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Is Commercial Real Estate a Ticking Time Bomb?
By Doug Solether, 2009-04-22

 

Commercial real estate loan debt coming due in the next three to five years could could mean that as much as $250 billion in losses.

 

Unlike residential loans, which are self amortizing, commercial loans typically have a balloon or call provision requiring the borrower to refinance or pay off the loan at a certain date in the future, typically 5 or 10 years. Between now and 2013, $1.3 trillion in commercial loans - for property types like shopping centers, office, multifamily, industrial, hotel and self storage - are coming due. According to Deutsche Bank, at least half of the maturing commercial and multifamily debt will not qualify for refinancing. And worse yet, two-thirds of CMBS debt will not be eligible for refinancing resulting in losses on securitized commercial mortgages of $50 billion; compared with $200 billion on conventional commercial real estate loans.

 

The Federal Reserve and Treasury Department are considering a number of options including providing incentives to banks to extend the maturity date of the commercial real estate loans in an effort to minimize damage. The alternative, more bank losses, more bankruptcies and plunging commercial real estate values.

 

Take for example General Growth Properties, the nation's second largest shopping mall owner. General Growth Properties was unable to refinance many of its commercial mortgages - even though many of the properties have positive cash flow - and was forced to file bankruptcy.

 

With sales prices down as much as 45% from the peak in 2007, rapidly increasing vacancies and tighter underwriting guidelines, even the strongest commercial mortgage refinancing candidates are having difficulty resetting the terms of their loans. And the fundamentals will only get worse going forward. Vacancies are up — expected by year's end to reach 13.5% for retail and 17% for office buildings — cutting potential income that commercial properties need to make their mortgage payments.

 

Add to that the threat of impending inflation - which means higher interest rates and more income required to service the debt - and the outlook looks bleak. But higher rates, higher vacancies and lower income available to service debt are only part of the equation.

 

Over the past 5 or more years underwriting standards were loose and commercial lenders were loaning up to 90% - and in some cases 100% - of a property's appraised value. Lenders justified over leveraging properties simply because the thought was rents would continue to rise and cap rates would continue to fall, eventually bringing values and debt service coverage ratios (DSCR) inline with traditional underwriting guidelines. Now, lenders are underwriting to much lower loan to value ratios (LTV) disqualifying borrowers from refinancing even with stabilized performing assets.

 

The Federal Reserve and Treasury Department are considering including commercial real estate loans in TALF which could help reduce defaults and bank losses. Additionally, there is a great deal of lobbying by real estate executives for more direct government incentives to encourage banks to extend the terms of loans coming due. Subsidizing the interest rate and paying a fee, e.g., one percent of the loan amount, so banks can earn more revenue on a commercial real estate loan are two options being discussed.

 

While losses on commercial real estate loans are relatively low at this time, increasing delinquencies, higher vacancies, lower consumer spending and a continued deterioration in the economy spells trouble ahead. Delinquencies for CMBS debt are around 1.7% today and are expected to increase to 3% by years end and as high as 6% in 2010. To put it into perspective, current residential delinquencies are in the 6%-7% range, so it's easy to understand the troubles that are brewing for both the commercial real estate sector and the US economy.

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This article is protected under the copyright laws of the United States (title 17 U.S. Code). Any unauthorized use is strictly prohibited. If you would like to reprint this article for use on a commercial website, please contact Crefcoa for more information.
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