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Commercial Real Estate: Inside The Crisis

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The residential housing market went into a tailspin over a burst housing bubble and a whole lot of bad mortgages. The commercial real estate market has suffered a different sort of one-two punch.

Between the recession and the financial crisis, many commercial property owners were left struggling, and many banks were stuck with troubled loans on everything from shopping malls and hotels to office buildings. Exposure to commercial real estate has fueled losses at major banks such as Morgan Stanley, which reported a second-quarter loss of more than $1.2 billion on Wednesday.

Experts say prospects for a turnaround in the near future aren't good, because the commercial real estate market's fortunes depend largely on free-flowing credit markets and cranked up spending by businesses and consumers – neither of which economists expect will happen anytime soon.

That means more commercial property loan defaults are likely, and that could mean trouble for the still-recovering U.S. banking system.

Here are some questions and answers on the problems facing the commercial real estate market, and what they might mean for the rest of the U.S. economy.

Q: What types of properties are considered commercial real estate?

A: Generally, there are five categories: office space, which can include several floors of a skyscraper or a single room in small building; industrial, which encompasses warehouse and factory space; retail, which ranges from a small storefront in a shopping center or mall, to a big-box space used by a large retailer like Costco; apartment complexes, typically with more than four units; and hotels.

Q: Who owns commercial property?

A: Much of it is owned by big public companies known as real estate investment trusts, among other large institutions. A lot of commercial property is also owned by smaller, regional developers.

Q: How does the commercial real estate market fit into to the U.S. economy?

A: By some estimates, the commercial real estate sector helps support more than 9 million jobs and generates billions of dollars in taxes.

When the economy is growing, businesses' demand for space also grows. Consumers also tend to spend more, which boosts retailers and hotel operators, and stokes demand for more retail space.

A healthy economy typically translates into more jobs, which helps fuel demand for apartments. When demand is up, landlords enjoy low vacancy rates and steady rental income, and are more able to hike rental rates.

But when the economy slows or enters recession, as it did in the fall of 2007, the reverse happens. Businesses scale back their needs for office and industrial space and trim payrolls. People who lose their jobs may be forced into leaving their apartments. Retail chains see sales tumble as consumers rein in spending and may be forced to shutter locations or even go out of business.

Q: How has the financial meltdown affected the commercial real estate market?

A: Commercial property landlords face several problems due to the economy and financial crisis.

The recession and rising unemployment have stifled demand for rental space, resulting in higher vacancy rates. Lenders have tightened underwriting standards, making it much harder for property owners to refinance and for would-be buyers to qualify for financing.

Those factors are contributing to a dearth of sales, a spike in commercial loan defaults and falling property values.

Q: What's happened to the value of commercial real estate during the economic downturn?

A: So far, commercial property values have declined as much as 45 percent off their peak in 2007, Richard Parkus, an analyst with Deutsche Bank Securities, recently told a congressional committee examining the danger posed by rising commercial property defaults.

Q: Where are vacancy rates projected to go?

A: Marcus & Millichap Real Estate Investment Services projects U.S. vacancy rates this year will hit 17.6 percent for office space, 11 percent for retail, 12.6 percent for industrial and 8.2 percent for apartments. Two years ago, the vacancy rate for was 12.6 percent for office space, 7.2 percent for retail, 9.4 percent for industrial and 5.7 percent for apartments.

Q: How do rising vacancies hurt owners?

A: When vacancy rates rise, properties generate less income for landlords – a problem because the amount of income a commercial property generates after maintenance and other costs is a major factor in its market value.

It's also a key consideration by lenders when an owner seeks to refinance, which is something commercial real estate developers often have to do to manage their debt load. A lender might be concerned that a high vacancy rate is a sign that the property might have trouble generating revenue, and might be hesitant to offer a new mortgage.

Q: What has happens when commercial property owners aren't making money, and can't refinance their loans?

A: Often, if they can't find a buyer to take the property off their hands or renegotiate an extension with the lender, they end up losing the property to foreclosure. Some, however, have filed for bankruptcy protection.

Q: What impact could rising commercial property defaults have on the U.S. banking system?

A: It could deliver a serious hit to the bottom line at banks that make commercial real estate loans.

Delinquency rates on such loans have doubled in the past year to 7 percent, according to the Federal Reserve. Small and regional banks face the greatest risk of severe losses from the loans.

Parkus estimates total losses in investments backed by commercial property loans could be as high as $90 billion in coming years. He projects losses on commercial real estate loans held directly by banks could hit up to $150 billion.

Q: What's the government doing to help?

A: Last month, the government opened part of the consumer lending program known as the Term-Asset-Backed Securities Loan Facility to commercial real estate loans. The hope is that will boost the availability of loans, helping to prevent defaults and facilitate sales.

Industry groups are now pushing for the government to extend this program through the end of next year.

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