On Shaky Ground: Commercial Real Estate Faces Financial Tremors

As the global recession drags on, new concerns are rising about commercial real estate. So far, this sector — which in the past has led the economy into trouble — has been overshadowed by the crisis in the credit markets that has lead to sharply depressed stock prices, a collapse in consumer confidence and rising unemployment.

Now, with loans written during the boom years coming due, property owners face higher vacancies and lower rental rates as a result of the recession, and a less-than-receptive environment for refinancing their obligations. Wharton faculty, industry analysts and politicians suggest that commercial real estate is about to become the next high-profile casualty in the ongoing economic meltdown.

“The shoe has already dropped,” says Wharton real estate professor Susan Wachter. “Values are down severely. Vacancy rates are at 20-year highs.” The Federal Reserve reports that delinquency rates on commercial real estate loans have doubled in the past year to 7%, as companies pull back on commercial space and retailers go out of business.

Typically, commercial real estate developers help lead the nation from boom into bust by constructing too much space and defaulting on loans, jeopardizing the stability of lending institutions. This time, problems in the financial sector are branching out into commercial property.

“This is entirely a financial crisis, first and foremost. The problem is the seizing up of financial markets, not overbuilding as in the past,” Wachter says. “The overall economy is weak and weakening, which is driving down rents. Past real estate crises were centered in real estate without an economy-wide crisis at the same time.”

With financing tight, it is difficult or impossible for property owners to rollover short-term financing when it comes due. For example, General Growth Properties, the second-largest shopping mall company, filed for bankruptcy court protection after its lenders refused to refinance $27 billion in debt. The Real Estate Roundtable in Washington, D.C., estimates $400 billion in commercial real estate loans will come due this year. By 2012, the figure will be more than $1.8 trillion.

“The commercial real estate time bomb is ticking,” said Rep. Carolyn Maloney, D-N.Y., during recent hearings on the commercial real estate industry before the U.S. Congress Joint Economic Committee.

Wharton real estate professor Joseph Gyourko notes that residential real estate has already surfaced as a major factor in the recession. Many homeowners bought properties at inflated prices fueled by easy credit and now hold mortgages that are worth more than the value of the underlying property. “I think there was mispricing in commercial real estate, too, but it is not as bad as in housing because that would be impossible,” Gyourko says. “There was a lot of optimism about commercial real estate values and a lot of cheap debt [was taken on]. I think there will be stress that will make this worse than what happens [during a] normal downturn.”

In a paper titled, “Understanding Commercial Real Estate: Just How Different from Housing Is It?,” Gyourko presents evidence that today’s weakly capitalized commercial real estate sector will send property values down, as has occurred in housing. The paper concludes that commercial real estate, which is “further subject to the negative economic shock of a severe recession, looks likely to pose another problem for the health of the banking sector and the financial system more generally.”

Wachter sees a bifurcation in the commercial real estate sector. Large, publicly traded real estate investment trusts (REITs), with equity in projects and access to public markets, are best positioned to ride out the downturn, she says. Other real estate firms, particularly those controlled by private equity funds that face short-term debt obligations to financial institutions that are in trouble themselves, will have less flexibility.

An Opportunity?

“This is an opportunity — or may be an opportunity soon — for REITs that are positioning themselves to take advantage of other companies and bottom fish to purchase significant properties at bargain basement prices,” says Wachter. She cites plans by Vornado Realty Trust to raise $1 billion to create a fund to invest in distressed properties. “It’s back to ‘cash is everything.’”

Indeed, publicly held REITs reported strong second-quarter results. The Dow Jones Equity All REIT Total Return Index, composed of 114 REIT stocks, rose 28.9% — the largest increase since the index was created in 1989.

Brian Case, vice president of research for the National Association of Real Estate Investment Trusts, says many REITs have shored up their positions with cash raised in secondary offerings. In the future, he expects to see a new wave of initial public offerings (IPOs) by private real estate investors who are proven managers with strong portfolios, but who are also under pressure from debt that is coming due. In a better credit environment, that debt might have easily rolled over, but in the current climate an IPO may be the only source of new money. They have two choices: sell into a very soft market through 2012 or, if they are strong enough, do an IPO and use that equity to meet debt obligations,” according to Case.     

Wharton real estate professor Peter D. Linneman agrees that private equity real estate funds face the greatest peril. Because the firms have committed so much capital, they have little in reserve to weather uncertainty, he notes. “I think it’s fair to say that economic and capital market uncertainty leaves a lot of those funds hamstrung.”

Meanwhile, the U.S. government is attempting to ease the crisis by extending its Term-Asset-Backed Securities Loan Facility (TALF) to troubled commercial real estate firms. The program opened for new real estate loans earlier this summer but received little interest. The TALF program was then extended to existing commercial mortgage securities. On July 16, the Federal Reserve Bank of New York said investors sought $668.9 million worth of loans to buy securities backed by commercial real estate loans that were made months or years ago. Two days earlier, Standard & Poor’s cut ratings on commercial real estate bonds issued by Goldman Sachs, JPMorgan Chase and other financial institutions, effectively disqualifying billions in bad loans from the government program.

“The government has successfully stopped runs on banks and has stabilized the banking economy, but that doesn’t mean it can coerce banks to make loans to entities where the value of their collateral is down as much as in real estate,” says Wachter.

Total losses in securities backed by commercial property loans could climb as high as $90 billion in the next few years, according to Deutsche Bank analyst Richard Parkus, who also testified during the recent Joint Economic Committee hearings. In addition, he estimated up to $140 billion in losses from construction loans made by regional and local banks is also in jeopardy. “We believe the bottom is several years away,” Parkus told the committee.

Wachter says the use of commercial mortgage-backed securities (CMBS) was not as flawed as mortgage-backed securitization in residential markets, but she predicts the CMBS market will face reforms before it becomes a force in commercial real estate finance again. Ultimately, however, securitization will continue to be an important element in structuring commercial real estate finance. “How it comes back is still in question, but it will come back. There are some clear issues with CMBS.”

In the meantime, property owners are scrambling to renegotiate with tenants and reposition properties to make them more likely to receive continued financing. Wharton marketing professor Stephen J. Hoch says retailers are approaching landlords and threatening to close their doors if they don’t receive concessions. “The REITs have adapted and tried to be proactive,” says Hoch. “It’s taken a catastrophe to wake up and smell the coffee.”

The Inflation Factor

Linneman cautions that a combination of record increases in the level of consumer savings as well as government fiscal and monetary policy designed to halt the economic collapse will inevitably lead to higher inflation. He notes that real estate companies have been able to predict an inflation rate of more or less 2% to 3% a year for the last 25 years, and focus more on location or operations. Now, he says, inflation has the potential to become a major factor in future real estate development and management decisions. “You have to actually say, ‘What is my view of inflation?’ and 2% to 3% is not an acceptable answer. You really have to think about it because the money supply could create a spurt of inflation that will swamp anything you do at the micro level with your property.”

Linneman says that while Fed Chairman Ben Bernanke has promised to pull back on the money supply the minute inflation ticks up, it will be politically difficult to pull back — by raising interest rates — while the country is still wrestling with lagging unemployment and weak credit markets.

Further, he argues, the government’s involvement in the economy will be another important factor shaping the future of commercial real estate markets. Actions taken by the Bush administration at the end of 2008, and later by the Obama administration, have thrown long-term market assumptions “out the window,” he says, noting that the government is taking on more socialist characteristics and creating more uncertainty in markets as policymakers change the rules of business. The government’s involvement in the economy will slow the rate of economic growth to rates not seen since the 1970s, he predicts.

Linneman says he voted for President Obama, but adds: “I didn’t vote for France” — where government plays a strong role in supporting particular companies and industries.

He is also critical of the current administration for not taking strong action to force banks to recognize losses, which he believes would have paved the way for renewed lending and growth. According to Linneman, it’s ironic that Larry Summers, who served as Treasury Secretary in the Clinton Administration and is now director of the National Economic Council, was constantly urging Japan’s banks to write-off bad assets during that nation’s prolonged economic slump. Now, he says, Summers is reluctant to take the same action against major U.S. lenders.

The administration seems prepared to let small banks go under, Linneman notes, although the policy would have little impact on commercial real estate because of their small portion of the real estate lending market. The largest 20 institutions control the bulk of the assets and the administration has not been forceful in encouraging them to clear out bad assets. Government ownership of shares in leading banks is a powerful reason. “It will look like we’re giving away the nation’s assets now that we are owners of these things,” says Linneman. Instead, “I think we will get prolonged stress.”

As technology takes on an increasingly important role in business productivity, replacing workers and their space requirements, real estate developers have steadily reduced the ratio of commercial square-footage to real GDP. Linneman notes that construction activity has dropped by half since peaking in 2006 and 2007. “The good news is that when the economy does turn around, we will be going into it with relatively little supply.” If the recovery is similar to those of the past, the upturn in absorption of vacant space and rental rates will be more robust than expected.

The future of commercial real estate, he stresses, is linked strongly to the overall economy. “Everything about real estate today is basically about the economy,” he says. “As the economy rebounds, confidence in general will grow. As that occurs we will see more confidence in capital markets and hopefully more stability in the political environment.”

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