Commercial real estate in a slow burn
February 12, 2010
The commercial real estate industry is in the midst of a perfect storm, says Zions Bank vice president of real estate Michael Morris. He expects 2010 to be more of the same, but is optimistic farther out.
The monthly report from the federal Congressional Oversight Panel (COP) charged with overseeing Troubled Asset Relief Program (TARP) spending was released Feb. 11 and makes many of the same arguments but says the "storm" could reverse economic recovery.
At the heart of the issue are commercial loans that are coming due over the next four years that will need, but won’t receive, refinancing.
"We’re in the midst of the ‘deleveraging of America,’" Morris told attendees at the annual CCIM | NAIOP Utah Commercial Real Estate Symposium Tuesday at the downtown Hilton in Salt Lake City.
The value of commercial real estate is down 43 percent nationally. The total debt load is $3.5 trillion.
Morris said commercial real estate value has lost $1.6 trillion. The COP reported that pension funds hold 68 percent of commercial real estate equity.
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Nationwide, 150 banks have closed and that number may double or triple, he added. The COP estimates 37 percent of banks are at risk especially community banks.
The financial product "Commercial Mortgage-Backed Securities" may not be seen again for a generation, Morris said.
Commercial real estate markets often lag behind residential markets and there’s a nine-month oversupply of homes on the Utah market, and a five-to-six-year supply of developed vacant lots, he said.
There’s just too much inventory in both kinds of real estate to expect a recovery on residential real estate this year, and commercial will follow, he explained.
Morris called the market crisis a "slow burn." That means recovery will be slow as well.
Jan Wilking with CRG Utah attended the symposium and said that Morris’s comments should not be perceived as pessimistic because he envisions a light at the end of the tunnel. Last year’s conference was plagued with fear and uncertainty. This year, people were confident the bottom is in sight.
Wilking also said the "slow burn" analogy is typical of the messages being distributed by industry professionals.
Right now he’s working with distressed properties and said assistance from the government could do a lot to help people hold onto property and banks stay in business.
There are a lot of people who took out mortgages between 2005 and 2007 at the "high water mark." Commercial real estate loans come due after three to seven years not the 30 years homeowners get. People who bought commercial property at the height of the boom are not only underwater, but are due on their loans.
"Commercial real estate is not in a good state," he said.
Even in Park City a lot of people owe more than their property is worth. The first half of 2010 will likely see increased vacancies and decreased rent.
"It’s going to remain a tenant’s market in the near term," he added.
He cited The Yarrow and The Claimjumper buildings as perfect examples of the crisis banks are in.
"That’s something you’re going to be seeing in the future," Wilking said. "Everything that could go wrong has gone wrong easy money caused this decline in value."
Even people who made conservative business decisions are in trouble, he said.
The perfect storm can be broken down as follows, he said: First there are many investors who likely won’t get their money back when loans come due in the near future.
Unlike most residential loans in which there’s a single lender and a single borrower, a several parties might own a piece of a commercial mortgage and they’re prioritized. If the debt of the party first in line equals 75 percent of the value of the property, and the property loses 25 percent of its value, there will be no money left to pay the other creditors.
The amount of distressed real estate will continue to increase, Wilking explained. Yet the number of transactions is down.
Lastly, as vacancies go up and stable tenants renegotiate leases to lower rent, the values of properties continue to decline. Wilking said presentations at the symposium suggest that’s already happening in Utah.
But like Morris, Wilking believes there’s a silver lining. He considers himself an optimist and one person’s misfortune is another’s opportunity.
"Real estate can be purchased at a reduced rate right now," he said. "And there are not that many people lined up to buy yet."
The most important thing to remember is that the bottom could be close, so much of the fear and uncertainty is decreasing, he explained.
None of that optimism can be found in the COP’s report, titled, "Commercial Real Estate Losses and the Risk to Financial Stability."
According to a government-issued press release found at cop.senate.gov, the panel is "deeply concerned that a wave of commercial real estate loan losses over the next four years could jeopardize the stability of many banks and prolong an already painful recession."
When the short-term commercial loans come due, they’re usually refinanced. But refinancing will probably not be available for loans coming due between 2011 and 2014, it explained.
"Even borrowers who own profitable properties may be unable to refinance their loans as they face tightened underwriting standards, increased demands for additional investment by borrowers, and restricted credit," the release reads.
The panel estimates 2,988 community banks almost 38 percent are at risk.
"A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American," the panel said.
"When commercial properties fail, it creates a downward spiral of economic contraction: job losses; deteriorating store fronts, office buildings and apartments; and the failure of the banks serving those communities. Because community banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery and extend an already painful recession," the press release concluded.
Park City’s Frontier Community Bank is not at risk, says CFO Haddon Libby. Its focus has been on individuals and homes, so it has few commercial mortgages on the books less than 20 percent. The majority is in residential mortgages and the bank has conservative loan to value ratio, so its portfolios perform well.