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The Recession Downtown

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Mark your calendars.

It’s the third quarter, and the worst appears to be over.

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With the stock market posting four straight weeks of gains, a growing number of economists say the economy finally has turned the corner.

That may be true for some ailing sectors of the economy. But if you’re in the business of commercial real estate, it’s tough to see any real glimmer at the end of the tunnel.

A Growth Industry: Vacancies

Commercial property values have fallen 35 percent since October 2007. Most analysts do not expect to see a rebound in values any time soon. Along with falling valuations there has been a drop in investment in new commercial construction ranging from malls to office buildings.

Vacancy rates, particularly in the retail sector, have been climbing nationwide.

With unemployment still on the rise, declining household income and restrained spending, U.S. retailers have been hit hard. Vacant storefronts have become common, even in the most affluent areas.

Mall owners from Anchorage to Atlanta have been forced to slash rents just to hold on to their anchor tenants. Despite these efforts, hundreds of retailers still have shut their doors.

Some areas like Honolulu, San Jose, San Francisco, Orange County in California and Long Island in New York have managed to keep their vacancy rates below 7 percent.

The vacancy rate among Los Angeles area retailers was around 8.3 at the end of the second quarter. Vacancy rates in metropolitan New York were hovering at 11.3 percent, which still was below the national average of 12 percent for the same period. By comparison, vacancy rates in Chicago shot up to 13.4.

Office vacancy rates have paralleled the retail sector. With the economic downturn has also come a significant slowdown in hotel occupancy especially among business travelers, a mainstay of the hospitality industry.

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These trends have made it tough for owners to refinance almost $165 billion of mortgages for skyscrapers, shopping malls and hotels this year. As a result, some companies, such as Maguire Properties Inc., the largest office landlord in downtown Los Angeles, have been forced to put buildings up for sale, often at a deep discount.

Why the Commercial Crisis Is Perilous

When Fed Chairman Ben Bernanke and his fellow members of the interest rate setting FOMC (Federal Open Market Committee) sit down tomorrow to discuss the state of the economy, the current distress in commercial real estate is likely to be high on their agenda. If nonresidential real estate remains in the doldrums, the Fed will be forced to keep benchmark lending rates near zero and leave its emergency lending programs in place.

Bernanke and his fellow Fed governors have repeatedly voiced their concern about the potential drag on the economy that may be caused by the continued crisis in commercial real estate. During his semi-annual testimony before the Senate Banking Committee on July 22, Bernanke told the members that he was “paying very close attention” to the commercial real estate market.

After the massive bailouts that already have been provided to the nation’s banks, Bernanke is clearly concerned that the risk of further losses in commercial real estate may reignite the financial crisis. It is precisely for this reason that the Central bank probably will prolong its funding for TALF (Term Asset-backed Loan Facility) as a means to support investment in the commercial real estate sector.

Traditionally, commercial real estate companies rely more heavily on bonds rather than direct borrowing to finance their operations. During 2007, the U.S. market for these bonds, known as commercial mortgage-backed securities (CMBS), was about $700 billion. With the advent of the credit crisis, the market for these commercial real estate bonds has dried up.

The central bank started TALF in March to help thaw credit by lending to investors who want to buy securities backed by auto and credit card loans. With pressure from the commercial real estate industry, the $1 trillion program then was expanded to include bonds backed by commercial mortgages. Investors who buy the securities submit them to TALF as collateral, and the government lends the investor a percentage of the purchase price, subsidizing the investment.

So far, however, with rents falling and vacancy rates still climbing, few commercial real estate bond issuers have tapped into TALF.

The Fed is willing to lend CMBS buyers up to 85 percent of the purchase price for TALF securities. While this appears to be a very liberal policy, it still may limit the program’s effectiveness. The problem is that many landlords, like L.A.’s Maguire Partners, already owe more than their property is worth.

As much as $500 billion of commercial real estate loans mature this year with another $400 billion coming due each year for the next several years. Unless there is a dramatic turnaround in commercial real estate values, this will continue to pose a major risk to economic stability.

Because of the continued slide in commercial real estate values, most banks have gotten out of the commercial real estate lending business. Consequently, it now has fallen to the Fed to find additional ways to support the commercial real estate bond market.

The authorization for the TALF program is set to expire at the end of the year. Unless commercial real estate prices stage a miraculous comeback, look for the Fed, with the support of Congress and the President, to further liberalize the TALF lending criteria, and to extend the subsidy program for at least one year, if not more.

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