The economy seems to have bottomed and is now moving in the right direction. One of the key indicators—sales
of existing homes—continues to increase (of course, sales didn’t have anywhere to go but up).
Don’t get me wrong, I’m happy to see some improvement in the market. But I can’t truly celebrate.
Another crisis is looming—the cresting wave of maturing commercial real estate debt. It’s the second act in our national credit crisis drama, but isn’t discussed as widely because more people have home mortgages than commercial real estate mortgages.
The commercial real estate industry faces collateral damage from the credit crisis that unfolded last year.
Availability of credit for commercial real estate has nearly evaporated, and the credit that is available is much more costly.
As availability shrinks and costs increase, commercial real estate values are being forced down.
Commercial real estate loans originated during the peak of the market, from 2005 to 2007, are set to mature in the next 12 to 36 months, and will have few options for refinancing.
This impending imbalance in supply and demand is driven by three factors:
• Equity requirements are up. The days of the fully leveraged project are over.
• Property valuations are down. Rental income is lower because of higher vacancy rates and appraisals using significantly more conservative assumptions.
• Capital available for lending is in short supply, particularly since the commercial mortgage-backed-securities segment of the market has all but disappeared.
Mortgage-backed securities were to commercial real estate finance what securitized residential mortgages were to home finance. You remember—those pools of residential mortgages that became almost impossible to value and caused a global banking crisis and a pile of toxic assets.
According to Marcus & Millichap Research Services, commercial mortgage-backed securities accounted for almost 40 percent of the increase in new commercial and multifamily mortgage debt outstanding in the first half of 2007. By the middle of 2008, it had disappeared.
It hasn’t reappeared. It’s impossible for a capital market to lose 40 percent of its source capital and maintain its liquidity. There’s just not enough money in the till.
Commercial banks have an additional challenge: An army of bank examiners and other regulators have determined that, as the famous song goes, “We won’t get fooled again.” As a result, banks are forced to reappraise and write down the real estate loans in their portfolios at the bottom of the market.
They also are expected to shrink their concentration of real estate loans—all at the same time.
Unfortunately, these policies are just as likely to exacerbate the problem as they are to diminish it. Paradoxically, even properties that cash-flow and service their debt are being declared underperforming, and the owners are being forced to pay off their loans or provide additional equity.
This is driving many property owners who have made every payment into insolvency unnecessarily.
What does all this mean? A significant number of property owners will default on their financing, and foreclosures on commercial properties will increase dramatically. Banks will experience further distress and possible failure.
And most important, for you and me, credit in all forms will be even tougher to find, and the economy will take longer to recover.
What can be done?
1. Bank regulators need to take a more pragmatic approach to the crisis. Owners who are making their debt payments need to be helped through the crisis, not forced into bankruptcy by overly rigid policies.
2. Bankers and appraisers need to stop insisting on overly conservative appraisals at the bottom of the market. If things are getting better, appraisals need to reflect it and not represent an over-correction.
3. Wall Street and the federal government must revive commercial mortgage-backed securities financing and investors’ confidence in it. If this product can be properly valued and understood, it can once again be a valuable capital resource.
It’s good to see signs of life in the economy. But if something doesn’t change, we’re going to see a collapse in the commercial real estate sector, and that’s not going to help the economy’s recovery.•
Mann is managing partner of Mann Properties, a family-owned real estate development company in Indianapolis. Views expressed here are the writer’s.