Commercial Real Estate Collapse Begins

The banking system is barely hanging on in the face of the residential real estate deflation, and the hammer is about to drop on the commercial market. Our banking system is doomed. there is no denying it. However, if we cancel the debt now, the real economy won't get destroyed with it.

Vacancy rates in office buildings exceed 10 percent in virtually every major city across the United States and are rising rapidly, a sign of economic distress that could lead to yet another wave of problems for the beleaguered financial sector. With job cuts rampant and businesses retrenching, more empty space is expected from New York to Chicago to Los Angeles in the coming year. Rental income would then decline and property values would slide further. The Urban Land Institute predicts 2009 will be the worst year for the U.S. commercial real estate market "since the wrenching 1991-1992 industry depression."

By many accounts, building owners have been caught off guard by how quickly the market has deteriorated in recent weeks. Rising vacancy rates were expected in Orange County, California, a center of the subprime mortgage crisis, and New York, where the now-shrinking financial industry dominates office space. But vacancies are also suddenly climbing in Houston and Dallas, which had been shielded from the economic downturn until recently by skyrocketing oil prices and expanding energy businesses. "The economic recession is so widespread that we believe virtually every market in the country will see a rise in vacancy rates of between two and five percentage points by mid-2009," said Bill Goade, chief executive of CresaPartners, which advises corporations on leasing and purchasing office space. Banks and other financial companies have not had the problems with commercial properties in this recession that they have had with residential properties. But many building owners, while struggling with more vacancies and less rental income, will need to refinance commercial mortgages in the coming year. The persistent chill in lending from banks to the credit markets will make that difficult - even for borrowers who are current on their payments - setting the stage for loan defaults. The prospect bodes poorly for banks, along with pension funds, insurance companies, hedge funds and others holding the loans or pieces of them that were packaged and sold as securities.

Jeffrey DeBoer, chief executive of the Real Estate Roundtable, a lobbying group in Washington, is asking for government assistance for his industry and warns of the potential impact of defaults. "Each one by itself is not significant," he said, "but the cumulative effect will put tremendous stress on the financial sector." Stock analysts say commercial real estate is the next ticking time bomb for banks, which have already received hundreds of billions of dollars in capital and other assistance from the U.S. government. Big banks - like Bank of America, JPMorgan Chase and Morgan Stanley - each hold tens of billions of dollars in commercial real estate bonds, which were sliced and diced into securities. The banks also invested directly in properties. Regional banks may be an even bigger concern. Over the past decade, they barreled their way into commercial real estate lending after being elbowed out of the credit card and consumer mortgage business by national players. Their weighting in commercial real estate has nearly doubled in the past six years, according to government data.

Just as home loans were pooled, then carved up and sold to investors as securities over the past two decades, commercial property loans were repackaged for the financial markets. In 2006 and 2007, nearly 60 percent of commercial property loans were turned into securities, according to Trepp, a research firm that tracks mortgage-backed securities. Now that the market for those securities has dried up, borrowers cannot easily roll over the loans that are coming due. Many commercial property owners will face a dilemma similar to that of today's homeowners who cannot easily get mortgage relief because their loans were sliced and sold to many different parties. There often is not a single entity with whom to negotiate because investors have different interests.

Effective rents, which have already started to fall, are expected to decline 30 percent or more across the country from the euphoric days of the real estate boom, according to real estate brokers and analysts. That is making it all the more difficult for owners, who projected ever-rising rents when they financed their office buildings, hotels, shopping centers and other commercial property. Owners typically pay only the interest on loans of five, seven or 10 years, and refinance the big principal payments necessary when the loans come due. Without new financing, owners will have few options other than to try to negotiate terms with their lenders or hand over the keys to banks and bondholders. Among commercial properties, the most troubled have been hotels and shopping centers, where anemic sales and bankruptcies by retailers are leading to more vacancies and where heavily leveraged mall operators, like General Growth Properties and Centro, are under intense pressure to sell assets. But analysts are increasingly worried about the office market.

The Real Estate Roundtable sees a rising risk of default and foreclosure on an estimated $400 billion in commercial mortgages that come due this year. DeBoer, the group's leader, said building owners are by and large making their loan payments. It is the refinancing that is worrisome. Most loans, he said, were made at 50 percent to 70 percent of property values. At the top of the market in 2006 and 2007, though, some owners took advantage of available credit and borrowed 90 percent or more of the value of a property, a strategy that works only in a rising market. Since then, property values have dropped 20 percent, DeBoer said. Where possible, owners are trying to extend loans. A lender might agree to extend the term on a 10-year commercial mortgage, for example, if the borrower remains current on his payments and can make an equity payment to compensate for the decline in the building's value. Already, $107 billion worth of office towers, shopping centers and hotels are in some form of distress, ranging from mortgage delinquency to foreclosure, according to Real Capital Analytics.

New York, the biggest market by far, leads the pack with 268 troubled properties valued at $12 billion. But there are 19 more cities, including Atlanta, Denver and Seattle, with more than $1 billion worth of distressed commercial properties. Analysts are especially concerned about buildings like 666 Fifth Avenue, One Park Avenue and the Riverton complex in New York, the Pacifica Tower in San Diego and the Sears Tower in Chicago, which were acquired in 2006 and 2007 with mortgage-backed financing based on future rents rather than existing income. "Many of those buildings are basically underwater," said Goade of CresaPartners. "The price they paid was too high to begin with. There's no way anyone would lend that kind of money today."