May 11, 2009

By George Ratiu, Research Economist

Commercial real estate is in a slump due to the several factors driving this recession. Dropping consumer demand for goods and services has pushed businesses to cut production and slash payrolls. Lack of credit availability and uncertainty about a recovery is causing many enterprises to curtail or postpone expansion and driving others into bankruptcy. In response, fundamentals have taken a hit—vacancy rates are rising, while absorption and rent growth have turned negative. On the sales side, the gap between buyers and sellers in regards to price is widening, with many failing to materialize. On the lease end, tenants are re-negotiating contracts early and landlords are forced to provide deeper concessions.

In addition to a difficult situation, commercial real estate is facing another threat—rising Commercial Mortgage Backed Securities (CMBS) delinquencies. Against the backdrop of recent stress tests on major U.S. banks—many of which have large real estate investments in their portfolios—the need for additional capital is not surprising considering the potential losses associated with CMBS performance.

Over the past decade and a half, the CMBS market has grown into the major provider of financing for commercial real estate projects. CMBS issuance in the U.S. grew from $14 billion in 1992 to $230 billion in 2007. In addition, the U.S. has been the major beneficiary of increased CMBS activity, as it accounted for more than 70% of global CMBS issues. As of the fourth quarter 2008, the U.S. CMBS market was valued at about $670 billion.

Now, the performance of the CMBS market is posing a growing threat for commercial real estate. Delinquencies, while significantly lower for commercial loans compared with residential ones, have been rising. Delinquencies of 30+ days have jumped from 0.61 percent in the first quarter of 2006 to 1.18 percent in the fourth quarter 2008. At the same time, delinquencies of 60+ days moved up from 0.49 percent in the first quarter 2006 to 0.83 percent at the end of 2008. Looking at the CMBS data by property type, multi-family delinquencies lead the way at 2.75 percent in the fourth quarter 2008, followed by industrial and retail, at 1.35 percent and 1.12 percent, respectively.

Compounding the situation, the lack of available credit and banks’ reluctance to lend, given the current economic environment, are putting pressure on commercial real estate faced with a wave of upcoming debt maturities. The volume of debt maturing in the next three years is expected to surpass $2.6 trillion.

The recent bankruptcy filing of General Growth Properties Inc. proved to be a case in point that the financial situation is taking a toll on commercial properties. Following an aggressive expansion strategy over the past few years, fueled by high debt levels, the company found itself unable to re-finance the approximately $29 billion in debt it had accrued. The company filed for Chapter 11 protection in April.

What makes the current situation in commercial real estate particularly difficult is the fact that many properties continue to be well-capitalized and performing. However, due to the way these properties are financed and the fact that many are facing maturing debts, the wave of delinquencies and foreclosures may just be starting.

In fact, based on data from Real Capital Analytics, the cumulative value of distressed commercial properties jumped from $3.9 billion in the first quarter 2008 to $72.7 billion by the first quarter 2009. The largest number of distressed properties is concentrated in the retail sector. As of the first quarter of this year, there were 1,276 distressed retail properties. In addition, based on lender, the retail sector also leads the way in distressed properties. Retail properties financed by CMBS accounted for 57 percent of distressed commercial real estate.

 

For many lenders, the preferred strategy at the moment seems to favor extending or modifying the terms of the loans. The hope is that by extending loans for another year or two, the market will improve and allow many of the performing properties to refinance. However, the risk associated with these loans remains.

Unless liquidity returns to financial markets and banks pick-up the pace of lending, the rate of delinquency will continue to rise. Considering that weak fundamentals are driving down the value of commercial real estate, with prices declining over the past months, banks’ willingness to refinance loans on these properties will certainly be tested. The outcome of General Growth Properties’ bankruptcy filing will likely provide an early indicator of the impact CMBS will continue to have on commercial real estate.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

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