Our Next Financial Showdown: Commercial Real Estate

Updated August 19, 2009
The U.S. economy is not out of the woods, but important indicators are at least signaling the end of the freefall in the housing market. Our next worry may be commercial real estate, which has been going through the same cycle of falling prices and lower incomes, leading to sending back the keys. The investors in commercial real estate are big institutions, but if the market falls apart we'll all feel it -- at the workplace and in our towns and cities.

Mortgages on commercial properties add up to just one-fifth of home mortgages, but at $2.4 trillion, they're still a major financial asset (as per the Federal Reserve's Report Z.1, March 2009, Table L.1). Commercial banks own about $1 trillion worth. And just like home mortgages, a large swath of them is in jeopardy, because commercial property prices, too, have fallen upwards of 25 percent, both in the U.S. and around the world.

Property prices will be under further pressure from falling rents, and a lack of credit to refinance mortgages that are coming due, according to analysts of commercial mortgage backed securities at Deutsche Bank. They expect a commercial default rate of 6.5 percent over the next ten years, up from below two percent for most of this decade. (Commercial mortgages typically have ten year terms, and no prepayment options.)

Rating agency Fitch has just announced an "expanded review" of the exposure of major US banks to commercial real estate, as reported by the Alphaville blog of the Financial Times. According to the rating agency, "the performance metrics of commercial real estate, an area with a significant risk exposure for the majority of Fitch's U.S. bank universe, continues to deteriorate at an unprecedented pace."

A large community of "distressed" investors is waiting to buy these properties at bargain prices from the insurance companies and pension funds that own them, but as with the first phase of the meltdown, the damage will not be limited to the institutional investors who own the properties, or hold the securitized mortgages.

An economist at a giant real estate investment firm told me to expect at least three repercussions on the ground:

If there's a default on a building mortgage and the bank takes it over, there are negative effects on the tenants. At the front end of a lease, the landlord typically helps pay for the fit-out, of the fuzzy boxes [i.e. cubicles] in offices, and in retail the numbers can be extremely high. So stores and offices won't be updated, and will start to look shabby after a while. The extreme case of that will be hotels, which are very expensive to keep fresh.

And there are other local issues. You'll see real estate prices continue to fall, which means a decline in ratables for the tax base. Cities and town rely heavily on those tax revenues, and if they can't get them from the commercial property owners they will have to raise taxes on homes.

Regional and local banks will be hurt too. The big CBD [central business district] towers, in New York or wherever, tend to be financed by commercial mortgage backed securities, but on the other side of spectrum -- garden apartments and low rise office buildings -- those loans are owned by regional and sub regional banks. Commercial real estate is upward of 15% of their assets, and will be a big driver of bank failures going forward.

There's no reason for runs on the banks, because the FDIC is there. But local banks are important job drivers, and community dislocation is something to think about as some of these banks fail.