The reports of the nation’s commercial real estate recovery have been greatly exaggerated.
Some marquee properties in the nation’s major cities recently have sold at high valuations, leaving many investors celebrating the commercial real estate sector’s comeback. But not everyone’s been invited to the party.
For most markets, property values are still depressed and will not likely improve decisively until the economy can generate significant sustainable job growth, and lenders are willing step in and finance transactions.
A sluggish property market recovery could be fatal for many smaller banks — those with assets below $10 billion — which hold $724 billion of commercial mortgages maturing in the next five years.
If property values in weaker markets, such as Cincinnati or Indianapolis, don’t improve before the loans come due, many borrowers will be forced to default. Community banks tend to have the biggest commercial property holdings as a percentage of overall assets, so mass defaults could cause scores of those lenders to fail.
"The problem that no one’s really addressed is how many banks are in trouble." said Daniel Neidich, chief executive of Dune Real Estate Partners, which manages funds that target distressed and other underperforming properties. "Obviously, where a third of your assets are overvalued, what’s that say about the bank?"
It’s a race against time.
"There’s no chance that property values will rise enough," said Ben Carlos Thypin, director of market analysis for Real Capital Analytics.
Many banks with big commercial real estate portfolios are hanging on by a lifeline the FDIC threw in October 2009. It allowed banks to extend the maturity date of loans, as long as the borrower was current with the interest payment. The policy is widely known as "extend and pretend," and has allowed banks to avoid writing down many of their commercial mortgages.
Investors looking to buy distressed loans wonder how long the FDIC will continue the reprieve, because at some point bank overseers cannot ignore obvious insolvence.
"The elephant in the living room is the regulators," Neidich said.
In New York, and Washington, and even cities like Seattle and Houston, borrowers are in a better position.
In Manhattan, office building prices are just 17 percent shy of their peak, and in Washington 18.5 percent, according to the Moody’s/REAL All Property Type Aggregate Index, a gauge of values for commercial properties more than $2.5 million.
Those markets have geographical and zoning constraints that limit new construction. They are also havens for foreigners to park their money, and the owners feel confident that they can find a buyer even in the worst of economic times, said Doug Harmon, senior managing director at Eastdil Secured, a brokerage that also raises capital for deals. Harmon has sold some of the nation’s priciest buildings.
"These deals normally showcase broad-based overseas interest which foster feelings of liquidity and safety," Harmon wrote in an email.
Fosterlane Management Corp., which represents Kuwaiti investors, earlier this month paid $485 million for 750 Seventh Ave. in New York. The price amounted about $820 a square foot for the building half occupied by Morgan Stanley.
That has pushed down the cap rate — a measure of the returns an investor can expect to receive on the building in its first year — to 4 percent, close to boom levels, according to Real Capital Analytics.
At the peak of the market around 2007 several top midtown office towers traded at $1,000 a square foot.
In Washington, D.C., the Market Square complex in March sold for $615 million, or $904 a square foot, a record for the city, Real Capital Analytics said.
But the U.S. is more than Manhattan and Washington.
The market values of office buildings, shopping malls, apartment buildings, and warehouses nationally are still 44.6 percent below their peak prices in 2007, according to the Moody’s index.
"The perception of the market is definitely skewed by the inordinate amount of attention given to the larger deals," said CoStar real estate strategist Christopher Macke.
Many properties that sold at or near the peak of the market in 2007 were priced with the expectation that rents and occupancy would rise, covering the amount of the loan and then some.
Instead, the recession eroded property values and rents. Borrowers found themselves unable to pay interest on ongoing mortgages or refinance with loans to cover balloon payments due when the mortgages matured.
That propelled mortgage delinquencies higher. Delinquencies are now at around 5.4 percent for bank loans compared with the traditional level of around 1 percent, according to preliminary data compiled by Trepp, which tracks and analyzes real estate loans.
Add loans to finance land, construction and apartment buildings, and delinquencies rise to 7.7 percent.
Of the nation’s $952 billion commercial real estate loans that are held by banks and mature over the next five years, about 18 percent exceed the value of the property by 20 percent or more, according to Trepp. Those are at the most risk of defaulting.
Smaller banks have a much higher concentration of commercial real estate on their books and are the most at risk if values do not rebound. They also have the most trouble raising capital.
"The smaller banks that have problems are going to have the hardest time dealing with it," Trepp Managing Director Matt Anderson said.
The high delinquency rates helped sink 13 banks in April, the most bank failures since July 2010, according to Trepp. Commercial real estate loans comprised 79 percent of the nonperforming loans of those bank failures, which included Community Central Bank in Michigan, Cortez Community Bank in Florida and Bartow County Bank in Georgia.
Trepp has 466 banks on its watch list of banks that are in danger of failing. There are about 7,500 banks in the U.S. (Reuters)
