Bad signs for commercial real estate 

There’s trouble brewing in commercial real estate.

Here’s the situation:

Say you bought a building for $1 million in 2005. At the time, you could get a loan for 75 percent of the value, so you paid $250,000 down and you owe $750,000.

Now it’s 2010, and your loan is due. It’s time to refinance.

You face two problems: First, the value of your building has declined due in part to fewer tenants, lower rents and fewer buyers. Say its declined 20 percent, so it’s now worth $800,000.

And second, banks are more cautious now, and they’re only willing to loan 65 percent of the building’s value.

You’ve paid off some of the building, but not much – say you still owe $700,000. The bank can only finance $520,000. You’re going to have to come up with $180,000 cash if you want to keep your building afloat.

That’s the problem thousands of commercial property owners are facing around the nation.

Some experts predict commercial real estate values will fall 50 percent from their peak before they start to turn around.

And with $1.4 trillion of commercial loans coming due in the next five years, a surge of defaults could be on the horizon.

New York-based analyst Real Estate Econometrics recently predicted the national default rate would reach 5.3 percent by the end of 2011, up from 1.62 percent at the end of 2008.

Some think Idaho is well positioned to avoid the worst of the impending crash.

“I think we’re going to be lucky,” said Michael Ballantyne, managing partner for Boise-based Thornton Oliver Keller. “This is a market I want to be in – I sure wouldn’t want to be in Los Angeles or Las Vegas or Seattle.”

But, he said, those bigger markets are starting to see some improvement, boding well for the Idaho market, which tends to lag about six months behind the primary markets.

And he said local developers tend to play a larger role in commercial development than national developers do, and the locals tend to be conservative.

Scott Raeber of Boise-based developer Brighton Corporation said commercial property foreclosures will largely avoid Idaho.

“There are not many local owners and developers that have that kind of money, that have those large loans that are making national headlines,” he said.

He said property values in Idaho will probably remain stable or stagnant for the near future, though there will be some “guilt by association” from the national overbuilding.

Local developers, he said, were able to shut off the construction valve a lot quicker than the bigger players.

But not everyone agrees Idaho is above the fray.
“The trends are not good,” said Washington Trust Bank Senior Vice President Dean Oberst, who is based in Meridian.

Oberst said Idaho is “mirroring” the national market at this point – developers got ahead of themselves building shopping centers that are not attached to big-name anchor stores.

A good number of commercial buildings were financed through commercial mortgage-backed securities, which means an intermediary issued the mortgage, bundled it with a bunch of other mortgages and then sold it to a group of investors
.
Those types of loans are no longer available.

“I can see where there’s going to be a significant amount of volume coming back on the market, and that will create some large issues – some uncertainty as to who’s going to finance those,” Oberst said.

Steve Zabel, a commercial loan officer for Idaho First Bank, described the fallout from the collapse of the CMBS another way: “That lending option is pretty much gone. That pretty much died with the real estate market, so they [property owners and buyers] have less competition amongst people who would want to lend to them. … What’s going to be interesting is there’s going to be a lot of demand for commercial lending through refinances or purchases if the economy improves, but there’s not going to be a lot of supply of loans available. Banks are going to have the power in that situation.”

Zabel also said banks aren’t going to be eager to foreclose on properties.

“It hurts the banks to foreclose on properties,” he said, “because then you’ve lost a depositor’s money, and as a loan officer you are the steward of your depositor’s money.”

He said it’s particularly painful to foreclose on properties that have lost value since the loan was issued – that’s value the bank will never gain back on that building.

“So it’s painful to do, but in some situations you have to be honest and look at a property and think, my borrower can’t afford this property; it was a poorly designed or poorly built property, or it needs too much in renovation to justify making some exception for it. At some point… you have to make a calculated determination that foreclosing is better than continuing the relationship.”

“I know for myself, …. I want to keep my good clients; I want to do as much for them as I can,” he added. “For the bank, most of the time it’s in its best interest to continue the loan.”

Zabel said the commercial foreclosure spree won’t be as bad as the mountain of residential foreclosures that have piled up over the last couple years.

George Iliff, managing principal at the Boise office of commercial real estate brokerage Colliers International, was leaning toward the same opinion.

“A lot of what you read and hear about is that it’s just going to be as bad as the residential side has been, and I’m not sure it’s going to quite get to that level,” he said.

But he described a series of dynamics at play against the commercial real estate industry, including tenants closing down, rents shrinking and financing disappearing.

“If you’re an income-producing property owner today, and have enough tenants to cover debt services and pay you income, if you have cash flow on the property and don’t have a loan that’s coming due in the next year or so, you’re probably OK,” Iliff said. “But if you have tenants that are leaving and rents that are shrinking, and if you have a loan that’s about to come due, then you probably aren’t OK, and you’re going to have to figure out what to do with the property – either sell it and take a loss or find more capital to put in the property and refinance it.”

He said the next couple years are going to be tough, but not necessarily disastrous.

In the 1990s, commercial real estate went through a more difficult period, but the general economy didn’t crash as a result.

“So I think we can go through a pretty tough patch in the commercial real estate side without it having devastating negative effects in the same way the housing bubble burst did,” Iliff said. “That doesn’t mean it’s good for it, but it doesn’t mean it’s going to drag the economy into the next big recession when the next wave of commercial foreclosures hits, either.”

He said commercial real estate trouble isn’t in a vacuum – pension funds and insurance companies and retirements funds have invested heavily in the sector, and they’ll feel the effects going forward.

But participation in the commercial market isn’t as widespread as participation in the residential market, so there’s hope.

“I think that as the national economy improves, … the commercial real estate business or market will i
mprove as well, because if tenants are profitable and are doing well and staying the same size and not requiring rent reductions – or even, perish the thought, expanding or growing – that will cure some of the problems with commercial real estate that exist today,” he said.

Iliff said the best-case scenario for everyone would be if the government put in place a program enabling banks to renew existing financing terms, allowing property owners to continue their loan payments without facing default.

Oberst of Washington Trust Bank said government action is probably not quick enough to make an impact in the market, where market forces “generally will take care of themselves.”

He said job growth is the only answer to the commercial real estate woes.

“When we have job creation, then retail space is needed, office space is needed, multifamily space is needed – job creation … would be truly the answer to everything we’ve lost in the economy,” he said.

Iliff said commercial real estate agents should work hard to survive until the market gets better, focusing on sectors (like government, education and medical) that are still active.

“Because as the market gets better, at least in my experience, it gets better pretty rapidly,” he said. “It’s almost like somebody throws a switch or rings a bell. So once that switch is thrown, if you can hang on long enough to get to that part, then you’ll probably do well.”

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