We are all conscious of the dark cloud of commercial real estate debt which lingers on the brightening horizon – with $3.4 trillion in outstanding debt, $1.4 trillion of which is coming due by the end of 2012— many feel this will spur the next leg in the credit crisis and possibly derail the broader economic recovery.
The situation seems especially ominous given that commercial real estate values are out by up to 40% from market highs and credit markets are only now raising their heads from hibernation. This means indebted owners do not have the ‘get out’ option of disposing the property and repaying their mortgage with the proceeds.
It also makes refinancing difficult. Borrowers have to put more of their own equity into a deal and lenders have increasingly tighter standards. Loan-to-value (LTV) ratios are not only lower than they were at market peaks, but have to be based on the current value of the property, which again is much lower than it was years previously.
However, according to many real estate economists, this fear is largely misplaced. Commercial real estate debt will likely put a dent in the the recovery in the credit markets, but due to a few key factors such as the the limited impact of commercial real estate loans on the overall economy, it won’t bring about the same wave of distress as the housing downturn did.
“As far as the impact of commercial real estate on the overall economy, I don’t think it’s going to be the next shoe to drop,” says Robert Bach, senior vice president and Chief Economist with Grubb & Ellis. “These problems are focused in regional banks and the Federal Deposit Insurance Corp. (FDIC) has a tested method of shutting those down on Friday and opening them on a Monday under the auspices of a bigger bank. These are not too big to fail banks. I don’t see [commercial real estate] as an unmitigated disaster—I see it as a repeat of what happened in the 1990s, but the economy can handle it.”
The FDIC, however, faces some concerns. A recent analysis by the agency’s Office of Inspector General found that during the peak of the real estate market many banks ignored FDIC’s 2006 recommendation that they keep commercial real estate holdings at less than 300 percent of total capital. Meanwhile, after dealing with 100 bank bankruptcies last year, today the agency is facing a deficit for the first time since 1933 and might lack the funds to deal with the potential fallout of a commercial real estate crisis.
In 2009, bank failures cost the agency $25 billion on top of the $20 billion it doled out in 2008. To deal with the money shortage, the FDIC is requiring banks to prepay $45 billion of insurance premiums by the end of this year. The premiums would cover the fourth quarter of this year and all of 2010, 2011 and 2012. Overall, the agency is projecting that bank failures between 2009 and 2013 will cost it $70 billion.
Meanwhile, more than $1.4 trillion in commercial real estate loans are scheduled to mature between 2009 and 2012, including $320 billion next year, according to ING Clarion Real Estate, a real estate investment management firm.
That’s coming at a time when new sources of refinancing remain scarce and valuations of commercial real estate properties are getting battered by weakening fundamentals. In the first half of 2009, the volume of distressed commercial assets grew 122 percent, ING reports, to $138 billion, including $32 billion in the retail sector.
The good news is that total volume of commercial real estate debt is about a third of the total amount of outstanding residential mortgage debt, which stands at approximately $10.9 trillion, according to the Federal Reserve Board’s figures.
Another important factor to keep in mind is that the residential mortgage crisis affected almost every homeowner in the country and so had a devastating follow on impact on consumer spending. Americans had been refinancing their homes and using the proceeds in the high street. By contrast, troubles in the commercial real estate industry might cause damage to banks and large institutions, but will have a limited effect on Main Street, says Clint Myers, strategist with Property & Portfolio Research, a Boston-based real estate research firm.
Any potential damage will also be mitigated by the fact that commercial real estate debt has been largely concentrated on the balance sheets of regional banks, rather than the big national players, and that most of the loans issued before 2005 feature solid underwriting, adds David J. Lynn, managing director with ING Clarion Real Estate.
Today, 54 percent of all commercial real estate loan defaults come from loans sponsored through commercial mortgage-backed securities (CMBS), which were a major source of real estate debt between 2005 and 2007. Loans issued by national and regional banks account for only 12 percent and 11 percent of all defaults, respectively.
That’s not to say that all those commercial loans won’t cause serious problems in the credit markets. As long as banks avoid realizing losses on commercial mortgages, commercial asset values will remain artificially high, Myers says. That, in turn, will likely limit the flow of new credit into the commercial real estate market, leaving some owners cash-strapped.
“The real stress in the system [will be on] the banks,” he says. “The pace at which regional banks fail will probably accelerate from this year to the next. And what it will mean is that there will be very little new lending activity for commercial real estate and it’s going to be very hard to grow.”
Equity Interface is an online real estate investment service designed to connect developers and accredited investors. By offering unparalleled research tools and information, Equity Interface empowers members to discover mutually beneficial real estate opportunities. For more information, please visit www.equityinterface.com
The US economy grew at a faster than expected 5.7% annual pace in the fourth quarter, the quickest in more than six years.
The first estimate put Q4 gross domestic product growth at its fastest pace since the third quarter of 2003. The economy expanded at a 2.2% annual rate in the third quarter. Analysts had forecast GDP, which measures total goods and services output within US borders, growing at a 4.6% rate in October-December period.
Growth was boosted by a sharp slowdown in the pace of inventory liquidation, a factor that could serve to mask the strength of the economic recovery. However, even stripping out inventories, the economy expanded at an annual rate of 2.2%, accelerating from the 1.5% increase in the third quarter, reflecting relatively strong performance from other segments of the economy.
Business inventories fell only $33.5 billion in fourth quarter after dropping $139.2 billion in the July-September period.
The change in inventories alone added 3.4 percentage points to GDP in the last quarter. This was the biggest percentage contribution since the fourth quarter of 1987.
In the last three months of 2009, consumer spending increased at a 2% annual rate, below the 2.8% recorded in Q3 when consumption received a boost from the government’s car scrappage scheme.
Consumer spending, which normally accounts for about 70% of US economic activity, has been held back by the worst labor market in a quarter century.
Business investment in the fourth quarter grew for the first time since the second quarter of 2008 as the drag from the troubled commercial property sector was offset by robust spending on equipment and software. Business investment rose at a 2.9% rate.
The growth of spending on new home construction slowed sharply in the fourth quarter to an annual rate of 5.7% from an 18.9% pace in the third quarter. Export growth outpaced imports, leaving a trade gap that contributed half a percentage point to GDP growth in the last quarter.
Equity Interface is an online real estate investment service designed to connect developers and accredited investors. By offering unparalleled research tools and information, Equity Interface empowers members to discover mutually beneficial real estate opportunities. For more information, please visit www.equityinterface.com
