(FORTUNE Magazine) – NOT MANY PEOPLE realize just how stunningly big the commercial real estate debacle really is or how savagely it will continue to sweep through the U.S. economy. For a frame of reference, imagine that the stock market -- now worth around $3.8 trillion -- was to fall in value by 30%, a loss of about $1.1 trillion. Assume also that many of the market's most visible and active participants were on, say, 80% margin. And finally, consider that the economics of the market after the fall suggested strongly that values would stay depressed for years. Would these facts grab your attention? Substitute ''commercial real estate'' for ''stock market,'' deflate the dollar figures by just a bit, and you've got the gist of today's drama. There is nothing hypothetical about it. By one estimate the total value of all U.S. commercial real estate was around $3.5 trillion in 1989. It is now perhaps 30% less. Just a diminution of a trifling $1 trillion or so, about twice what the U.S. stock market gave up on October 19, 1987, in the crash heard around the world. The force of this disaster is smashing into the life of almost every American. Before this mess is over, a large number of buildings that the U.S. simply doesn't need will fall to the wrecking ball. New construction has slowed to a crawl, causing pain to those near at hand, especially in the building trades, and impeding the economic recovery. A coming pinch in property taxes will affect municipal services unless the shortfall can be made up from other sources. The banks and life insurers that financed all those structures have been gripped by anxiety and driven in many cases to parsimony in the granting of all kinds of loans, not just those to real estate borrowers. The lenders are also still being presented with new catastrophes, most recently the foundering of the Reichmann family's real estate development company, Olympia & York (see box). Ordinary people are uneasy about the nation's financial system. Do you feel a shaft of doubt about the safety of your savings? It was sent your way by commercial real estate. Because vacancy rates are sky-high -- almost 19% for offices -- your qualms are apt to continue for quite a while. According to calculations made by Edward Frydl, associate director of research at the Federal Reserve Bank of New York, there is enough excess office space in the nation right now to, in effect, supply the needs of business for the next ten years. To derive that estimate, he assumed an optimistic 3% growth rate for service sector employment over the decade and took past trends as an indicator of how much space each service worker uses. Coming at the problem in a somewhat different way, David Shulman, director of real estate research at Salomon Brothers, has produced an equivalent projection of 11.8 years. So it will be a decade at least before the commercial real estate market comes out from under. The real estate glut was created by a building frenzy in the 1980s that lost touch with what the U.S. needed in the way of commercial buildings -- offices, stores, hotels, apartments, industrial facilities. In turn, the frenzy got much of its steam from wrongheaded tax laws that encouraged this vast misallocation of resources. Even now, the spacemaking machinery isn't entirely turned off. A few end-of-the-boom buildings are still straggling into markets that don't need them, and some contractors are putting up ''build to suit'' structures designed for the specific requirements of corporate clients. WORKERS not fortunate enough to land those special jobs have been wracked by an industry unemployment rate of more than 17%. The value of new commercial construction in 1992, as estimated by data gatherer F.W. Dodge and adjusted for inflation, is expected to be the lowest since 1976. The excess space around has rents on a toboggan. At the annual meeting last fall of the sober- sided Urban Land Institute, an important realty research organization, the gloom could not have been cut with a bulldozer. One program moderator, a woman, wound up her session with a distraught cry: ''Goddamn it, our industry is in shit!'' Some of what she bewails is important only to the direct participants. Falling rents, for example, are in themselves a zero-sum game: What landlords lose, tenants gain. But falling rents also create a plunge in values that has sweeping effects. Measuring one of these, David Wyss, research director of DRI/McGraw-Hill, calculates that for every $1 lost in construction wages, salaries, and profits, suppliers lose $1.07 in business. To see how the ripples of real estate rock boats all around the economy, consider a new 35-story office tower just north of Times Square in Manhattan. Completed in late 1990, the building, 750 Seventh Avenue, was put up by a once smashingly successful New York developer called Solomon Equities and financed with a $187.5 million construction loan from a Citicorp syndicate. From the front, the building is crisply handsome, a structure of sloped glass surfaces topped by a tapered spire. Toward the rear there are problems: In March a fierce wind blew out several windows, which are now boarded shut. And inside appear the sure signs of real estate sickness. The building is absolutely empty except for a lone security guard in the lobby and a clutch of building employees scattered here and there. Prospective tenants could probably negotiate 18 months of free rent on a 20-year lease. But nobody has signed up -- and this business of the windows won't help. Last year Citi, which is loaded with $6.6 billion in problem commercial real estate assets, moved to foreclose on 750 Seventh -- ''to get the key,'' as the trade says. But Solomon Equities quickly sidestepped by putting the building into bankruptcy, hoping to salvage a sliver of equity. Among 750's long list of unpaid creditors when it filed for Chapter 11 were Tishman Construction and Otis Elevator. Also hooked were a deli a half-block away that provided food to Solomon's staff and was stiffed for $75; a plumbing company in the Bronx that installed $1.5 million of piping and fixtures; a Manhattan horticulturist whose plants at $2,000 a pot keep the security guard company; a stone company in New Jersey that supplied $1.2 million of granite for the building's lobby and entryway; and Manhattan advertising agency Lois/U.S.A. Some creditors have since settled for less than 100 cents on the dollar, but among those still owed is the ad agency. Says its boss, George Lois, of the $42,267 he's out: ''Hey, that's life.'' Beleaguered New York City also has a stake in 750 Seventh. Just to get the building up and gracing the Times Square area that the city is trying to lift % from sleaze, the Big Apple granted the owners tax concessions for seven years. For now, the building's annual taxes are only $1.8 million and these are being paid by the Citicorp syndicate. But that echoing empty space is a forceful reminder of the sword that commercial real estate holds over this city and many other urban areas. THOUGH THE RANGE is wide, big cities get an average of 54% of their tax revenues from levies on property and much of that typically comes from commercial buildings. In Los Angeles County the estimated take from commercial property is $2.3 billion annually, and in New York City it's $6.8 billion. Neither locality can afford to lose any slice of that income, yet the drop in values raises the strong probability that they will. An early real estate casualty, Dallas, has already felt that sting. When property values stopped rising in the middle of the 1980s, the city's first response was to cut services and whittle the pay of municipal employees. Then market values of both homes and commercial properties began dropping. Commercial, though, fell further and faster, from $34.7 billion in assessed value in 1986 to $30.6 billion for 1991. Dallas has raised tax rates for everybody to keep the revenues coming. Still, commercial properties today account for only 66.7% of the tax base, vs. 67.8% back in 1986. Versions of that script may be played out around the country in the years ahead. Tax revenues from commercial properties are almost inevitably headed down in such overbuilt cities as Chicago, Los Angeles, Miami, New York, and Phoenix -- and somebody is going to have to pick up the slack. Maybe you. Normally, the whole apparatus of commercial construction helps energize an economic recovery. Not this time. Wyss of DRI/McGraw-Hill believes that the absence of construction's ''early kick'' accounts for the recovery's difficulty in getting off the ground. Another economist, Kenneth Rosen, at the University of California at Berkeley, thinks the lack of vitality in construction could shave half a percentage point of growth off the recovery ahead. The repercussions are brutal for anyone who feels compelled to sell property in today's market. Alas, that's all of us taxpayers by way of our agent in Washington, the Resolution Trust Corp. The RTC has been dumping the commercial properties of failed savings and loans at prices typically well below 50% of their original stated value. Every dollar the RTC doesn't get is a dollar added to the taxpayers' bill. Just how bad things are hits home when private sellers have to step down to accept cellar prices on major properties. The last deal of that ilk to merit national attention involved Manhattan's 1540 Broadway, another Times Square denizen and Citicorp special. Now in Chapter 11, this 44-story, 1.1-million- square-foot glass complex cost an estimated $330 million to build, and was largely financed by a $253 million construction loan provided by Citi and a syndicate of 17 Japanese banks and financial institutions. Completed in late 1990, the building stayed cavernously vacant and unwanted until this March, when the German media company, Bertelsmann, agreed to buy it for $119 million -- which will be all the bank syndicate gets, period. Considering the lenders involved, the results give new meaning to the term Japan-bashing. In many ways, the most profound effects of the real estate crisis are falling, somewhat justly, on the industry's lenders, without whose blessings and bankrolls none of this mess could have materialized. For eons banks and insurance companies have made real estate loans, but this time the injured include lenders that had to detour to find the trouble. Property and casualty insurers don't normally do much real estate finance. Nonetheless, USF&G got the bug for this business in the mid-1980s because of the returns it seemed to promise, and swung right in there with $1.1 billion in mortgage loans and direct investments that are now causing it enormous discomfort. Several finance companies have taken wicked beatings, among them Household International, which has $667 million in commercial real estate loans and properties and is flailing in the quicksand. In the past two years Westinghouse Financial Services has suffered operating losses of $2.5 billion, mostly from commercial real estate. Its parent, Westinghouse Electric, reported a $1.1 billion loss in 1991 and has watched its stock fall by about 50%. The commercial banks and life insurance companies simply put themselves on cruise control. All told, banks have about $400 billion in commercial real estate loans outstanding and $26 billion in foreclosed properties for a total exposure of $426 billion. The life insurers have about $256 billion in mortgage loans and $47 billion of real estate they own directly -- an estimated $7 billion of that foreclosed properties -- for a total of $303 billion. Add up the exposure of the banks and life insurers, and you've got a / $729 billion bundle. That's big. In fact, it's more than twice what the two industries have in equity capital. How much of that exposure is currently bad news? Government statistics show that at year-end 1991 the banks had $45 billion in commercial real estate loans, about 11% of their total, that were ''nonperforming'' in one sense or another. Some of these loans were overdue by 30 days or more; some were paying interest but not on the originally contracted terms; and some were actually performing loans on which full payment was nonetheless doubtful. On these loans, bankers were applying some payments received to principal reduction rather than recording them as interest. For the life insurers, there are no exactly comparable figures. But at year- end, loans 60 days overdue or in the process of foreclosure amounted to about $14 billion. When the properties already foreclosed are added in, the two industries had a $92 billion bag of trouble at year-end. That's $92 billion not contributing fully to earnings and $92 billion of principal under a dark cloud. With real estate values as unstable as they are now, extraordinary controversy exists about what the carrying value of loans should be on banks' and insurers' books. Are regulators or accountants going to force the lenders to make large provisions for losses to reflect the drastically low valuations that the market is putting on properties? This is not an academic accounting argument. Big write-downs would mean reduced capital, which might drive weaker institutions into mergers and cause some to fail. It is a question of who survives. The argument recalls the early days of the so-called LDC crisis, when it became apparent that Latin American and other less developed countries could not possibly pay the huge debts they owed banks or anybody else. In those days the regulators tacitly agreed to let the banks carry their LDC loans at unrealistically high levels, so as not to reduce their stated capital to a pittance. But today at least some bank regulators are arguing that real estate loans should not be given the same break. Meanwhile, the state regulators who oversee the insurance companies have until recently been out to lunch on this issue. Though new rules are now being written, mutual insurance companies have not been required by the ''statutory'' accounting principles they follow to set up reserves for problem loans at all. Some mutuals, among them Prudential and Northwestern Mutual, have nonetheless done so. ( PUBLICLY OWNED insurance companies and banks are required by generally accepted accounting principles (GAAP) to carry their loans and foreclosed property at ''fair value.'' By definition, that's the amount at which a transaction -- not including forced or liquidation sales -- could currently take place between a willing seller and a willing buyer. In a market featuring many transactions, an appraiser would find the fair-value concept entirely serviceable. But in today's market both ''willing seller'' and ''willing buyer'' are oxymorons. In general, there is a huge spread between what the seller wants to get and what the buyer wants to pay. Consequently, gridlock prevails, except for transactions that resemble liquidation sales -- such as, for example, the Bertelsmann deal. So appraisers and regulators are forced to fall back on another method of valuation, which is to estimate a property's future cash flows and discount these back to present value. This process has a surface feasibility. But discounting requires you to use an interest rate high enough to compensate for the risk of this investment vs. alternatives, a matter immediately introducing controversy into the calculation. Beyond that, the rules say cash flows should be estimated on the basis of ''reasonable and supportable assumptions.'' How do you possibly determine those in a market that's totally in flux? To illuminate the challenge, let's look at the phenomenon charmingly known as ''tenant migration,'' which means a renter moves on for better space, cheaper rent, or some combination thereof. Says Richard Boyle, vice chairman of Chase Manhattan: ''Right now there is tremendous mobility in the market.'' Thus, UPS moves its headquarters from Connecticut to Atlanta, and Cabot Corp. returns from the Boston suburbs to downtown -- yes, the flow sometimes even goes in that direction. First State Management, a Boston insurance company, leaves an older building in the financial district for a new tower three blocks away. A fact that helps: Asking rents in downtown Boston have dropped from the $50-per-square-foot range in 1986 to $30 or so. ''The tenants are having a picnic,'' says Boyle. The owners are not. They have resorted to a form of cannibalization in which landlords hold out every inducement possible -- cheap rent, no rent for a year or two, lavish improvements, the defrayal of moving costs -- to get or retain tenants. So the vacancies roll from building to building. When Bertelsmann occupies its new Times Square pad, for example, it will vacate 500,000 square feet in other Midtown spots. OWNERS with expiring leases live in dread. Mitsubishi Estate owns 80% of the Rockefeller Group and, by extension, the same proportion of Manhattan's renowned Rockefeller Center. Twelve buildings that form the core of the Center have an amazing 45% of their leases expiring in 1994. In the mid-1980s this impending flood of expirations was considered bullish. The average rent on the leases running out was about $42 per square foot and the Rockefeller Group, then controlled by the Rockefeller family, forecast re-leasing in 1994 at an average of $75 per square foot. In your dreams. Asking rents in the Center's midtown Manhattan neighborhood are no better than $39, and Mitsubishi Estate's Excedrin concern has to be whether it can keep tenants at anything close to that rate. So what value would an appraiser, asked to rely on ''reasonable and supportable assumptions,'' put on this property? It happens there's an answer because Rockefeller Center Properties, the real estate investment trust that holds a $1.3 billion mortgage on the buildings, obtains an annual appraisal. According to James Felt Realty, a New York appraiser, the fair value of the property at year-end 1991 was $1.6 billion, which is down 6% from a year earlier. Were a bank examiner assessing that dainty reduction, he might be skeptical. In any case, among those real estate folk looking smart today are the Rockefellers, for selling 80% of their family company -- and a like piece of this rental problem -- to Mitsubishi Estate a few years ago for $1.4 billion. As all this suggests, the range of assumptions that an appraiser or a bank examiner could make about any given building that does not have its tenants absolutely locked up is almost limitless on the downside. Says Craig Hatkoff, managing partner of Victor Capital Group, a real estate firm that advises both banks and borrowers: ''In today's market the problem is that 'reasonable' valuations made by a pessimist can be 40% to 50% below equally 'reasonable' valuations made by an optimist. And that's a range that is jeopardizing the capital of the banking system.'' The regulators in Washington know that, and they have been backing and filling about how to handle the problem. One faction wants the banks' loan values to be hammered down to reality, whatever an examiner decides that is, and the other faction wants forbearance. Not that anyone even whispers that word. Since the savings and loans drowned in forbearance, it has become, says a Congressman, ''the dreaded F word.'' The hawks in the government on this issue are the General Accounting Office and the Securities and Exchange Commission. They want truth in accounting, even if that reveals the capital of some banks to be unacceptably low. Said Comptroller General Charles Bowsher of the GAO to Congress in January: ''We strongly believe that accounting needs to report the facts.'' The doves are the Treasury, the Federal Reserve, and the main bank regulator, the Comptroller of the Currency. They seem to think that a little fuzziness about the capital position of the banks is in the public interest. In the name of the credit crunch, they have also been bent on encouraging banks to make an occasional real estate loan now and then, though that is close to a futile effort. The campaign of the doves culminated at the end of 1991 with two flybys put on for the examiners' benefit. First, in November, came an interagency memo that enjoined examiners who are evaluating loans to ignore ''worst-case scenarios that are unlikely to occur'' and to envision the market's return to normal conditions. Then came a December conference of senior examiners in Baltimore, at which they were urged in golfing lingo to play it down the middle of the fairway and stay out of the roughs and hazards. Presumably this meant that they should not use discount rates high enough to destroy the value of loans and therefore the banks' capital. So how did the examiners respond? Christopher Mahoney, a senior bank analyst at Moody's Investors Service, says he cannot see that the examiners have so far paid the doves much attention. He points to the examination late last year of Wells Fargo, which has an overabundance of real estate loans and above- average exposure to California's sagging economy. In the vernacular, this examination was ''targeted'' strictly at real estate loans, and it was immediately followed by the company's announcement that it would add $700 million to its reserves, which raised these to $1.64 billion at year-end. Says Mahoney of that shocker: ''I thought that with all of this pressure coming out of the Treasury and the White House, we wouldn't see any more cases of the regulators moving in and saying your valuation methods are out of line. But that's what I think we saw here. If there were going to be true forbearance, then you might have got a signal from seeing Wells Fargo sail through. The fact that it didn't tells me as an analyst that other institutions are still at risk of the same thing happening.'' That's why the possibility of a speedup in bank mergers, and even bank failures, exists. In the meantime, many lenders have buckled down to serious cost cutting, which they hope will pump up their profits and capital. Last summer the Federal Reserve published some statistics on the profitability in 1990 of what it calls ''real estate banks,'' defined as institutions having at least one-eighth of their assets in commercial real estate. About 25% of the nation's more than 12,000 banks fit the definition that year. The other 75%, no great earners themselves, had domestic profits amounting to 0.53% of their assets. Profits for the real estate crowd, which the Fed says included banks of all sizes, were only 0.28% of assets. For these laggards, the difference meant around $2 billion in lost earnings. Once burned, twice shy. Credit expansion grew more slowly last year than at any time since World War II. The New York Fed's Edward Frydl concludes that the contraction was partly due to lack of demand. But he also believes that the banks' real estate burdens increased their caution about lending not only to that sector but to other would-be borrowers as well. Berkeley's Kenneth Rosen, who is a consultant to banks, says there is no doubt about this spillover effect. ''The capital of many banks has been eroded,'' he says, ''and so they're tight with all kinds of lending, not just real estate. I think that will continue for at least a year.'' In their lending, the life insurance companies are similarly cautious. But their risks of loss arise from different circumstances. Typically, banks make construction loans and thus depend for repayment on a plethora of new buildings filling up. They also sometimes lent more than 100% of construction costs. Conversely, the typical loan for an insurer has been a mortgage on a fully leased building against whose value it may have lent 75%. In their loans, therefore, the insurers have been relatively conservative. Many of their mortgages, though, are on buildings facing a large number of lease renewals, and so the insurers are slated to be unwilling participants in the rollover derby. In the 1980s, moreover, some insurers greatly shortened the maturity of their mortgages because they were using these to ''match'' guaranteed investment contracts (GICs) -- in effect, large deposits -- made by corporations placing 401(k) money belonging to their employees. That is, the insurers were offsetting the superior rates they were paying on GICs with the superior rates obtainable on the mortgages and fixing the maturity of each instrument at five to seven years. Many of these ''bullet'' mortgages are coming due from 1992 to 1994 -- and a significant number won't be paid. MEANWHILE, corporations will be pulling their GIC business from any insurer they think overly exposed to real estate problems. So insurers heavy in both GICs and real estate, such as Aetna Life & Casualty, face a liquidity problem as these portfolios mature. Aetna knows it and has been girding itself by socking available cash into highly liquid securities, such as Treasury bills. It has also been in negotiations to sell its American Re-Insurance Co. subsidiary to Kohlberg Kravis Roberts for about $1.4 billion, which would create a lake of liquidity for Aetna. Chester Murray, a senior insurance analyst at Moody's, says insurers are way behind the banks in their accounting valuations of real estate loans, in part perhaps because they lack a federal regulator comparable to the Comptroller of the Currency. But regulatory pressure for change is building. In the wake of the big failures at Mutual Benefit Life and Executive Life, Congress is considering federal regulation of the industry. The National Association of Insurance Commissioners has imposed a new requirement that all insurers, including the mutuals, be audited and is belatedly writing rules that will make reserves for real estate loans obligatory. And the SEC is investigating the accounting of certain publicly owned, but for the most part unidentified, insurers. The commission isn't saying much publicly about that project, but it is believed to be on the warpath against the accounting magic that produces a year of good earnings, then a year of big reserve hits, then once again a period of good earnings. The SEC's point of view is that companies should be setting up reserves for real estate loans when these are perceived to be needed and not in huge gobs at carefully selected times that suit the company's convenience. TRAVELERS INSURANCE has said it is a target of the SEC's inquiry. As they did at Equitable Life two years ago, real estate and GIC problems have sent Travelers in search of a capital infusion or a merger partner. The company's main error in real estate was a binge on Southwest loans and properties some years back. It began confessing its sins with a $415 million provision for reserves in 1988, then came back with another $650 million in 1990. In 1991, by then under the SEC's thumb, it booked reserves of $102 million. The company's profits for the year were $318 million. The fear that Travelers and any other weakened insurer surely has is that it will meet the fate of Mutual Benefit. That company, once known as the Tiffany of insurers, dropped in class in the late 1980s, when it overdosed on real estate loans and investments. After word spread last summer that the company was in trouble, policyholders flocked to surrender their policies and get their money out. To stop this run, the state of New Jersey seized the company and put a moratorium on further withdrawals. Out went the old management and in came a turnaround artist, Victor Palmieri, known for his work at Penn Central and Baldwin-United. Mutual Benefit is today paying death and disability claims, plus certain annuities. Otherwise, the policyholders who didn't make their escape in time are, at least for now, imprisoned in the company. Palmieri sometimes sounds as if he were also jailed. He says that dealing with Mutual Benefit's more than $5 billion in real estate assets is extraordinarily difficult, given the state of the market. His doleful summary: ''It's impossible to liquidate and it's awfully tough finding a suitor.'' Prominent among the countless other insurance and bank executives who face similar troubles is Citibank's Robert McCormack, newly in charge of U.S. real estate and most recently in charge of extracting dollars from LDC debtors. He reports directly to Chairman John Reed, which shows just where real estate ranks in Citi's list of things to agonize over. McCormack hardly exudes optimism about his portfolio. The liquidity problems, he says, are great. But he is cheered by having mostly new structures to worry about. ''Over time,'' he says, ''the real problems are going to be with the older buildings.'' These often require expensive retrofitting if they are to attract tenants, and they cannot easily accommodate today's computer and communications wiring. Without question, they are the prime candidates for demolition in the years ahead. As for McCormack's liquidity problem, it will not be demolished soon. The universe of would-be buyers is small and inhabited mostly by what Victor Capital's Hatkoff calls ''grave dancers, bottom fishers, and vultures.'' Many ; owners long for bids from pension funds. But the funds have also been bushwhacked by real estate and are largely sitting on the sidelines. Arthur Mirante, president of real estate firm Cushman & Wakefield, explains why the market lacks liquidity: ''For you to sell me a building, we've got to have some agreement on where the market is going to be three, four, five years from now. Lacking that, most of the deals are going to be forced sales made by owners with financial problems. In that kind of market, the buyers have no reason to move up their bids.'' How long, how long, will it take for this burden to be lifted? If regulators push for write-downs, financial institutions will feel the concussions, as in a mine field, by way of bankruptcies, bailouts, and mergers. If regulators exercise the F word, the lenders will be drained slowly and insidiously as they have been by the LDC debt. Ultimately, this problem that arose from a long period of dementia will fade. Chase's Boyle promises that will be so: ''In our lifetime,'' he said recently to a small group of discussants, ''the market will turn and go the other way.'' Too bad if that suggests the timetable in his mind. The oldest person there was 62 and has a life expectancy of 21 more years.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: CB COMMERCIAL CAPTION: Back in 1981 the national vacancy rate for offices in downtown business centers was 4.8%. Today it's a scary 18.8%. Among the cities where vacancies rose markedly in the last year are Dallas, Cleveland, San Diego, Minneapolis/St. Paul, Los Angeles, Chicago, and Seattle. CITY OFFICE VACANCY RATE

CHART: NOT AVAILABLE CREDIT: FORTUNE TABLES CAPTION: HOW THE BIG LENDERS RANK IN REAL ESTATE These tables list the ten largest banking companies and life insurers by total assets but rank them in order of their commercial real estate exposure. One inconsistency in the figures: Nonperformers for the banks include some loans less than 90 days overdue, but those for the insurers do not.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCES: CB COMMERICAL, NEW AMERICA NETWORK, CENSUS BUREAU CAPTION: National vacancy rates

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: BUREAU OF LABOR STATISTICS CAPTION: Commercial construction employment