the hard way about the consequences of assuming too much risk. “We put too much risk in striving for opportunistic returns,” DiRe reflects. “We had very good success right up until the crisis, of getting amazing alpha on the real estate portfolio, meaning we were getting roughly 15 to 20 percent returns annually. Everyone started to believe that was what real estate was supposed to do.”

To achieve its outsized returns, CalSTRS was taking on both real estate risk, in the form of development and lease-up strategies, and financial risk, meaning higher leverage. “When the crisis hit, we all had a kind of wake-up call. Oh, there’s another side of this coin,” DiRe says.

Like many investors, CalSTRS dialled down its risk exposure after the crisis, targeting lower-risk core to be 60 percent of its portfolio, while lowering its opportunistic target from 50 percent to 20 percent. “We worked with our board to have the real estate portfolio emphasise its income component, which is typically 4 to 5 percent on core assets,” DiRe says. “The net effect was that real estate no longer would be seen as a big alpha producer, like private equity.”

Similarly, portfolio risk management became commonplace after the GFC, added Edgar Alvarado, formerly Allstate Investments’ group head of real estate equity and now an independent advisor. “We started to look at risk correlation across asset classes, not only counterparty risk but structural risk,” he says. “There were hidden risks in the portfolio that people hadn’t looked for or even expected to find.”

To lower risk, investors also began shifting to fewer managers after the crisis. “I don’t think people were really sensitive to the fact that investors had as many as 100 or more managers in alternatives alone, let alone across the entire portfolio, until we were in the downturn,” remembers Alvarado. “With so many managers, it becomes virtually impossible to identify the underlying risk characteristics across so many platforms and strategies.”

Changes for investors

But the changes investors made post-Lehman extended beyond risk reduction; equally notable was the push for more control of capital. “When the tide went out, it became very clear the disadvantages the fund model had,” says Alvarado. “Institutions discovered that in the fund model, that’s it, you’re along for the ride.”

Many institutions committed to opportunistic closed-end funds from 2005 to 2007 but found the funds’ strategies often no longer made sense in a post-crash environment. They had little or no rights to recall capital or control asset sales, DiRe recounts: “LPs tried to work together to convince GPs to stop or delay investing, with little success.”

Investors also began to increasingly scrutinise fees post-Lehman, when returns suffered but the same fees were being paid to managers. “When things were going great in the early 2000s and fund managers were returning target returns, that wasn’t too bad, we were all making money,” Alvarado says. “But during the downturn, fee structures didn’t change much. So, when you’re barely making your preferred return, the fee drag, all of a sudden that’s huge. I’m feeling the pain, but they’re not.”

He adds: “Alignment of interest in closed-end funds fell apart during the GFC. When you factor in control of capital, investment pace, lower fees, economies of scale, risk transparency and reporting; all those factors in combination contributed significantly to the emergence of more direct strategies, like joint ventures, separate accounts and co-investments.”

Even non-fund investors in real estate found themselves stuck during the crisis and likewise changed tack. Bayerische Versorgungskammer, Germany’s largest pension fund, bought an office building in Paris in 2002, and had planned to convert the property from a single-tenant use to a multi-tenant use. “It took us five years longer to execute the business plan than we originally thought,” says Rainer Komenda, head of real estate investment global at BVK. “The recovery of the greater area of Paris was super slow after Lehman.”

Post-Lehman, BVK was more sensitive to the location of an asset and to single-tenant risk. It also focused on diversifying its real estate portfolio, which had primarily consisted of office and retail pre-crisis, to include larger allocations to industrial and residential, too, while also adding more niche strategies such as student accommodation, senior living and self-storage. Additionally, it nowadays steers clear of investments that offer only one exit option.

Warning signs

Some industry observers say they could see “cracks” long before Lehman filed for bankruptcy. Others believe such cracks are again visible today. Political economist Ann Pettifor is one onlooker who sees warning signs today of another crisis on the horizon, pointing out that global debt was $142 trillion, or 269 percent of global domestic product in 2007 and today it is $247 trillion, or 318 percent of GDP. “Far from deleveraging global debt, we’ve actually releveraged,” she notes, adding that banks have continued to lend to whichever borrower is willing to pay the most for a loan. “Those who offer the highest price are the most likely to obtain lending and they tend to be the riskiest.”

Comparing the current situation with 2007, “the parallels are scary”, Pettifor says. “They are worse than just the fact that levels of debt are high and interest rates are rising after 10 years. What’s more worrying is that we don’t have the tools to deal with it really.” Far higher debt and deficit levels than those of a decade ago mean there is less insulation from another potentially catastrophic financial event, she adds.

Pettifor: sees ‘scary’ parallels between 2007 and today

The most significant impact of the Lehman bankruptcy was the changes in central bank monetary policy, according to Pettifor. A decade ago, just before the financial crisis, “we did not have central banks providing massive amounts of liquidity in the form of quantitative easing to financial institutions that promptly directed that funding or liquidity into assets,” she says. “Of course, they moved partly into government bonds, which were highly favoured. But because of the shortage of government bonds, they also moved into property. So, the property market, in my view, has been massively inflated by QE and that’s also not sustainable.”

Kava takes a somewhat different view: “Lending was much riskier prior to 2008, with far less structure and much higher leverage levels.” However, he has noticed leverage inching up to 80 percent or more in some cases today. “A year-and-a-half ago, you’d be hard pressed to find more than 75 percent leverage,” he says. “It’s creeped up a little bit.”
Kava adds: “There’s more capital chasing deals. It’s gotten more competitive, given how expensive real estate is and how much capital has flowed into the sector. Some funds have been looking to get back up to 85 percent leverage to try to get to their returns.”

But Todd Henderson, head of real estate for the Americas at DWS, the asset management arm of Deutsche Bank, says real estate risk is not only contingent upon leverage levels. “I would be very careful about categorising 80 percent LTV just nominally, being by definition, a big risk,” he says. “The character of the cashflow today is much better at these LTV levels, even 80 percent, than for many assets pre-crisis, when we regularly saw 85 to 90 percent LTV, if not higher.”

Despite the late-stage cycle, the state of the real estate market is nowhere close to what it was a decade ago, he says. “Just the fact that things are highly leveraged or just the fact that things are overpriced – and I’m not saying any of that is the case today – doesn’t forecast the storm is coming,” Henderson adds. “When you look across supply, when you look at valuations, when you look across mortgage debt as three big indicators of the relative health of the real estate market, they’re all in balance with what their 20-year historical averages have been, and therefore I think the market is healthy.”

DiRe notes many investors are still haunted by the events of 2008 and have been careful to avoid making the same mistakes: “I think there’s a lot better attitude, a lot more humility in the marketplace than there was at that time because that memory was so severe. It was so harsh that I don’t think folks that sit in our chairs and have to put out investments have forgotten that we were a little too confident, thinking that markets would just continue to move up. I think there’s a lot more risk aversion now.”

Kava believes understanding what went wrong and how to fix the problem was not apparent at the time. But in hindsight, everything makes sense. “It stays with you for a long time,” he says. “You spend your career trying to figure out how to not let it happen again.”



Although the bank – which once held as much as $32.6 billion in commercial real estate assets – was best-known as one of the largest underwriters of commercial mortgage-backed securities, it was also active in many other areas of real estate, including a sizeable property funds platform. As of 31 December 2017, Lehman Brothers Holdings had $58 million of commercial real estate assets remaining in its portfolio, according to its most recent quarterly financial report.

• The principal business: Founded in 1993 and included strategic advisory, initial public offerings, common stock, investment grade and high-yield debt, preferred stock, convertible securities, bank loans, mezzanine debt, CMBS, private placements and private equity
• Real Estate Private Equity Group: Established in 2000 and included three global opportunity real estate funds – the 2000-vintage, $1.6 billion Lehman Brothers Real Estate Partners; the 2004-vintage, $2.4 billion Lehman Brothers Real Estate Partners II; and the 2007-vintage, $4 billion Lehman Brothers Real Estate Partners III – as well as Lehman Brothers Real Estate Mezzanine Partners I and II, which were formed in 2005 and 2007 and totalled $1.7 billion in assets including senior loans, mezzanine loans, preferred equity positions and REO assets. The management of the three Lehman Brothers Real Estate Partners funds were sold to Silverpeak Real Estate Partners, the spin-out of the REPE group by the former senior management team in 2010, while the management of the two Lehman Brothers Real Estate Mezzanine Partners funds were acquired by PCCP in 2009.