by Gary H. London

A congresswoman from Nevada recently introduced legislation dubbed the Community Recovery and Enhancement Act of 2010 to provide short-term tax incentives to jump-start reinvestment in commercial real estate. The goal of the legislation is to stabilize community banks, prevent additional foreclosures and stem the bleeding in the commercial real estate industry. But will it? And do we need another government distortion of the private market?

I can’t think of a worse idea, other than putting Sarah Palin in charge of non-domestic lending by Fannie Mae.

It is true that all segments of the commercial real estate industry are in some distress. The chart accompanying this piece shows the proportion of distressed sales by property type on a nationwide basis using data from the CoStar Group. It seems pretty dire, but then there are many positive signals. Vacancy rates in many markets have peaked, and rents are not slipping as fast.

In multifamily markets, concessions, while high, are being reduced, and Class A is starting to show rent increases in many markets.

The problem with this proposed legislation is that many properties are not just financially distressed where cash flows are insufficient to cover what may have been excessive financing relative to values, but many of these properties are also in functional distress.

Functional distress is caused by obsolescence in design, features or location. In the case of retail, property investors and lenders often failed to consider if there was sufficient demand for every format out there. Now we are stuck with too many big boxes, too many lifestyle centers, and too many outlet centers. The only retailers doing well and expanding are the value players and the services that do not sell any physical goods.

Office buildings are resplendent with functionally obsolete properties. Their future economic sustenance will depend on the ability of owners to upgrade and retrofit to contemporary standards, and with energy and water saving systems that maximize the productivity of the occupants.

The focus of the proposed legislation is “distressed” because their owners purchased the asset at the peak, paid too much in an era of declining revenues; or they overleveraged the assets, putting them in a financial bind much the same way as homeowners have overleveraged their homes. But by helping these owners, will legislators merely prolong obsolescence?

In fact, the housing resuscitation effort is a good lesson. As well-intentioned as it was, we are now seeing that the legislation to forestall foreclosures and otherwise resuscitate the housing market through tax credits has accomplished nothing more than delaying the inevitable: The legislation targeted the weakest assets and the weakest participants in the housing markets. Any short-term gain seems to have been succeeded by a longer term stall in the overall performance of the housing market.

Nuts and Bolts of the Legislation

The CRE Act, introduced by Rep. Shelley Berkley, D-Nev., is premised on easing refinancing and providing tax incentives to attract new equity into commercial real estate. (This should ring a familiar bell to anyone who remembers the syndications of the 1980s and the pain of reversing the tax benefits in 1986.) Its central provision is to provide newly invested capital to reduce outstanding debt, with the remainder going toward capital improvements, and qualifying new investment for a 50 percent bonus depreciation to enable investors to deduct losses without regard to passive loss limitations.

Together, these incentives are designed to provide an opportunity to lower the loan-to-value ratios of existing properties as well as improve debt coverage ratios, giving lenders the ability to refinance debt and rebalance capital reserve levels, thus freeing up additional lending capacity for the overall economy.

Let Them Fail

One problem is a scarcity of “new tenants” who want existing space, sometimes in poor locations. There is a vacancy rate of more than 20 percent in the retail sector nationwide.

Lenders who are underwater are there because they made bad decisions and the taxpayers bailed many of them out of trouble. Any financial restructuring has to be based on the idea that revenues will somehow come back to these weaker assets and the higher values and cash flows will cure the “temporary” loan problems. But if this legislation actually worked, it would do so at the expense of the currently healthier assets in better locations with better formats and better tenant mixes and superior management. This is because there are only so many tenants to go around and nothing in the legislation will induce more consumer spending.

The commercial markets are structurally on the brink. Many of the retail centers that presumably are targeted by the CRE legislation should be left to die. These centers simply are not needed. What is needed is to allow competition and capitalism to work by rewarding innovative and more efficient formats and operations.

This means that old shopping centers should become mixed-use centers by subtracting retail space, and adding housing, medical offices, community space and other alternatives to their sites.

It is better to let the assets fail. If investors and lenders know that when they make huge mistakes they will not be bailed out by the U.S. government, then presumably they will make better decisions.

While U.S. policymakers argued that these Wall Street firms were “too big to fail,” the same cannot be said of real estate. Real estate is not too big to fail. Real estate is held incrementally by a broad array of investors. Even the biggest are small by big Wall Street investment bank measurements.

Most of the bad real estate investments and holdings are bad because their owners made bad investment decisions. They took the risk, they should take the hit.

While I admire their chutzpa, I am still astonished that the large commercial retail trade organization, the International Council of Shopping Centers, is behind this legislation. It’s like, “Everyone else got a bailout, why not us?”

The reason is simple. Your members don’t deserve one. Too much retail has been built since the turn of the century. Too much other retail was neglected. Too many retail shopping center owners simply collected checks, dubbed “coupon clipping” in the industry, and didn’t reinvest to upgrade their centers.

Most importantly, too many shopping centers simply cannot and will not survive in an era where a growing number of retail transactions are digital. They are no longer based in “retail” real estate, but rather from warehouses.

Let’s not add to the tax burden and transfer wealth from those who got it right to those who didn’t.