Economy and Banking & Finance and Real Estate & Retail

Defaults also hit business property: Experts expecting bump in commercial loan woes

April 28, 2008

In the few short months since Gordon Hendry began leading the Property Management Division for the local office of CB Richard Ellis, the firm has become involved in a growing number of commercial loan defaults.

Locally, CB Richard Ellis is the courtappointed receiver for Plainfield Crossing, a 92,000-square-foot West Washington Street strip center anchored by Value City, and for Crooked Creek Center, a 52,000-square-foot center at 79th Street and Michigan Road. Hendry expects the local office will be assigned to manage even more troubled properties this year.

Likewise, on a national level, Los Angeles-based CB Richard Ellis is acting as a receiver for several pieces of real estate, including Bridgewater Falls, a 635,000-square-foot lifestyle mall in Ohio.

Locally based Premier Properties USA Inc., the beleaguered developer facing scores of lawsuits, owns Bridgewater Falls and a strip center in Plainfield called Plainfield Commons. Beyond Premier's problems, concerns are much more widespread regarding whether the upheaval from the housing crisis will spill over into the commercial real estate sector.

"There is not the access to capital that there was in the past, in the current market," said Hendry, director of asset services at CB Richard Ellis. "That's why you're seeing some properties coming into this kind of situation."

Indeed, commercial mortgage-backed securities-one of the primary commercial mortgage investment vehicles-have all but dried up since last August. This year may see less than $100 billion of CMBS issuance volume, not even half the $230 billion recorded in 2007, according to Moody's Investors Service.

The freeze follows what occurred with subprime real estate lending. Valuations increased as a result of access to cheap capital and easy credit. And like the housing market, commercial real estate values are expected to tumble, as much as 25 percent through 2009, according to some experts. Higher financing costs and slower demand for commercial real estate during an economic downturn will erode property values.

Steve Dolvin, an assistant professor of finance at Butler University, likened the extreme fluctuations in lending practices to the snapping of a rubber band.

"Banks historically tend to overreact in both directions," he said. "Part of the reason we got to where we were was because they were too lenient."

Cause for concern

Among those who think the commercial real estate sector will suffer nearly as much as the residential market is Henry Efroymson, chairman of the Bankruptcy and Creditors Rights Practice Group at the Ice Miller LLP law firm.

Several properties in the metropolitan area-including raw, undeveloped ground-are in various stages of foreclosure, he said, and the trend could continue another two years.

One of his clients, Atlanta-based Dominion Capital Management LLC, is among Premier's largest lenders. It attempted to auction ownership interests in eight Premier properties April 17, including Bridgewater Falls, but had no takers. The lender plans to sell the 600,000-square-foot Metropolis mall in Plainfield separately. All told, Dominion is selling the properties to collect on loans exceeding $100 million.

Efroymson is certain Premier could have avoided its struggles, had they occurred at another time.

"[The loans] could have been restructured, if this problem would have developed two years ago," he said. "But because it's developed now, when credit is so tight, it's virtually impossible to restructure today."

Premier built its portfolio on large deals with little margin for error. But experts say small retail developers are the ones feeling the most pressure.

Their tenants are less likely to be national retailers and, thus, are less stable. A broken lease or one that is not renewed, or a short-term loan on which the developer can't secure the same terms, might be enough to send a property into foreclosure.

But larger mall owners may not emerge totally unscathed. Since last fall, eight mostly midsize retail chains, including electronics seller Sharper Image, have filed for bankruptcy protection. Those that have avoided filing are shutting down stores to preserve cash, according to The New York Times. During the next year, Foot Locker plans to close 140 stores, Ann Taylor 117 and jeweler Zales 100.

Bankrupt chains are leaving behind tens of millions of dollars in unpaid bills to a host of suppliers, including shipping companies, advertising agencies and mall owners.

Once the property owner declares bankruptcy, a lender typically will ask the manager, in some instances CB Richard Ellis, to protect the asset until a buyer can be found. That process can take months.

Or is it overblown?

The local office of another property manager, St. Louis-based Colliers Turley Martin Tucker, is in talks with lenders on a couple of properties that may fall into their possession.

Still, Tim Michel, senior vice president of investor services at the local office, said the commercial real estate market remains relatively strong.

"There are isolated developers or owners that have a project or two that didn't work out," he said. "I don't think anybody foresees a huge problem on the horizon."

Neither does CB Richard Ellis, despite the amount of receiverships it's managing. A report it finished late last month accused Wall Street's credit markets of overreacting to the "likely" increase in commercial real estate mortgage losses-perhaps overestimating future default rates by as much as three times.

"The reality is that commercial real estate markets remain sound, with low vacancy levels and construction moderate in all but a few markets," the report said.

While CB Richard Ellis expects vacancy rates to inch up and peak sometime in 2009, they still will be lower than previous highs set in 2002-2003.

That's what makes this commercial mortgage crisis so confounding, said Efroymson at Ice Miller. Historically, defaults arose from property meltdowns, leaving too little cash flow and too much debt. The difference now is that vacancy rates and cash flow are not that bad, he said.

Besides tightening borrowing requirements, lenders also are using the weak financial climate as an excuse to purge loans that in the past they would have tried to work out, Efroymson said.

And, raw ground financed with construction loans and too much mezzanine debt is leaving no equity in the project. With no money available to borrow, the property ultimately ends up in foreclosure.

Further reductions in the interest rate and pumping more money into the banking sector may help solve the credit crunch, Efroymson said. A natural correction causing development to slow may provide relief as well. Yet, a rebound could be months away.

"We're all hoping our instincts are wrong here and our economy will stabilize in late 2008 or early 2009," Efroymson said, "but it's very possible that will not occur. We're seeing a real meltdown now."
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