Commercial Real Estate Dogging the Economy

Commercial real estate is the biggest soft spot in the economy right now. Although sales are finally starting to tick up after sliding for six straight quarters, that’s just the first step in a long slog to recovery, and the troubled sector will remain a drag on the economy for at least another year.

Transaction volume is still light, “but we’re starting to see signs of healing,” says Suzanne Mulvee, real estate strategist with Property and Portfolio Research, a CoStar company. The value of deals made inched higher in the third quarter of last year and increased a bit more in the fourth. Investors decided to come off the sidelines, attracted by bargains on top-tier malls, offices and apartment buildings.

The vacancy rate won’t top out until the end of this year, however, at around 17.5% for offices and 15% or so -- a record high -- for industrial property. According to Jon Southard, an economist with CBRE Econometric Advisors, “Things are progressing, but the road is a long one.” Making matters worse, there’s plenty of “shadow space” -- offices that were emptied by layoffs but are still leased. That space doesn’t show up in vacancy rates, but until companies refill it, they won’t be looking for additional space.

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Defaults and foreclosures will climb as well. Between a quarter and half of all commercial real estate loans maturing this year and next are underwater, reflecting inflated purchase prices at the peak of the boom in 2006 and the first half of 2007 and the subsequent plunge in values of 40%.

Inevitably, more banks will bite the dust. Our estimate: about 350 over this year and next. We expect as many as 700 institutions to fail by 2014, mostly small banks that avoided the subprime housing collapse but went heavy into commercial property. Since January 2008, about 190 banks have fallen by the wayside.

Regulators are urging lenders to be flexible, amending and extending loans that are coming due -- about $150 billion this year and $170 billion more in both 2011 and 2012. And many banks are modifying terms if a borrower has decent cash flow. But with rents down more than 10% on average over the past year, that’s limiting the number of loans that qualify.

And the fact is, even if banks don’t foreclose or write down loans that have gone sour, they are winding up with less money to lend. During the boom, loans were repackaged and sold to investors as securitized debt. That replenished banks’ supply of lendable funds. But that market has dried up. With no way to offload outstanding loans, and relying much more heavily on deposits to fund loans, banks are much more tightfisted when borrowers want to renegotiate loans coming due. In 2007, investors bought nearly $20 billion a month in securitized debt. Last January, the total was just $80 million.

The tight credit situation is crimping growth across the board, not just in construction and industries tied to real estate. There’s little risk, however, of the problems triggering another big downturn in the economy. Ailing commercial real estate doesn’t pack the punch that problems in the residential market did, when defaults and foreclosures prompted the financial markets to freeze up and nearly sparked a panic.

Washington can do little to speed the recovery. The Federal Reserve’s program to buy securities backed by commercial real estate hasn’t helped much. It’s a case of waiting for the fever to run its course and patiently looking forward to a better 2011. As Fed Chairman Ben Bernanke told Congress last month, “The solution is to get the economy growing overall.”

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