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Ongoing Drag: Commercial Real Estate

Jonathan D. Miller / Feb 07 2010

For Release Monday, February 8, 2010

Jonathan D. Miller Here’s the good news: The economy may be turning the corner thanks to a heavy dose of government stimulus. And since March stock and bond portfolios have rebounded and at least house prices have bottomed after a three year freefall.

But lots of problems remain — not just slowness of job recovery. Just check the corner I watch for a living: commercial property. This sector continues to sink, buried in hundreds of billions of dollars in bad loans to overleveraged owners, who paid too much during a frenzied 2004-2008 transaction binge. Representative of these toxic assets, half-built condo projects, see-through floors in office buildings, and papered-over mall store fronts stand on view from coast to coast.

Commercial real estate usually lags post-recession upturns. But continuing declines in office, shopping center, hotel, apartment and warehouse markets strain the nation’s still-fragile banking sector and threaten to temper prospects for sustained economic recovery.

Out of mutual self-preservation, property owners and their lenders obfuscate the extent of losses in a dance of mutual convenience called “extend and pretend.” Banks don’t foreclose on defaulting borrowers so the financial institutions can avoid booking losses, which could spook resuscitating credit markets. Government regulators encourage this kabuki theater and pump money into banks helping them build up loss reserves so they can eventually take write downs and reconcile balance sheets. Everyone has been hoping that the economy can recover quickly enough to bridge some of the declines. But the gloomy jobs picture and burdensome household debt (all those mortgage, credit card, car, and student loans) combine to hobble demand for office, retail, and apartment space as well as hotel rooms.

So “extend and pretend” will likely turn into a bridge to nowhere — at some point this year commercial properties will inevitably crash land, after losing on average 40 percent to 50 percent in value. Premium locations in the nation’s important gateway cities will fare better — investors already circle properties in New York, San Francisco, and Washington, looking for bargains. That may well keep a floor on prices in such cities — but not in secondary and tertiary markets not directly linked to global pathways. Office rents in many cities have retreated to 1980s face rates as occupancies continue to decline. Apartments and industrial properties are registering record vacancies and rent erosion.

Finally facing reality, tapped out owners begin to turn back the keys to lenders — they don’t want to maintain debt service payments in projects without hope of generating expected revenues or recouping lost value. That’s what happened to the Peter Cooper Stuyvesant Town complex in Manhattan late last month. Bought at market highs for $5.4 billion in 2006, the apartments may be worth about $1.8 billion today. Savvy investment pros like Tishman Speyer, Black Rock, and their pension fund clients take hundreds of millions of dollars in losses on their equity investments, but non-recourse loans pin most of the write downs on lenders (including Fannie Mae and Freddie Mac) and an array of bond holders, who could land in extended and messy litigation scraps over who has rights to what remains.

Out of necessity, more banks will start to drop the foreclosure hammer, taking control of troubled assets and pushing out owners who can’t or won’t maintain properties. Each such action risks permanent diminution in value. More regional banks will fail under the weight of bad real estate debt (15 so far in 2010 after 130 last year) and the FDIC will take over, then foreclose and try to sell property assets. As lenders start to recognize losses, buyers and stressed owners will gain greater confidence about pricing levels, helping revive moribund transaction markets. But few investor players expect any chance for a robust comeback unless the economy starts to generate large numbers of jobs.

Developers, meanwhile, will be dead in the water for several years, tamping down demand for construction jobs and materials — commercial building pipelines across all property types register their lowest volumes on record. Most recent vintage projects, especially condominiums and hotels, head directly into default — tenants continue to economize and expect generational low rent terms not the record highs anticipated by builder pro formas at ground breakings.

All these setbacks delay recovery in the financial sector and the overall economy — banks must reserve for losses instead of lending to businesses to help stimulate hiring. State and local governments suffer declines in tax revenues from depreciating property values and lower sales volumes. Beyond lost construction jobs, the real estate sector collapse also vaporizes tens of thousands of high-paying “middlemen” professionals — lawyers, brokers, investment managers, appraisers, mortgage bankers, and analysts who had gorged in the fee fest from frenzied property buying, financing and flipping. The vanishing value mirage dissipates an important industry and destroys paper wealth on which credit markets staked enormous investment bets.

Any good news here? Yes. From all this carnage, expect cash buyers to make opportunistic purchases and eventually reap outsized profits. But how many cash buyers are left at all?

Jonathan Miller authors the authorative annual Emerging Trends in Real Estate report for the Urban Land Institute. His email is