The next big nasty: US commercial property

By Associate Editor David Stevenson Feb 18, 2010

David Stevenson

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It's a fair bet that you haven't yet read the US Congressional Oversight Panel's February report.

I can't say I'm too surprised. It's 190 pages on "Commercial Real Estate Losses and the Risk to Financial Stability". Hardly likely to get your pulse racing.

But I can tell you, behind that desiccated title, it's scary stuff. In fact US commercial property could be the next big nasty to hit the financial markets.

Here's why.

Commercial property was one of the biggest casualties of the credit crunch, on both sides of the Atlantic. The valuations of offices, shops and warehouses tanked as a string of tenants went bust. Property owners realised they'd bought far too many buildings with borrowed money. And also that they weren't then able to afford the debt repayments. So waves of forced selling drove commercial values down much further than in the housing market.

At the start of the month we wrote about what's been happening in the British commercial property market. Here there's been a recent pick-up in prices, but we don't trust it: Get out of UK commercial property.

Over in the States, it's been just as bad, if not worse. Prices of commercial property - real estate - are down by 43% overall since the October 2007 top, says Moody's Investors Service. Retail rents have plunged by a third from the peak. For offices, rents are down 40% and vacancy rates are as high as 18%.

Are there happier days ahead for US commercial property?

Yet the latest news looks brighter. One of the two largest US shopping mall owners, Simon Property Group, has just offered to pay $10bn to buy the other, General Growth Properties (GGP).

That's just what investors like to see. So does it mean that happier days are back again for US commercial property?

Not at all. For a start, General Growth Properties is on the rocks. In fact, it's bust. It had loaded up on far too much debt back in 2004, which seemed a good idea at the time. But last April, GGP was forced to submit the biggest-ever real estate bankruptcy filing in American history. So Simon is simply trying to make the most of the situation.

The big problem about to hit the market

What's more, a much, much bigger problem is about to hit. Back to that Oversight Report. And bear in mind it's been written by a top government body consisting of bank governors, law professors and high-ranking legal, accounting and compliance types. Not the sort of people known for getting over-dramatic.

Between this year and 2014, about $1.4 trillion in commercial real estate loans will need refinancing, says the panel. Many of these "were made carelessly in a rush for profit at the height of the real estate bubble". But nearly half are now "underwater". In other words, the properties are worth less than the borrowers owe.

If the latter can't cajole a friendly banker to lend them the cash to roll over their loans, it's big problem time. Those loans will go into default and the underlying properties will be repossessed. Even borrowers who own profitable properties may not be able to refinance their loans. That's because there's been a sea change since the first lumps of money were doled out in the boom. Lenders have toughened up their lending criteria and now demand much more collateral to back their loans.

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What will this all mean? Here's where it gets really nasty. The largest commercial real estate loan losses are forecast for 2011 onwards. Bank losses could be between $200bn and $300bn. That could be enough to make the banking system unravel. Since the start of 2009, 161 US banks have failed. And the panel is very worried that many more, particularly mid-sized and smaller banks, could go bust.

There's no way of knowing how bad it could get. Remember those 'stress tests', done last year on 19 major US financial institutions to check out their capital reserves? The tests only looked as far forward as the end of 2010. So 2011 will be unknown territory. More worrying, America's mid-sized and smaller banks never had to jump through the same hoops as their bigger rivals. Yet proportionately, they're even more exposed than the larger lenders to commercial real estate loan losses.

Avoid commercial property and stay defensive

The net result could be carnage. US bank loans are already contracting at a 16% annual rate, as David Rosenberg of Glusken Sheff points out. America's smaller lenders are needed to finance small businesses and create new jobs. But even those lower-ranking banks that survive the commercial real estate crunch won't want, or be able, to lend. So more businesses and families will be starved of credit. That would mean more empty offices, hotels, and shops – and more lost jobs. Families renting flats could be evicted, even if they've never missed a payment, if the whole apartment block is repossessed.

Indeed, the commercial real estate loan fallout "could trigger economic damage that would touch the lives of nearly every American", says the Panel, adding to "prolonged weakness throughout the economy".

And there's no easy answer. The government and the Federal Reserve can't bail out every bank. They've borrowed so much money already, they've just about run out of financial ammo.

Earlier this month we talked about 'debt time bombs' about to go off. Well, commercial property is just another of these bombs, which I don't believe the US stock market has factored in yet. When it goes off, expensively rated shares that depend on strong US economic growth are in danger of suffering some very big future falls. That's why you should avoid being invested in them, and stick with defensives.

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Comments (5)

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  • 1. Karen

    (18 February 2010, 11:14AM)  Complain about this comment

    When are the people who are paid to govern going to spend some time and effort in planning for the future rather than the knee jerk reactions to problems we already have.

    Money Week has been predicting the financial crisis for around 4 years now and there is no excuse for our government in particular to have been unable to plan better.

    Record numbers of people have been made bankrupt, done IVA's, had homes repossessed and effectively been removed from the economy as they have no spending power. It doesn't need a genius to work out that the economy will not recover as long as no one has any trust in the government, banks, other businesses etc.

  • 2. Bob Roberts

    (18 February 2010, 11:55AM)  Complain about this comment

    It is 2014 again - you can fight and win a world war between now and 2014.

    When 2014 comes are there going to be hundreds of articles online about property, commercial and residential, plunging in price by 2019.

    We have a limited time on this planet.

  • 3. Billy Busted

    (18 February 2010, 03:46PM)  Complain about this comment

    *The Global Debt is not short or medium term resolvable.
    *Fiscal and Political policies must operate in parallel, they don`t.
    *Middle ground safe centre politics will not stimulate change.
    *No creativity to address acceptable solutions.
    *Established western democratic process collapsing.
    *Emerging eastern economies and politics too imature.
    *Too great is the growing division between wealth and poverty.
    *Too many disfunctional factions compound country problems.
    *Civil unrest provides the medium for Dictatorship.
    *Global unrest provides a medium for War.

    ..................You get the picture?

    *The establishment , bankers , the legal system , politicians , leaders of industry , lack of disciple , and uncontrolled greed
    are just catalysts .

    ..................In the past, these issues have been resolved by WAR.

  • 4. ricardo snyder

    (20 February 2010, 03:48PM)  Complain about this comment

    Too many prophets of gloom. All of this scary stuff "sells

    newspapers". Too much negative thinking is not good for any of us.

    The depression has brought havoc...but we will come out of it.

    Prices are falling...but the sky is not.

  • 5. Plato

    (21 February 2010, 05:28PM)  Complain about this comment

    We, The People, are doomed if we don't change the current Political System, both Democrats & Republicans are Corrupt and
    Incompetent, neither party has Solutions, Competence and Honesty their collution with Major Multinational Corporations is
    against the interests of the General Population of Taxpayers.
    Solutions ? Dismantle the Political parties replace Professional
    Politicians by Competent Accountable Professionals that will be
    prosecuted and jailed if corruptions or incompetence is found.
    Viva the New America!

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