The terms "commercial real estate" and "next shoe" generate more than 29,000 hits on a Google search.
For the past few months, there's been a drumbeat that it's just a matter of time before commercial real estate collapses and wreaks havoc on the economy. The thought is that the mountain of commercial real estate debt coming due in the next few years will trigger a second wave of the credit crunch as an avalanche of losses rumbles through bank balance sheets. This, in turn, will derail the momentum the economy has had in recent months as it begins to recover from the deepest and longest recession since the Great Depression.
The main evidence for this view includes data points such as the fact that commercial real estate values are off by 40 percent from market peaks and that there is approximately $3.4 trillion in commercial mortgage debt outstanding. Of that, about $1.4 trillion will come due by the end of 2012.
In our newsletter today, we talked to economists who have a different view. It's not because there aren't problems. The questions are what the scale of those problems will be and what effect they will have on the financial system and the economy.
Our story points out:
[C]redit 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.
Borrowers that can't put up more of their own equity will be in trouble, especially as occupancies and rents continue to erode. It means there will undoubtedly be defaults by borrowers and problems at banks as they foreclose on properties. Moreover, while most residential real estate debt was concentrated at the largest banks in America, commercial real estate debt is spread all around and will create messes all year that the FDIC has mopped up. Already, about 100 banks have failed in 2009. There's more of that to come. That's what FDIC Chairwoman Sheila Barr is talking about when expressing concerns about commercial real estate debt.
Indeed, there are no less than three stories today that illustrate the kinds of problems that will result from issues in commercial real estate. Reuters has a story of about a mall that is now owned by the Federal Reserve Bank.
The Fed finds itself in the unusual situation of being an Oklahoma City landlord after it lent JPMorgan Chase $29 billion to buy Bear Stearns last year.That money was secured by a portfolio of Bear assets. Crossroads Mall is the only bricks and mortar acquired through bailout. The remaining billions are tied up in invisible securities spread across hundreds, if not thousands, of properties.
Meanwhile, in Cupertino, Calif., the Cupertino Square Mall is being liquidated after the lender foreclosed on the property.
Gramercy Warehouse Funding I LLC now owns the property at 1023 Wolfe Road. The New York-based lender foreclosed on the property and purchased it for $65 million at a trustee sale in May.Mall owners Cupertino Square LLC and Vallco International Shopping Center had failed to make adequate protection payments of approximately $780,000 to Gramercy in March and April after filing Chapter 11, according to Richard Lapping, who represented Cupertino Square in bankruptcy court. Orbit Properties LLC was the main stake holder in property.
The bankruptcy court converted the case to Chapter 7 and ordered the mall's liquidation on June 26. Gramercy gave Cupertino Square mall owners a $195 million construction loan in 2006 and claimed the owners still owed them $113.8 million.
Lastly, the Block 37 project in development in Chicago is facing foreclosure.
Bank of America and a group of lenders are moving to foreclose on the retail and transit portion of the mixed-use development, claiming Chicago developer Joseph Freed and Associates LLC has, in essence, run out of money, according to a lawsuit filed Monday in Cook County Circuit Court.Freed issued a statement Tuesday calling the banks' lawsuit a "misguided action that could halt the project" and make it "near-impossible to restart."
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The banks have been negotiating with Freed since March, when the developer technically defaulted, the lawsuit said. Since then, cost overruns had reached "at least" $34 million as of Aug. 25, court documents said. Freed owes $128.5 million on a $205 million construction loan, the filing stated.
The point of today's story wasn't that these kinds of things won't continue to happen. The questions is, though, will the damage from incidents like this be enough to thrust the financial system back into chaos or hurt the broader economy? The economists we spoke to (and the view we endorse) is that commercial real estate won't do that kind of damage. For one thing, the $3.4 trillion figure is only about one-third the amount of residential real estate debt outstanding. Moreover, a healthy percentage of the $1.4 trillion in debt will be refinanced.
This is the argument:
"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."
In many cases the assets will be generating a steady cash flow or be candidates for turnaround specialists. Some properties will be doomed. Others will just need an experienced management team to come in and stabilize the property. As the economy improves, real estate fundamentals should improve with it meaning rents and occupancies will also stop falling. There's a reason Simon Property Group has billions in cash on hand. It's not just to pay down debt. It will be for opportunities that emerge to buy assets from indebted owners. Some of the properties that get foreclosed may be dead malls, but many, many others will not be. There's a big difference between troubled assets and troubled owners. Both things may trigger foreclosures, but the latter will be big opportunities for other players in the sector.
Look at how REITs are faring these days. The two "problem children" of the sector were Australian limited properties trust Centro Properties Group and Chicago-based mall REIT General Growth Properties. Centro has taken major steps to resolve its financing issues and General Growth is working its way through bankruptcy. But since March--when General Growth filed--REIT share prices have staged a major rally. The Morgan Stanly REIT index is now up more than 100 percent since hitting its lows that month.
The reason is because REITs have been able to tap public markets all year for debt and equity offerings. Companies have raised tens of billions through these offerings. The proceeds have gone to pay down debt. Others have managed to refinance expiring lines of credit. There have also been joint ventures and strategic asset sales. As a result of all of this, REITs have by and large not only taken care of debt expiring in 2009, but 2010 as well. Most are looking at debt expiring in 2011 or 2012 or are poised to go on the offensive and acquire assets as other borrowers falter.
In the end, commercial real estate debt will present challenges for borrowers and banks for years to come. But I don't think the problems will be enough to throttle the financial system further or necessitate further bailouts or other governmental measures. And it won't pose a systemic threat to the economy. If you want to look anywhere for a reason to be worried about continued recovery, look at the jobs picture, not commercial real estate.