Commercial Properties Could Undermine Recovery

Could the defaults and foreclosures of office towers, shopping malls, and half-built condo complexes bring down the rest of the economy? That's been the worry in recent weeks, as the "slow motion train wreck" of commercial real estate picks up steam.

"Both in the U.S. and Europe, experts are concerned that stress from the commercial real estate sector could undermine the fragile economic recovery," said Anita Likus in the Wall Street Journal.

The worry is that a wave of foreclosures and loan defaults for commercial properties in the year ahead could create more serious problems for the financial system. But the commercial crisis is different in fundamental ways from the residential subprime mortgage bomb that started our problems two years ago.
Commercial real estate is a big problem. There is now more more money tied up in troubled commercial real estate than in homes facing foreclosure. Commercial real estate properties totaling $160 billion are behind in their loan payments, according to the December report from Real Capital Analytics. In comparison, about 350,000 homes received some kind of foreclosure notice in December, according to RealtyTrac. If you plug in an average home sale price of about $280,000 (according to the U.S. Census), that's a relatively modest $98 billion in residential real estate on the edge.

• The problem is getting bigger. Close to 5 percent of all commercial real estate loans sold as bonds are now delinquent, and that rate could almost double, to 9 percent, in 2010, according to analysts at credit rating-agency Realpoint LLC. That would represent a huge amount of late payments to lenders. Harry Macklowe and Tishman Speyer will have company: Expect to read a lot more stories this year about trophy office towers in trouble.

• But much of the damage is done. The financial crisis created by home loans hit banks hard for a simple reason - banks borrowed heavily to finance their real estate-backed investments, so even slight losses to their investments put them underwater. While some commentators think banks are still too highly leveraged, they are much less vulnerable to falling asset values than they were before the crash. Citigroup, for example, has an overall leverage ratio of 17 to 1 today, which sounds high, but it's nowhere near the 37 to 1 ratio it had in 2007, according to analysis from Sprott Asset Management. (Sprott, for one, still believes that banks in general are overleveraged).

Also, prices have already fallen steeply for commercial real estate, and some experts already think the market has reached it's bottom. Here's a chart of commercial real estate prices and housing prices through the bubble from economist Paul Krugman at the New York Times:

Krugman's red line represents commercial real estate prices. It hardly looks like an accident waiting to happen - the bubble seems to have burst. As JP Morgan Chase CEO Jamie Dimon said in a speech earlier this week in San Francisco, "Commercial real estate is a train wreck, but it's already happened."

• Positive signs. There were some positive trends emerging at the end of 2009 that may take some some pressure off of commercial properties in trouble. Cash buyers, including real estate investment trusts and foreign investors, are beginning to return to the market, according to Real Capital Analytics. That will lend some support to prices and could throw a lifeline to properties on the edge. Also, financing is becoming more available for commercial real estate - two Wall Street commercial real estate lenders re-opened for business in December, which should provide some relief to commercial properties that need to refinance expiring loans.

"We have hit bottom and are starting the new decade on the upswing," according to Real Capital.

To stay with the train analogy, it seems there is light at the end of the tunnel.
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