COMMERCIAL REAL ESTATE- A TICKING TIME BOMB ?

During the recent commercial boom that took off in 2005 and lasted through early 2007, Wall Street called the shots on lending. Investment banks pooled commercial mortgages, bundled them into loans and sold them to investors as bonds, called Commercial Mortgage Backed Securities. The cheap, ample debt fueled a real-estate boom that sent prices soaring to record levels and allowed investors to enjoy phenomenal returns not found in other investment vehicles.

According to The Real Estate Roundtable, a real estate trade group, investment in commercial real estate in the United States is valued at more than $6.5 trillion dollars. Over the past ten years, mortgage debt associated with investment in commercial real estate has nearly tripled, growing to nearly 3.4 trillion. In addition, investment in Commercial Mortgage Backed Securities (CMBS), packages of pooled loans backed by mortgages on office buildings, industrial properties, malls and other retail centers, and apartment buildings grew over 60% in the past decade. Yet, as the frenzy reached its peak in early 2007, underwriting became increasingly lax and investors started to balk at buying the bonds. Sales of commercial mortgage-backed securities have been ravaged by market conditions since last fall.

What is even more bothersome is that unlike their residential counterparts, most commercial real estate loans are underwritten for five, seven or ten years with a balloon payment due at the end. Normally, the property owner will refinance the loan with a new loan of longer maturity at that time. But with more stringent underwriting rules, declining values and declining cash flows, many loans may not qualify for refinancing. A borrower’s inability to refinance may force a borrower into default. The Real Estate Roundtable, a key trade group for the industry, late last year predicted that more than $400 billion of commercial mortgages will come due through the end of 2009. Foresight Analytics estimates that $160 billion of commercial mortgages will mature next year even as credit for refinancing remains non-existent, and cash flows from rents and leases are way down due to the recession.

According to Deutsche Bank of all of loans maturing through 2012, over two thirds (370 Billion) will not qualify for refinancing under the more stringent underwriting guidelines. So how can we keep the commercial real estate sector from becoming the “tipping point” that keeps the US economy in its current recession? Will there be widespread maturity extensions or widespread foreclosures and liquidations? Many real estate expects argue that commercial real estate markets will likely recover within six months as the general economy begins to recover, which will resolve the refinancing problem. Others feel the only answer is government programs that will prevent hundreds of billions of dollars in commercial real estate loans from default which in turn will call further damage to bank portfolios, damage to insurance companies and other investors in commercial properties.

I believe the answer involves three important principals. First, repairing the credit markets and restoring liquidly to the commercial real estate market should be a top priority. The Federal Reserve and the Treasury, under the TALF or Term Asset Backed Securities Loan Facility, should adapt a funding program to make it attractive for investors to buy debt backed by office buildings, hotels, stores and other income-producing property. TALF is not a bailout or loan but the issuance of asset backed securities collateralized by student loans, auto loans, credit card debt, small business loans and potentially commercial loans.

Secondly, FASB 157 should be revised to temporarily suspend the Mark to Market provision. Since 2007, publically traded companies are required to values assets and liabilities at its current market value rather than its book value. Problems can arise during volatile times when there may not be any market for the particular asset. Until this month, FASB 157 required backs and other financial intuitions to price these assets at fair market value in a distressed market, therefore decreasing capital. Many believe the use of mark-to-market accounting lead to the subprime meltdown. Mark to Market caused volatility for the company's shareholders. That's because the fair value of its subprime mortgages became increasingly difficult to calculate when the mortgage market began to dry up in 2007. As financial institutions clung to the high valuations to which they were accustomed, the bottom fell out of the subprime arena, and companies with billions of dollars of subprime on their books were forced to write those assets down to almost nothing. For investors, this meant that a company's assets could be wiped out overnight - and share prices reflected this. In April 2009, the Financial Accounting Standards Board voted to approve new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation, starting in the first quarter of 2009.

Lastly, the government needs to reject tax treatments that are unfavorable to real estate investment. Recently changes have been proposed that would increase the capital gains rate, chance the 1031 or tax deferral exchange rules and increase taxes on partnership “carried interest”. All of these changes will further depress investment in commercial real estate.

The Charleston Real Estate Voice
Lisa Safford
Summit Commercial Properties
www.summitcommercialproperties.com