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The Economy–Will Commercial Real Estate Hold Up Recovery?

November 23rd, 2009 · No Comments · Economics

The economy is beginning to pick up. Unemployment numbers are falling. About a third of the Stimulus funds are in operation now with more and more coming every day. But there is one snag. The commercial real estate market.

Commercial real estate has been in trouble for a while, as a result of the general economic downturn. Since October of 2007, commercial real estate prices have fallen by 40-45%. This means that a great number of the loans that will come due in the next few years are on property that is valued less than the value of the property.

Major real estate developers are worried because prices are lower, rents are lower, yet investors want a better return on investment in order to take the risk in hard times.

Office vacancies fell to 17% in the third quarter of 2009, the lowest in five years. Many people, including some of the world’s most astute real estate investors and managers see anything from a guaranteed mild real estate sell-off to the possibility of a major commercial real estate disaster, causing a serious setback in the economic recovery.

A recent failure by just one company, Capmark Financial Group has gone into Chapter 11 bankruptcy after originating $60 billion in commercial loans. These are big numbers but they are a fraction of the potential damage.

With $3.5 Trillion or more in outstanding loans and with a significant amount of those maturities coming at the end of 2009, there is a problem. When the value of the properties is less than the loans on the properties, something has to give. In residential real estate, that is called foreclosure. The problem is less complicated and less drawn out in the commercial market, but is is similarly serious.

In Houston, for example, the price of office buildings has fallen by 50%. Sales in the last 12 months were $459 million, which sounds good until you know that the previous year’s sales were $2 billion. The average square foot price of an office building was $77 this year compared to $155 last year.

Across the country there are billions of dollars in commercial real estate that will come due that are “under water.” In other words, the owner wants to renew a mortgage on a property that is worth less than it was when the money was originally loaned on it, and where the rents that can be earned are less than anticipated when the original loans were made. So…what to do?

This is where the questions begin. The Federal Reserve has issued guidelines for these kinds of loans. Apparently, with continued good analysis of a commercial real estate owner’s sound financial status and the underlying value of the property, if it is under water merely because of a severe drop in the economy, such as the general market conditions described concerning Houston, for example, then the Federal Reserve will not intervene. The property may be worth less now than it will be in a couple of years.
This will create what many are calling “zombie” properties, ones where the owners are allowed to continue, while banks trust that that the commercial real estate market turns up soon.

So, is this a good thing? It would greatly reduce the economic consequences of currently depressed commercial real estate prices. But some in the industry say that it will have negative results for other properties and will only result in kicking the can down the road for a couple of years and will result in much greater losses in the long run.

The important thing is to know that this is a problem that may not be solved in every case.

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