What's causing the slow motion commercial real estate crash?

As the economy tries to rebound from its horrific slump, commercial real estate has remained a potential source of trouble. Both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Tim Geithner have highlighted the uncertainty that exists in the sector, which could lead to loan losses hitting an already-fragile banking system. Of particular concern are regional banks, whose portfolios tend to be more heavily concentrated in commercial assets. This became particularly evident after Colonial Bank, an Alabama-based lender with significant exposure to construction and commercial loans, became the largest bank failure of the year.

Even as the sector continues to struggle, capital has been flowing in searching for opportunities. In recent weeks, hotel chain Hyatt, mortgage modification ship Pennymac, and commercial REIT Starwood Properties Trust, have all filed for IPOs. DailyFinance asked Jonathan Horn, Senior Managing Director, and Josh Malka, Managing Director, at Helios Capital LLC, a mortgage loan advisory firm to banks, for their outlook on commercial real estate -- and what it means for the banking system and the broader economy.

The pair were quick to explain that hopes for a rapid turn in the fundamentals would remain elusive. "This is the calm before the storm... we haven't bottomed out yet," Malka said. The smaller banks they work with are "stuck between a rock and a hard place, and they don't know what to do," as the market prices of loans remain distressed and capital reserves are too low to absorb the losses they would take at the market price. As discussed last week, many banks would be undercapitalized or technically insolvent if they were forced to mark their loan portfolios to market.

That situation won't persist forever, though. "A lot of banks simply can't afford to discount to the level" the larger institutions that dominate the market are looking for in order to clear returns in excess of 20 percent, Horn said. "At some point, banks are going to have to discount these loans," and take their losses, he added, noting that the interest investors have shown of late will speed the process up somewhat.

What areas present opportunity, and what should investors be shying away from? Helios -- which focuses on deals in New York, New Jersey, and Florida -- sees some loans still trading at 90 cents on the dollar if the property has good cash flow, but also sees deeply distressed loans backed by speculative assets trading as low as 30 cents on the dollar. "Most of our deals involve good assets that have simply been mismanaged, or where a borrower spread themselves too thin" through leveraging up to acquire additional properties, Horn said.

One possible area of upside for commercial real estate, ironically, comes from the struggles in residential real estate. "The flavor-of-the-month asset is multi-family properties," Malka said. "With all the problems in the residential market, people are running back to apartments and renting," making for a favorable situation compared to office or industrial properties, which are grappling with reduced demand and an overhang of supply.

James Cullen edits and writes at CollegeAnalysts.com. He has no personal position in the stocks mentioned above.

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