How Commercial Real Estate Could Trigger a Double-Dip

Reports that commercial real estate (CRE) is suffering from a double whammy of soaring vacancies and declining valuations have been making news recently with sobering regularity. DailyFinance addressed the risks that CRE meltdowns pose to banks in early December. And in a stunning confirmation, just weeks later Morgan Stanley announced it was "walking away" from five San Francisco office towers, giving them back to the lenders. These accounts address the impacts on real estate investors, banks and hard-hit locales such as Southern California. But a bigger, often-overlooked, risk is the potential for CRE to remain a drag on the U.S. economy for years to come, or its potential to trigger a slide back into recession -- the so-called double dip that many fear.%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%%Four primary factors are behind the tumble in CRE prices -- and they're eerily similar to those that powered the residential housing boom and bust:
  • Overbuilding in marginal locales that lacked adequate jobs and services to support massive new commercial construction (malls, hotels, business parks, resorts, etc.)
  • Excessive valuations fueled by low interest rates and easy credit
  • Highly leveraged bets on future appreciation
  • A banking sector that's extremely vulnerable to write-downs and losses from foreclosures
How much have prices tumbled? According to Moody's/REAL Commercial Property Price Index, CRE prices have plummeted 41% from the peak in 2007. Or in many cases, even more. For example, a hotel in Hawaii that sold for $250 million with a $230 million mortgage a few years ago is now only worth about half that amount.

It Starts With the Banks

In a recent research report, Deutsche Bank analysts expect 75% of current CRE loans won't qualify for refinancing. With more than $2 trillion in CRE debt maturing from now until 2013, that suggests $1.5 trillion cannot be "rolled over" into new loans. Part of this crunch stems from the fact that commercial property loans are typically shorter-term than residential mortgages; most common are terms of five to seven years.

Of course, speculators aren't the only ones who are losing big. The banks that provided the mortgages are in trouble, too -- and that's where the problems in CRE can start weighing down the entire U.S. economy.

Over the next few years, the Deutsche Bank analysts estimate CRE losses to lenders of $200 billion to $300 billion. With banks already reeling from losses stemming from U.S. residential real estate's 30% decline from its 2006 peak of $20 trillion (a value set by Federal Reserve data), the analysts believe that "hundreds of banks, mainly smaller community and regional banks, are likely fail." These losses will hit vulnerable regional banks especially hard because they loaded up on commercial loans in recent years.

Don't Bet on Another Bailout

Will the banking sector once again require taxpayer bailouts as these huge losses start draining regional banks' reserves, pushing them toward insolvency? It's unlikely the public will support another TARP-type rescue. It's perhaps even more unlikely that politicians will risk their careers in an election year by supporting yet another massive bailout of lenders that knew -- or should have known -- the risks inherent in highly leveraged CRE loans.

What will happen as banks absorb billions of dollars in new losses, thanks to the meltdown of CRE? They'll have much less money to lend to other borrowers. And that contraction of credit in a fragile economy could trigger a double-dip recession. Anyone believing that banks are "on the road to recovery" hasn't factored in the hundreds of billions of dollars in CRE losses forecast by industry analysts.

Property values are another problem. In that area, CRE faces significant structural headwinds to a recovery. Perhaps the single most important one is the contraction of the consumer economy that supported seemingly endless expansion of malls and other retail space. Consumers' net worth has fallen by about $12 trillion, their incomes are either flat or declining, taxes are rising across the board (income, sales, property, etc.) and baby boomers face the generational task of saving far more for their retirement than seemed necessary at the top of the housing bubble.

That boils down to less money available to spend on discretionary goods and services, and hence less demand for retail space and for resorts and hotels.

Cyberspace Means Less Commercial Space

The steady growth of Internet shopping also saps the demand for bricks-and-mortar retail space. Web-based shopping has already reordered the bookselling industry and is well on the way to permanently reducing demand for other retail outlets.

Beyond retailing, the Net is also transforming demand for office space, as increasing numbers of knowledge workers telecommute from home, cafés or other decentralized locations. That means less need for office cubicles -- and for conference rooms, considering that teleconferencing and other Web-based communications are eroding the old model of business travel and meetings. This also means less demand for business-related hospitality services, such as hotels and restaurants.

Add these structural headwinds to the unavoidable heavy losses and write-downs facing CRE lenders, and you get a recipe for a major drag on lending, banking profits, property taxes, employment, construction and all the other sectors of the economy.

Whether these forces will tip the U.S. into a double-dip recession depends on many other factors, but they certainly have the potential to add to the contraction of credit that's bedeviling wide swaths of the economy. And we all know what happens when credit disappears.
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