US commercial realty still on shaky ground

Optimism about a national economic recovery, fuelled by rising stock prices and an improved residential real estate market, is tempered by the widespread belief that a raft of commercial real estate loan defaults is just around the corner.

Fears of a commercial real estate mortgage meltdown are bolstered by persistent unemployment, which has led to office and retail vacancies, rising commercial loan default rates and hundreds of bank failures – including two in the Bay Area in recent months, San Francisco Chronicle reported.

A wave of commercial mortgage foreclosures will probably translate into more empty storefronts and offices, decreased municipal property tax revenue and fewer bank loans available to start and expand businesses.

But while most commercial real estate experts agree that in 2010 there will more loan defaults, scores more bank closures and limited construction lending, many observers do not believe that commercial mortgage defaults will derail the recovery. "Things are not rosy, but the outlook for commercial real estate as the next shoe to drop after the residential mortgages just really isn't what we see," said Steven Buster, President and Chief Executive Officer of Mechanics Bank.

Buster said that while there is a perception that the commercial real estate market will soon collapse in the way the residential market did, the two markets are fundamentally different.

In recent years, many home mortgages were extended to buyers who never had enough income to cover their debt. In contrast, commercial real estate fundamentals did not change, Buster said.

In general, lenders did not issue loans to businesses without adequate income to cover their mortgage payments.

While many residential properties that fell into foreclosure were deeply underwater (meaning their loans were much larger than the value of the property), fewer distressed commercial properties have such a large imbalance. Buster and others said troubled borrowers will get significant relief from recent efforts by the Federal Deposit Insurance Corp (FDIC) to help banks modify commercial loans in a way that extends the terms and does not cut into the lenders' capital.

If borrowers can hold on to their properties in the coming months, the strengthening economy should bolster their prospects, analysts said. Rebounding businesses eventually will need to hire workers and need more office space, pushing up rents, the theory goes.

Matthew Anderson, a partner with Foresight Analytics, a real estate research and forecasting firm in Oakland, said predictions of a commercial loan default deluge may be overstated.

"The scenario in which banks work with borrowers to tread water is looking more likely," Anderson said. "The economic recovery is real and starting to take hold, and late next year we may see more demand for commercial space."

Still, the numbers do not look good.

Foresight Analytics' figures show that the percentage of commercial property owners in the Bay Area with mortgages 30 days or more past due increased about half a percentage point in the third quarter, and in big cities verged on five per cent – a level that analysts say restricts lenders' ability to issue new loans. San Francisco jumped a percentage point to 5.2 per cent.

Also daunting is the fact that more than half of the $1.4 trillion (Dh5.4trn) in commercial mortgages coming due nationwide in the next five years are underwater.

San Francisco offers a bleak local snapshot: Office vacancy rates were at 14 per cent in the third quarter, up from 10.5 per cent in the third quarter of 2008, and rents dropped from approximately $42 per square foot annually to $32 per sq ft in that same period.

Declining property values have led to the demise of banks heavy with commercial loans. In October and November, the FDIC closed the 14-branch Pacific National Bank and the 63 branches of United Commercial Bank.

Anderson predicted 600 of the nation's approximately 8,000 banks will fail between the third quarter of 2009 and the end of 2011.

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