Three Reasons Commercial Real Estate Could Hold Back a Recovery

Stock prices have rallied for much of the last month. The housing market has shown some early signs of life. And some of the latest economic reports haven’t been the disasters that many experts feared.

While this is hardly a portrait of an economy on a roll, there are enough bright spots to nurture a feeling that the U.S. economy is finally on a path to recovery - especially given the upbeat response the latest elements of the Obama administration’s fix-it plans have received.

But there’s a dark cloud in this picture. And it’s big - big enough, in fact, to potentially finish off the U.S. banking sector, blotting out the U.S. economy’s new dawn.

That dark cloud is the commercial real estate sector. With rent prices falling and vacancies rising due to the recession-weakened economy, delinquencies on commercial mortgages are already escalating steeply. And the credit crunch bred from the recession is often making it impossible for property owners to avoid deeper trouble by refinancing.

"It’s a one-two punch combination: First, soaring vacancies take the wind out of positive cash flow; then the credit crisis hits like a rabbit punch, snapping off the main arteries to refinancing," says Money Morning Contributing Editor Shah Gilani, a retired hedge-fund manager and expert on the U.S. credit crisis who predicted the implosion of the commercial real estate sector several years ago. "This is like Samson hitting the ground. The giant asset class we call commercial real estate is not going to get up any time soon."

Here in the U.S. market, commercial real estate is worth about $6.5 trillion, and is financed by an estimated $3.1 trillion in debt.

And that debt is going bad at an escalating rate. In March, the delinquency rate on about $724 billion in securitized debt reached 1.8%. As percentages go, that’s a pretty small number. In fact, it’s less than a quarter of the housing market’s record-breaking mortgage-delinquency rate of 7.88% for the fourth quarter, according to the Mortgage Banker’s Association.

But don’t let that 1.8% rate fool you: The delinquency rate on commercial-real-estate debt has more than doubled just since September, according to a new Deutsche Bank AG report called "Commercial Real Estate at the Precipice."

With that increase, experts say the delinquency rate on commercial real estate has already almost equaled the rate achieved during the last U.S. economic slump, which took place at the beginning of this decade. And forecasts now call for the current downturn in the commercial real estate market to rival - and perhaps even exceed - the plunge of the early 1990s, when nearly 8% of all commercial real estate loans went sour. Banks and thrifts took nearly $50 billion in charges, and nearly 1,000 lenders failed, The Wall Street Journal said.

The fallout this time could be much worse - for three key reasons:

• Commercial Real Estate Is a Heavyweight Sector: Although soaring defaults on student loans, auto loans or credit cards certainly won’t help a nascent economic recovery, those slices of the debt market are dwarfed by their commercial real estate counterpart. What’s more, the $3.1 trillion that makes up the commercial real estate debt market is three times the size it was during the early 1990s - meaning the potential for losses is steeper than ever before.
• Commercial Real Estate Is Closely Tied to Employment: The second factor is jobs. In the housing market, a loan default essentially affects a single family. In commercial real estate, a default typically signifies big problems at the company that owns or occupies the building or property that the loan finances. And those "big problems" typically translate into reduced jobs. This is debt that’s backed by the mostly vacant downtown high-rise where your neighbor worked before his employer downsized; by the neighborhood mall that shoppers avoid after it lost its Starbucks (SBUX), Circuit City, Linens ‘N Things and Mervyns retail locations; or by a factory of a now-bankrupt supplier of parts for the General Motors Corp. (GM) passenger car that’s been canceled.
• A Nosedive in the Commercial Real Estate Sector Could Torpedo Any Improvements the American Banking Sector Has Seen: Since 2007, 47 lenders have failed, of which one quarter had an exceptionally high exposure to commercial real estate loans. Until recently, the U.S. banking sector has been an economic "black hole," whose unending appetite for capital left nothing for actual economic stimulus efforts. That black-hole syndrome seemed to have been resolved recently, allowing the Obama administration to enact other stimulus plans. But many experts fear that a severe downturn in the commercial real estate sector might be enough to reopen this interstellar capital chasm, blunting all other rebound initiatives. Foresight Analytics LLC estimates that - as a result of the ongoing downturn - the U.S. banking sector could incur as much as $250 billion in commercial real estate losses, enough to cause another 700 banks to fail.

"Any bank that has a sizable book of commercial real estate loans could have serious problems in 2009," Jamie Peters, a bank analyst at Morningstar Inc. in Chicago, told The Minneapolis Star-Tribune.

This time around - compared to the early 1990s - banks left themselves no margin of safety in the form of "Tier I Capital" - a measure of how well a lender can navigate serious levels of losses. The higher the ratio, the less likely a lender will be able to work its way through a stretch when loans start going bad.

In 1993, less than 2% of U.S. banks and thrifts had an exposure to commercial real estate that was more than five times their Tier I capital. By the end of last year, that ratio had spiked to 12%, involving about 800 banks and thrifts.

As Money Morning reported, the U.S. Treasury Department and the U.S. Federal Reserve are working on a program that would induce private investors to buy into debt backed by such income-producing commercial properties as office buildings, retail stores and hotels. The program - the Term Asset-Backed Securities Loan Facility (TALF) - is seen as a way of breaking the toxic-asset logjam, and to bring capital to debt that can’t be refinanced because of the ongoing credit crisis.

This is an attempt to avoid the [dangerous] "repeat of what happened on the residential side: A complete choking up, foreclosure disasters and increased stress on the banking system," Jeffrey DeBoer, chief executive of the Real Estate Roundtable, told The Journal.

What has real estate executives really worried is the looming surge in commercial real estate loans coming due. Until now, delinquencies on commercial real estate loans have stayed below historical levels, due mostly to the limited amount of speculative construction that’s taken place in recent years. But delinquencies are now surging - in a big way - just as the volume of loans coming due is also spiking - and just as the few remaining lenders willing to make the kind of loans needed to refinance this debt are exiting the market.

"The credit crisis has got so bad that refinancing of even good loans may be drying up," says Richard Parkus, head of commercial-mortgage-backed securities research at Deutsche Bank, and the author of the aforementioned "Commercial Real Estate at the Precipice" report.

Commercial real estate loans differ from their residential-loan counterparts, which borrowers repay after a set period of time - usually 30 years. Commercial mortgages usually are underwritten for five, seven or 10 years with big "balloon" payments due at the very end. At that point, the property owner usually turns the loan over and refinances it. A borrower’s inability to refinance could force it to default.

All of a sudden, scores of experts are warning federal lawmakers that hundreds - or even thousands - of resort hotels, retail malls and shopping center properties and commercial complexes of all sorts are headed for, are on the verge of, or are already in default, a Memphis Daily News report stated. The reason: About $530 billion of commercial mortgages will be coming due for refinancing in 2009-2011 - with about $160 billion maturing this year - even as credit for refinancing remains non-existent, and cash flows from rents and leases are way down due to the recession, property researcher Foresight Analytics concluded.

What’s not clear is how soon the crunch will come - or if it will come at all.

The Real Estate Roundtable, a key trade group for the industry, late last year predicted that more than $400 billion of commercial mortgages will come due through the end of 2009. Foresight Analytics estimates that $160 billion of commercial mortgages will mature next year.

"Unfortunately, the commercial real estate market is even more vulnerable to economic cycles, and here I’m talking about deep recession, than residential real estate," Money Morning’s Gilani says.

The current recession - which started in December 2007 - could be the wild card, Gilani says. If the U.S. economy continues to improve, as it seems to be, and as many experts predict will continue to, cash flows from properties won’t keep declining, and defaults won’t escalate. Unfortunately, there’s an inertia that takes hold during a downturn: Companies continue to slash jobs, shutter plants, close stores and otherwise cut expenses - often even after the broader economy shows early signs of new life. This inertia could be enough to cause commercial real estate vacancies to rise and defaults to escalate.

If that happens, it’s possible the commercial real estate sector becomes the "tipping point" that could keep the U.S. economy ensconced in its current recession, or, if the recovery is truly underway, push the U.S. market into a "double-dip" downturn.

Time will clearly tell.

Original post

Comments

[sunny12945:]

No lender will lend or refinance the debt on a commercial property (bought prior to 2007) which in most cases was over priced and also bought on over leverage. The asset prices are declining faster than the affected debt holders trying to re-finance on an over priced assets in the first place! No lender can afford to finance a property which may be close to BK in this on going recession.

Bottom line asset prices are declining for 2 reasons - over priced and over leveraged! This is a solvency issue not a liquidity issue. Bubba and the gang are trying re-inflate prices of houses and commercial properties, when any lender knows how risky it is, irrespective of QE! Policy makers are ignoring this glaring truth. May be they can own these commercial properties like they own 80% of AIG. INSANITY rules!

Apr 01 06:07 PM

[dawase@gmai...:]

Love SRS here although it may take a while to play out and the cost will eat some returns.

Short IYR also works. Karen Finerman suggested short BPO earlier this week. It had a decent pop today, might be a good short entry.

Disclosure: Long SRS

Apr 01 07:50 PM

[Lilguy:]

I think Mr. Patalon has it right, and I have even fewer doubts than he does that CRE values will decline sharply and defaults increase sharply in the next year. And the additional negative impact on an already fragile US economy will be substantial.

Unfortunately, I also think the CRE domino is just one of several that is in the early stages of falling--all with negative effects on the US economy.

First, there is a major second-wave of home mortgage defaults beginning to build as the various "alt" mortgages pile on top of the wave of sub-prime defaults and broad rising of the prime mortgage default sea. That wave won't be through for 4 more years.

Second, credit card debt and personal financial debt defaults are also building into a new wave in the wake of growing job losses and the virtual end of HELOC financing (the home ATM). These, too, will not crest for several years.

Third, and maybe most important, I don't believe the Administration's current strategy of trying to refill bank coffers with taxpayer cash will work. The ensuing bank insolvencies and/or "pre-privatizations" will end what's left of business and household credit availability, create economic fear comparable to that experienced in the Great Depression, and absolutely destroy any credibility the US Government has left as a useful tool for solving our growing economic problems.

It's not only not over, it's really only beginning, especially since the Administration insists on focusing America's limited financial credibility on resurrecting Wall Street as it was, not coping with the myriad problems of Main Street.

Apr 01 08:56 PM

[BxCapricorn:]

You nailed it! The whole FAS 157 hoopla isn't about subprime, it's about CRE which is still held at 100% on the balance sheets of these banks. It's one thing to have a bunch of homes sell at discounts, while it's quite another to have giant buildings, office parks, casinos, etc. completely stop making payments and have no one able to meet your asking price.

Apr 01 10:52 PM

[Mark Bern:]

The author has begun a discussion with broad coverage of the problem and strong points supporting his arguments. Lilguy has, IMHO, added correctly that this is just one of a number of dominos teetering on the brink.

In the end Treasury and the Fed will either find a way to loosen the credit markets or not and that will tell the story. My gut tells me that the answer is "not." In the short term there may be appearances of making headway, because of the sheer amount of money being pumped into the system.

There will probably be some sort of near-term bounce or apparent stablization caused by improvements in numbers of residential sales (at ever lower prices with nearly half coming from foreclosures) and the temporary effects of the stimulus money pouring into the economy.

However, as reality seeps in that unemployment continues to rise at historic rates, store closing increase instead of subsiding, business bankruptcies rise in numbers, and more industries come under pressure due to a prolonged lack of consumer demand, credit will tighten again and Wall Street will wake up.

As much as I would love to see the economy recover and the stock market bottom there is still one major reason I am not ready to jump back in and risk my meager savings yet. I have lived through several recessions. This is different. This time the problems are spread across a broader swath of the economy and it is global in scope. There are not enough pockets of strength to lead us up and out. But foremost in my concerns, is this: I have not seen capitulation in the markets yet. I have not only witnessed capitulation, I have experienced it first hand. We have seen a relative or partial capitulation, but there have been too many jumping back in at the so-called bottom each time we have a good drop in the indexes.

Because of that we haven't been able to "build" a strong enough bottom formation to provide the type of support needed to hold when the bottom is retested. This process can take several months. This market hasn't waited a week before it takes off again. And with the levels of distress in fundamentals we're experiencing now I would expect the bottoming process this time to take much longer than it would in a "normal" recession.

We still have several more shoes left to drop before the economy can truely stablize and start to grow again. CRE, Alt-A, ARMs, Insurance, to name a few. We are already experiencing big drops in demand for leisure activities, hotels, arilines, and restaurants but this won't be fully exposed until summer vacation time gets into full swing. We have a lot of problems just under the surface that are about to be exposed. CRE is one very big one, but just one of many.

Apr 01 11:57 PM

[lookbeforeU...:]

I would like to thank the author for the time and effort put into such a post, along with the authors of the measured responses. This issue is an important reminder to all of us that the problems created by the incredible valuations and leverage of the last half-decade have created billions in "dead assets" that are either extremely difficult to unwind or still incredibly overvalued, and the various government programs intended to deal with the problems will be unable to stop the natural market forces. Our society seems to have very little patience for the steps necessary to properly deal with such an economic crisis, and the government seems intent on "saving" the banks by bankrupting the Treasury, so I must agree that after the limitations and consequences of the bailout plans are fully exposed, there will be more pain to come in equities and bonds. I counsel patience for prudent investors - you're better off being late to the party than being the chump who pays for it.

Apr 02 12:50 AM

[billp37:]

"April 2 (Bloomberg) -- Commercial property loans in default or foreclosure grew in the first quarter as the U.S. recession cut occupancies and the credit crisis stymied refinancing.

Delinquent loans increased by 43 percent in the first three month of this year to $65.9 billion, according to data from New York-based research firm Real Capital Analytics Inc. That’s up from $46 billion at the end of 2008.
..."

www.bloomberg.com/apps...

We are concerned about PRU and TIAA/CREF exposure to commercial real estate since they send retirement checks.

"Life insurance companies, hobbled by real estate investments and committed to paying some costly retirement contracts, face more cuts in their credit ratings before the year is up and have little choice but to seek capital in unforgiving markets. ...

Hartford Financial’s stock fell to $9.67 a share on Wednesday, a stunning 61 percent decline since last Wednesday. MetLife’s shares, which closed at $28, are down 22 percent in that period. Stock in Prudential Financial, which ended the day at $26.54, is down 32 percent. ...

But companies that got into the variable annuity market early may suffer, because early pricing models were too optimistic. Variable annuities differ widely, but in general they allow buyers to accumulate savings over a number of years, and then receive a stream of payments in retirement. To gain market share, many insurers added consumer-friendly features, like guaranteed minimum income streams and other guarantees. ...

With the stock markets shredding equity investors’ retirement accounts, people who bought variable annuities are in the enviable position of winning a bet against an insurance company. The insurers are going to have to make good, even if their own investment portfolios are battered. ..."

www.nytimes.com/2008/1...

Apr 02 08:42 AM

[Franklin Bird:]

Reading through the comments here, I'd have surmised that every last commercial property borrower was paying no interest!

Apr 02 10:58 AM

[pitchingpen...:]

A new run-on scentence might be nice:

It will be a welcome change of pace to begin to hear the ranting move from "those irresponsible, greedy homeowners who overpaid and who couldn't afford and didn't deserve their homes in the first place and just need to lose them", to "those irresponsible, greedy commercial property owners who overpaid and who couldn't afford and didn't deserve their buildings in the first place and just need to lose them".

Apr 02 02:50 PM

[marketman54:]

How come no one is talking about this!! George Soros wrote and article a week ago that said there will be a 30% drop in the commercial real estate market and the owners of these properties cannot and will not be able to get financing.

The same goes for credit card defaults. As more and more people loose their jobs, they will not be paying their already maxed out cards.

Things are gonna get really bad, don't be fooled by this B.S. run in the market. Get ready to short the financials.

Apr 02 09:35 PM

[reverse mor...:]

I will admit to lacking serious knowledge in commercial real estate, with my experience being in single family homes. And yet it does not surprise me, since the economy, whether rising or falling is akin to dropping a stone in pond, the ripples affect everything nearby in an ever widening circle.

Many of my conversations a year ago were not only talking about the then coming election, but also the amazement (read fear) about how prices were soaring at local markets, with the price of a loaf of bread hitting astounding prices. Those on a fixed income were very hard hit, and those small business owners who occupy commercial real estate, have no doubt felt the sting also.

Good post, excellent food for thought.

Apr 04 03:04 PM