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A new real estate crisis could wreck recovery

April 24, 2010

Get ready for a new wave of economic pain.

Americans are growing more optimistic about the recovery, which has added fuel to the stock market rally. But there’s just one problem: The mortgage crisis that walloped homeowners and financial markets is only now reaching commercial real estate.

The Congressional Oversight Panel says more than $1.4 trillion in commercial real estate loans will come due between now and the end of 2014. Because of tight credit and declining property values, many borrowers won’t be able to refinance, the panel said in a February report.

The upshot: Banks—especially smaller, community institutions—may take a huge hit, swallowing losses on underwater loans that could jeopardize their stability and ability to lend to other customers, according to the report.

“A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American,” the panel said in its report.

Henry Efroymson, an Ice Miller attorney representing developers in loan-workout negotiations with banks, puts it even more starkly: “This is just a huge, mind-boggling problem. There is almost unanimity among economists that this is the biggest threat in the American economy and world economy.”

Problems so far have occurred largely outside the spotlight. Many of the struggling developers are privately held, not high-profile real estate investment trusts like Simon Property Group and Duke Realty Corp. The public REITs generally have been stronger performers and also have benefited from the ability to raise hundreds of millions of dollars in equity through stock offerings.

But some private firms are starting to succumb to the pressure. Last year, office developer Lauth Group put key units into bankruptcy. And in recent months, retail developer Broadbent Co. has faced a spate of lender lawsuits, and sought Chapter 11 protection for one of its centers.

Banks also are feeling the strain. One example: At the end of the fourth quarter, Muncie-based First Merchants Corp. was saddled with $15 million in “other real estate owned,” most of it commercial real estate it took over from defaulted borrowers. That’s seven times the amount on its balance sheet two years earlier.

But even tougher times may be ahead for the banking industry, as lenders and developers come to grips with the reality that many of their projects are worth far less than they are carrying in loans, real estate attorneys and other experts say.

“You have hit the point where banks are getting pressure from regulators to take action” on troubled commercial real estate loans, said Wendy Brewer, a Barnes & Thornburg partner whose clients include banks.

The problems are most severe for developers that refinanced at the height of the market—stripping out equity at the same time. But even developers that thought they were charting a conservative course are getting stung by declines in the value of the real estate they put up as collateral.

Brewer is familiar with a vacant parcel in the Indianapolis area earmarked for residential development that appraised for more than $1 million three years ago but now has a market value of only around $500,000.

She said values also have tumbled for retail centers that failed to lease up before the recession hit. Declines have been less pronounced for established centers with long-term leases in place.

In a different era, developers at loggerheads with their banks would find a new lender. But these days, an alternative source of financing rarely is available.

And what used to be the salve that healed all wounds—a sharp rise in property values—isn’t likely for years.

The Federal Reserve last year gave banks additional guidance in dealing with souring loans. But Efroymson believes regulators need to give banks more help, in part by liberalizing accounting rules and providing consultants to assist in structuring workouts. He said Congress also needs to get involved.

One challenge for banks under current rules is that if they write down loans, they must post collateral with the Federal Reserve—a double-whammy that pinches their ability to lend to other customers.

Regulatory and legislative action at this late stage would be no panacea, he said, but would soften the blow. Without intervention, he fears an avalanche of defaults that destabilize banks and cause deflation.

That would be devastating, he said.

“We need employment right now,” Efroymson said. “Employment occurs when the gross domestic product goes up, not down.”•

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