If you’re looking to get some, it’s fabulous.
If you’ve already got it, you’re looking to cut a better deal.
If you own some, you’re starting to sweat bullets.
If you’re the Fed, you’re holding your breath.
Residential real estate foreclosures may have captured the economic headlines, but policymakers at every level are fretting about the mounting bank losses stemming from the depressed commercial real estate sector.
Too Much
During the third quarter alone, the average cost of commercial real estate leasing fell 8.5 percent from the previous year. That’s the steepest single year decline in rents since the mid ‘90s.
There is a huge glut of empty offices. In a sign of how hard the economy is hitting businesses, more than 20 million square feet of office space was vacated from June through the end of September.
The commercial real estate industry is already hurting from tight credit and an oversupply of inventory. Falling rents and the dramatic upturn in vacancies may push commercial real estate firms over the edge.
Banking regulators at the Federal Deposit Insurance Corp. (FDIC) and the Federal Reserve are girding for a second shot to the real estate sector of the economy after the residential real estate bubble burst.
Along with portfolios that still are chock-full of troubled residential real estate assets, hundreds of banks may be just as vulnerable as a result of commercial real estate failures. Unlike individual residential paper, the loan amounts are multiples higher. Moreover, when the loans go sideways, it’s frequently impossible to find qualified and interested buyers for repossessed commercial asset.
FDIC Chair Sheila Bair has grown increasingly vocal about her concerns over the liabilities small and medium-sized banks are facing because of slumping commercial property values and rental payments.
Bair recently commented that commercial real estate for banks has become a “looming problem.” In the coming months, Bair believes commercial real estate losses will become “more of a driver in credit losses and bank failures.”
So far this year, the FDIC under Bair has closed 98 insolvent banks to protect insured depositors. These closures have drained the FDIC’s reserves. Just last week, the closures forced the FDIC to seek a three-year advance on premiums from member banks to replenish its funds in preparation for another wave of bank interventions.
Holding Off on Foreclosures
Fed officials also are uneasy that so many banks have been slow to book losses on their commercial real estate loans. Like the losses they suffered on the residential side of their ledgers, it’s becoming increasingly evident that banks have failed to set aside adequate reserves to cover the crumbling value of their commercial real estate assets.
To the alarm of regulators, banks have been reluctant to foreclose on their commercial real estate loans. Instead, they have been fudging the numbers by extending the term for the borrowers in the desperate hope that the market will turn around. In this way, the banks don’t have to re-write the loan, take possession of the property, or more importantly, charge the loss against their already thin reserves.
Reportedly, Fed analysts recently prepared an internal paper that projected that commercial real estate losses could be 45 percent next year. According to the paper, commercial loans may be the most “toxic” loans on bank books because most were structured as interest-only to incentivize the borrowers.
This has meant that the banks making the commercial loans have gotten no benefit from amortization since it requires borrowers to repay interest but no principal.
After the commercial real estate bubble burst in the 1990s, the tech and dot.com booms bailed out the market. Another difference between then and now was that most of the premium urban commercial real estate holdings were owned by foreign investors and financed by banks in their own countries, not U.S.-based lenders.
Chief among the big losers were the Japanese who sank billions of their trade capital into purchasing commercial properties in to major urban centers from L.A. to New York, Chicago, Houston and Atlanta. When commercial real estate values collapsed, the losses were booked by offshore banks.
This time, it has been U.S. investors who were lured to commercial real estate purchases by attractive interest rate packages and the illusion of an eternal cornucopia of profits. While investors from Miami to Las Vegas have quickly soured as vacancy rates have soared, it’s now U.S. banks that have been left holding the bag.
Dozens of projects like the $8.5 billion City Center mega-development in Las Vegas has been left unfinished. Despite securing hundreds of millions of dollars in deposits, City Center developer MGM has been forced to put much of the project on hold leaving its investors and lenders stranded.
Even in smaller markets like Tampa, FL, commercial real estate is careening. In Tampa, one in ten commercial properties is in some form of distress.
At this writing, it still is unclear whether the rapidly imploding commercial real estate market will be a tsunami that swamps the banks causing another rash of failures or whether it’s simply another surge in the flood that has left so many institutions treading water.
John Cohn is a senior partner in the Globe West Financial Group, based in West Los Angeles. He may be contacted at www.globewestfinancial.com
