For months, the buzz has been that commercial real estate—with $3.4 trillion in outstanding debt, $1.4 trillion of which is coming due by the end of 2012—would precipitate the next leg in the credit crisis and possibly derail the broader economic recovery. To some, that mountain of debt coming due represents a clear parallel to the trillions of dollars in residential loans that helped destroy more than 100 banks and made the current recession the deepest and longest since the Great Depression.
The situation seems especially ominous given that commercial real estate values are off 40 percent from market peaks and credit markets are barely out of hibernation mode. That means indebted owners can't sell a property and repay their mortgage with deal proceeds. It also makes refinancing difficult. Today, borrowers have to put more of their own equity into a deal and lenders have tighter standards. Loan-to-value (LTV) ratios are not only lower than they were at market peaks, but have to be based on the current value of the property, which is lower than it was a few years back. That means a bank might want to replace an 80 percent LTV mortgage on a property once worth $10 million with a 60 percent LTV mortgage on a property now worth $6 million. To some people, this is sending off warning bells that commercial real estate may do as much damage to our financial system as residential mortgages did in 2007 and 2008.
Yet according to many real estate economists, this fear is largely misplaced. Commercial real estate debt will likely stall the recovery in the credit markets, they note, but because of a combination of factors, including the limited impact of commercial real estate loans on the overall economy, it won't bring about the same wave of distress as the housing downturn did.
"As far as the impact of commercial real estate on the overall economy, I don't think it's going to be the next shoe to drop," says Robert Bach, senior vice president and chief economist with Grubb & Ellis, a global commercial real estate services firm. "These problems are focused in regional banks and the Federal Deposit Insurance Corp. (FDIC) has a tested method of shutting those down on Friday and opening them on a Monday under the auspices of a bigger bank. These are not too big to fail banks. I don't see [commercial real estate] as an unmitigated disaster—I see it as a repeat of what happened in the 1990s, but the economy can handle it."
The FDIC, however, faces some concerns. A recent analysis by the agency's Office of Inspector General found that during the peak of the real estate market many banks ignored FDIC's 2006 recommendation that they keep commercial real estate holdings at less than 300 percent of total capital. Meanwhile, after dealing with 100 bank bankruptcies last year, today the agency is facing a deficit for the first time since 1933 and might lack the funds to deal with the potential fallout of a commercial real estate crisis.
In 2009, bank failures cost the agency $25 billion on top of the $20 billion it doled out in 2008. To deal with the money shortage, the FDIC is requiring banks to prepay $45 billion of insurance premiums by the end of this year. The premiums would cover the fourth quarter of this year and all of 2010, 2011 and 2012. Overall, the agency is projecting that bank failures between 2009 and 2013 will cost it $70 billion.
Meanwhile, more than $1.4 trillion in commercial real estate loans are scheduled to mature between 2009 and 2012, including $320 billion next year, according to ING Clarion Real Estate, a real estate investment management firm. That's coming at a time when new sources of refinancing remain scarce and valuations of commercial real estate properties are getting battered by weakening fundamentals. In the first half of 2009, the volume of distressed commercial assets grew 122 percent, ING reports, to $138 billion, including $32 billion in the retail sector.
The good news is that total volume of commercial real estate debt is about a third of the total amount of outstanding residential mortgage debt, which stands at approximately $10.9 trillion, according to the Federal Reserve Board's figures.
What's more, because the residential mortgage crisis affected almost every homeowner in a country with a homeownership rate of 67 percent, it had a devastating impact on consumer spending, which makes up about 70 percent of U.S. GDP. During the housing boom, Americans would refinance their homes and use the proceeds to shop till they dropped. Once refinancing became impossible, consumer spending dried up. By contrast, troubles in the commercial real estate industry might cause damage to banks and large institutions, but will have a limited effect on Main Street, says Clint Myers, strategist with Property & Portfolio Research, a Boston-based real estate research firm.
Any potential damage will also be mitigated by the fact that commercial real estate debt has been largely concentrated on the balance sheets of regional banks, rather than the big national players, and that most of the loans issued before 2005 feature solid underwriting, adds David J. Lynn, managing director with ING Clarion Real Estate.
Today, 54 percent of all commercial real estate loan defaults come from loans sponsored through commercial mortgage-backed securities (CMBS), which were a major source of real estate debt between 2005 and 2007. Loans issued by national and regional banks account for only 12 percent and 11 percent of all defaults, respectively.
After the collapse of Lehman Brothers, the government isn't likely to let another big national lending institution go under, so most of the damage from bad commercial real estate loans will be contained in the regional bank sector, Lynn notes. And the financial system could withstand the failure of several hundred regional banks without toppling over, adds Myers.
That's not to say that all those commercial loans won't cause serious problems in the credit markets. As long as banks avoid realizing losses on commercial mortgages, commercial asset values will remain artificially high, Myers says. That, in turn, will likely limit the flow of new credit into the commercial real estate market, leaving some owners cash-strapped.
Myers doubts the possibility of another large bankruptcy in the public REIT sector, since REITs have proven they can raise enough funds to survive through equity offerings. But there will likely be added pressure on privately-held real estate investment firms.
"The real stress in the system [will be on] the banks," he says. "The pace at which regional banks fail will probably accelerate from this year to the next. And what it will mean is that there will be very little new lending activity for commercial real estate and it's going to be very hard to grow." --Elaine Misonzhnik