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Is the Commercial Real Estate Market About to Implode?

I have noticed when talking to banks that when the subject turned to commercial loans they seemed much more hesitant and started talking about options at other banks. There have been discussions that the commercial market is weaker than it seems. I was able to talk to a lending officer off record about the situation. The following is what I learned:

Three to five years ago there was a boom in commercial sales with a lot of buyers taking 3 to 5 year balloon notes. We know that a lot of the problems with the residential market were that a few years before the market crashed, people also got balloon loans. When their mortgage term expired, they had to get a new loan but they were not able to get financing anymore and were forced into foreclosure.

So the situation is repeated with the commercial real estate market. However in the residential market only a small percent of borrowers got a balloon loan. In the commercial market pretty much everyone gets a balloon loan. The 30 year fixed rate mortgage is basically not available for commercial loans and with the balloon note financing option the problem is compounded.

3 to 5 years ago there was a large number of commercial sales, now all those balloons are going to start expiring. When asked about the economy Atlanta Fed president, Dennis Lockhart said

"The risk I’m watching most closely is commercial real estate. There is a heavy schedule of commercial real estate financings coming due in 2009, 2010, and 2011.”

What will make matters worse are the banks themselves. Fearing the potential problems in the commercial market they are pretty much avoiding commercial loans. In fact it’s interesting that when you mention getting a commercial loan many banks will often point you in the direction of a competitor down the street.

What this means is that when many of these balloon loans start to expire the borrowers are going to find a lot of closed doors when they start to look for a bank to help them refinance. Its hard to know how many of the expiring loans will not be able to obtain financing. A report recently released by Deutsche Bank estimated that half of the loans expiring in the next 3 years will not qualify for financing. One of the authors Richard Parkus wrote "People are only now beginning to realize there is a looming crisis".

A case in point is the collapse of General Growth Partners, a real estate investment trust that owns or manages 200 regional shopping malls. The company filed for bankruptcy in April 2009. The reason they were forced into bankruptcy was not because their income had dropped off, but instead they had several balloon payments expire and were not able to find banks willing to refinance those loans.

So basically the doomsday scenario is this. Current owners have balloons that will expire. The current owners are not able to find new financing because banks are scared of being more exposed to a dicey commercial real estate market. As owners declare bankruptcy more and more properties are dumped on the commercial market. At the same time it’s more difficult for potential buyers to get properties because again banks don't want to give them loans.

To make matters worse, the banks can drop any pretence about wanting to stay in the market. In 2007 and 2008 banks had to strike a balance between wanting to limit their exposure to the real estate market and wanting to protect their long term brand. Being a bank, they didn't want to exit the market altogether.

If for instance Chase Bank had simply stopped giving out residential loans during 2008 it would have done significant damage to there long term brand. So instead they had numerous restrictions to limit their loans and exposure to the market, while publicly saying they were lending like they always had. However, if the banks want to limit their exposure to the commercial market they don't have to worry about playing such a balancing act since limiting commercial loans has less of a risk of hurting their long term brand.

The federal government could provide some kind of bailout to try and improve the commercial lending market but I don't think it’s that likely for a few reasons.

The public is pretty fatigued with the idea of bailouts so I don't see another large scale bailout moving through Congress. The government spent a lot of money in the last few years, so providing more funds for bailouts is pretty risky. In addition, the fear of an economic depression which helped push the first few bailouts through is pretty much gone. Lastly the average person will notice that their neighbor is facing foreclosure but the commercial real estate market is removed from most people.

So the negative factors for the commercial market are greater than the problems the residential market faced in the past few years. Over the next 12 months it will be interesting to see how this plays out

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Comments

Nice analysis. I've heard that one reason the banks are so skittish is that they can no longer diversify their risk because the secondary market (securitization) of commercial loans has basically stopped functioning.

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