Issue of the week: The next real estate meltdown

If you thought the residential real estate crash was bad, wait until you see what’s in store for commercial real estate, said Colin Barr in Fortune.com. With companies big and small laying off workers and abandoning expansion plans, “lenders are facing a surge of defaults on commercial mortgages and construction loans made when prices were much higher and demand for space much stronger.” Commercial real estate prices have fallen a stunning 41 percent since October 2007, according to Moody’s Investors Service, while office vacancies rose 17 percent in the third quarter to a five-year high. The deterioration of the commercial real estate market spells big trouble for many U.S. banks, which hold about half of the $3.5 trillion in loans secured by U.S. commercial real estate. Yet many banks haven’t faced up to their looming losses. One research firm estimates that since the downturn began, banks have lost about $110 billion on commercial real estate and construction loans. But so far they have reported losses amounting to only a third of that sum. “Deferring that reckoning can create a bigger problem later.”

What makes the high default rate “really, really worrying” is that it shouldn’t be all that hard to stay current on a commercial real estate loan, said Daniel Indiviglio in TheAtlantic.com. Most loans are structured so that borrowers make only interest payments for the life of their loans, then repay the principal in a single “balloon” payment when the loan comes due. Business must be really bad if they can’t even make their interest payments. And what happens when those balloon payments come due? In a stronger economy, borrowers would be able to easily refinance. But it’s a different story in today’s hypercautious lending environment. An estimated $500 billion in commercial real estate loans is coming due in each of the next three years, and they won’t all be refinanced.

That’s why many investors are exercising “extreme caution,” said John Gittelsohn and Thomas Keene in Bloomberg.com. Consider the case of billionaire investor Wilbur Ross, known for buying high-quality assets on the cheap. He has at least $1.5 billion available to buy commercial real estate loans and other debt from U.S. banks. But because he foresees a “huge crash in commercial real estate,” he won’t be sifting the wreckage for bargains until he sees a rise in occupancy rates and rents, along with other signs of recovery. “All the components of real estate value are going in the wrong direction simultaneously,” Ross says.

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Federal banking officials are scrambling to contain the damage, said Zerohedge.com, a financial website. But they’re unlikely to prop up the commercial real estate market the way they’ve supported residential real estate. Instead, the feds are “telling banks to resolve problems on their own,” by negotiating with their borrowers. Regulators promise to look kindly on such efforts. In other words, don’t expect a federal bailout for commercial real estate. The consequences for the economy as a whole will be “staggering,” but “the biggest loser in all of this will be banks.”