Nov. 30, 2009

(Sept. 4, 2009)

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, has been 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 shopping-mall developer 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.

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 cabdriver, Lawlor got an M.B.A. 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 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 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 Avenue, an office tower that the savvy giant Vornado bought for $542 million in 2006—Lawlor's bid was the lowest.

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