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Bankruptcy attorneys in the San Francisco Bay Area have not been going hungry. For two years they’ve had a steady diet of dot-com, technology and telecommunications casualties. And the Pacific Gas & Electric Co. Chapter 11 case has generated tens of millions of dollars in attorney fees for a half-dozen firms. Now bankruptcy lawyers are preparing for their next course: commercial real estate. With office vacancy rates at record highs, landlords are looking wobbly. But while the market appears ripe for a shakeout, there are signs that this may not lead to a windfall of bankruptcy work. Real estate owners and their lenders apparently learned their lessons in the previous downturn and avoided some of the same mistakes this cycle. “We’re pretty deep into a trough here, and if this were the ’80s there would be a flood of real estate bankruptcies,” says James Stillman, a partner at San Francisco-based Murphy Sheneman Julian & Rogers. Bankruptcy attorneys at many Bay Area firms report only a slight increase in cases involving distressed property owners so far. Randy Michelson, the co-chair of Bingham McCutchen’s bankruptcy and financial restructuring litigation group, says she currently has three or four significant cases that involve commercial real estate. “I think it is the next wave,” she says. “I don’t think it’s quite hit yet.” What’s saved many landlords from bankruptcy until now, say Michelson and others, is low interest rates that allow landlords to still pay their mortgages despite whatever revenue shortfalls they’re experiencing. There’s no question that some landlords are experiencing serious cash flow problems. According to real estate services firm Grubb & Ellis, San Francisco is awash in 14 million square feet of empty office space, a 21 percent vacancy rate. The previous record, in 1987, was 17 percent. In the city’s South of Market district, where Internet companies were once ubiquitous, the vacancy rate is a staggering 51 percent. “This is the highest it’s ever been,” says Grubb & Ellis Research Director Colin Yasukochi. “The trend still points toward higher vacancy because there’s about 1.25 million square feet of space coming from new developments.” Meanwhile, rents in so-called Class A buildings, the best office space, have plunged roughly 60 percent from their peak two years ago. “This can’t go on forever,” says Mike Buckley, a bankruptcy partner at Oakland, Calif.’s Crosby, Heafey, Roach & May. “You couldn’t last three or four years with the vacancy rates we have now — even with low interest rates we have now.” Typically, a landlord will file for Chapter 11 bankruptcy protection when they’ve defaulted on their debt payments and a lender is about to foreclose on their building. Since Chapter 11 provides an automatic stay, property owners can use the bankruptcy process to hold on to their buildings while adjusting their debts. But even if a distressed landlord doesn’t take the Chapter 11 route, bankruptcy lawyers bill hours in out-of-court workouts between the landlords and their lenders. During the last real estate downturn of the late 1980s and early ’90s, Buckley estimates that 40 percent of his practice was devoted to real estate matters. While bankruptcy lawyers already have full plates at the moment, Buckley isn’t worried about not having sufficient resources to take on a surge in real estate insolvency work. “Our real estate people would be perfectly capable of taking care of the upsurge, with the real bankruptcy lawyers taking care of any litigation,” explains Buckley. “That’s the way we’ve done it the last three times.” The only question is whether this real estate downturn will unfold like the last one. According to some attorneys, the nature of today’s real estate market could prevent an avalanche of bankruptcies. Many of the city’s big office buildings are in strong hands. According to Grubb & Ellis, about 50 percent of the Class A office space in San Francisco is owned by national, diversified real estate companies. This means a money-losing building can be kept alive by the parent company. “If they have high occupancy in San Antonio and St. Louis and D.C. and low tenancy in San Francisco, it’s not the end of the world,” says Frederick Holden Jr., chair of the insolvency and corporate restructuring group at San Francisco’s Brobeck, Phleger & Harrison. And conservative lending practices by the banks mean that property owners aren’t necessarily being crushed by debilitating loans. “I honestly think that lenders did learn one or two things from the ’80s,” says Stillman, of Murphy Sheneman. “The lenders and borrowers are not as naive.” In the old days, says Stillman, many savings and loans loaned money to landlords based on projected future revenues. This meant that a landlord who borrowed money at the top of the market would be hurled into default as soon as there was any appreciable dip in operating income. The new generation of lenders is more tightfisted. “Even for people who borrowed money at the peak,” says Stillman, “it was our experience that the underwriting criteria were much more conservative.” But while property owners might not go under at a dot-com-like pace, bankruptcy lawyers still expect the real estate market to provide them with some work going forward. “It doesn’t mean there isn’t going to be action,” says Patrick Murphy, a name partner at Murphy Sheneman. “It’s going to be more muted, and it’s less likely to be visible in the bankruptcy court. There’s going to be plenty of ownership interest wiped out.”

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