Sub- prime crisis has softer impact on US commercial property
EVEN optimistic US commercial- property developers are stacking sandbags to hold back a financial deluge in the market for office towers, shopping malls and other commercial real estate.
In recent weeks, sales of commercial property have nearly hit a standstill.
The market value of such projects — and the mortgages on them — have declined as the spreading fallout from the crisis in risky, or sub- prime, mortgages has made credit hard to come by.
Developers are putting the brakes on new properties, cutting deals with tenants to keep space occupied and, if possible, extending the terms of their existing debt when it comes due.
On the bright side, however, the commercial- property downturn isn’t expected to be nearly as steep as the current slump in the housing market, where recent data showed foreclosures rising to the highest level on record in the fourth quarter of 2007. Losses by commercial- building owners, lenders and investors are likely to be tempered by the lack of overbuilding in recent years and the ability of most offices, shopping centres, hotels and other commercial properties to keep current on their mortgages for the near future.
Fundamentally the markets are in pretty good shape,’’ Moody’s Investors Service managing director James Duca says.
So far, most of the pain from the downturn has been borne by banks and other institutions that hold debt or securities collateralised by commercialreal- estate loans.
These loans have fallen in value as the market has struggled to reappraise their risks.
The outlook could worsen if the US economy falls into a deep recession, driving rents down and vacancies up. But even without a deep dive, it isn’t going to be pretty.
Last week JP Morgan Securities, which says the US economy has entered a recession, projected that commercial- property losses over the next five to eight years would be about $ US120 billion ($ 129.4 billion) for building owners, banks and investors, or roughly 4 per cent of the sector’s $ US3.2 trillion in outstanding debt.
That’s far short of the $ US200 billion in losses that JP Morgan is projecting from the sub- prime debacle, a 15 per cent loss rate.
Even more reassuring for commercial property owners, most analysts are predicting that the pain this time won’t come close to the real estate carnage of the early 1990s, when developers such as Donald Trump and Olympia & York collapsed.
William Tanona, a Goldman Sachs Group analyst, expects Bear Stearns, Citigroup, JP Morgan Chase, Lehman Brothers, Merrill Lynch and Morgan Stanley to take combined commercialproperty- related write- downs of $ US7.2 billion in the first quarter, following $ US1.8 billion of such write- downs in the fourth quarter.
During the current downturn, commercial real- estate values are likely to fall 20 per cent from their recent peaks, according to JP Morgan Chase.
By contrast, Credit Suisse projected late last month that home prices, which peaked in 2005 and have declined substantially since, will fall another 25 per cent to 40 per cent in some regions before hitting bottom.
The delinquency rate on the $ US840 billion of outstanding US commercial mortgage- backed securities is less than 0.5 per cent, near its historic low, according to Trepp LLC, which tracks the market.
While the rate is rising, Moody’s doesn’t expect it to exceed its average rate of closer to 2 per cent over the next year. Compare that with the roughly 20 per cent of commercial loans made by life- insurance companies in 1986 that defaulted in the following 10 years.
Why is the current bad- loan rate so low? For most of this decade, develop- ers have been showing unusual discipline in delivering new product, with the exception primarily of hotels.
Office developers in the top 50 markets this year are expected to complete 53.9 million square feet of office space, according to Reis Inc, a real- estate data company.
While that’s close to double the 2004 pace, it is less than 40 per cent of the average 144 million square feet delivered annually in the five years leading up to the collapse of commercial realestate prices in the early 1999s.
Reis chief economist Sam Chandan says commercial developers haven’t overbuilt because the commercial realestate market didn’t start recovering from the last recession until 2003 and 2004. Usually it takes a few years after a recovery until developers start building numerous speculative projects that have little or no pre- leasing.
We weren’t far along enough in the cycle for the market to start chugging,’’ he says. And then demand began softening because of ( the slump in the) residential market.’’ Now that financing has evaporated, new development has screeched to a halt. That’s bad for employment and the nation’s economic output, but also means most existing projects will be protected from new competition.
While office landlords haven’t dropped their asking rents, many have started offering more concessions, such as interior construction work and months of free rent, so their so- called effective’’ rents are lower. According to Reis, effective rents were flat or falling in 16 markets in the fourth quarter of 2007, compared with seven markets in the third quarter.
The problem is that while most properties’ cash flows are holding up, their values are falling, primarily because financing is so much more costly.
That’s particularly scary for owners ( and their lenders) who borrowed aggressively during the easy- money years of 2005 to 2007 and need to refinance soon. Many won’t be able to borrow nearly as much or get the same terms, putting them at risk of default.
The recent high- profile travails of New York developer Harry Macklowe show what can happen when shortterm loans on highly leveraged property come due. Macklowe is in danger of losing most of his real- estate empire.
Of the $ US44 billion in commercial mortgage- backed securities that need to be refinanced this year, $ US24 billion is in short- term debt securities issued between 2005 and 2007, according to Moody’s. Many borrowers will be able to extend existing loans, but some, such as Macklowe, may be left struggling.
Most commercial- property owners aren’t as highly dependent on shortterm financing as Macklowe and other high- flying developers.
And most of those who borrowed during the easy- money years have seven to 10- year terms on their loans, presumably enough time for the capital markets to figure out how to price real estate and other forms of debt.