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The Coming Commercial Real Estate Disaster

November 20, 2009

To the editor:

Thanks to Republican campaign ineptitude and widespread anti-incumbent backlash, Croton’s March election brought a rogue village board and a mayor intent on imposing zoning changes over the objections of many residents. Now we know what living under a one-party Stalinist or Maoist regime is like. Bruising litigation will inevitably follow. In the meantime, what else will happen? Nothing. In the almost six years since passage of the Gateway Law, not a single dollar has been spent in Croton by owners or developers of commercial properties. The same can be expected in Harmon under the zoning changes to that law.

Passage of the changes was a masterpiece of bad timing. Although the collapse of the residential real-estate market has been a disaster, “you ain’t seen nothing yet,” as entertainer Al Jolson used to say. A second bubble, this time in commercial real estate, is about to burst and sweep over the economy like a tidal wave, dooming development everywhere. Federal Reserve Chairman Ben Bernanke hinted at this when he told a House committee last month, “Commercial real estate remains a serious problem.”

A significant indicator, quarterly returns on commercial property compiled by the National Council of Real Estate Investment Fiduciaries, has been negative for the past five quarters, the longest continuous downturn since 1992. Beset by vacancies, owners of shopping malls, hotels, office space, apartment buildings and industrial sites—and the bankers who financed them—face crucial decisions over the next two years as the mortgages on these properties come due.

“A crisis of unprecedented proportions is approaching,” according to Dr. Randall Zisler, chief executive officer of Zisler Capital Partners LLC. Commercial property prices have fallen by 30 to 50 percent from their 2007 peaks, Zisler estimated in a recent report. This precipitous plunge has wiped out the equity in most real-estate deals based on debt financing since 2005.

Although the commercial real estate market is only about one-third the size of the $22 trillion residential market, its problems are considerably more serious. Home mortgages run for 15 to 30 years, but much of the $1.6 trillion in outstanding commercial real estate loans are for shorter terms of three to seven years. Many of these loans were written by bankers at the height of the boom. Zisler, whose firm specializes in real-estate investment, expects another $500 billion to $750 billion of mortgage debt to be added to that number as a result of “unscheduled maturities”—unanticipated defaults by owners of commercial properties—will bring the dollar amount at risk to well over two trillion.

“Unfortunately, traditional lenders of consequence are practically out of the market and massive amounts of maturing debt will not easily find refinancing,” Zisler pointed out. “Marking-to-market outstanding debt will render many banks, especially regional and community banks, insolvent, especially since much of the debt is likely worth about 50 percent of par, or less,” a consequence of having to reduce the value of their holdings.

According to FDIC data, commercial real estate made up 56 percent of U.S. banks’ loan portfolios in 2006. It was only 40 percent a decade earlier. For about 5,600 smaller banks with assets under $1 billion (about 90 percent of all U.S. banks) the percentage of loans secured by commercial real estate is even higher—74 percent.

In addition to vacancies and lost rents, those who bought commercial real estate at the height of the boom face the same dilemma as homeowners—plunging values. When their loans come due, they will owe more on the mortgage than the property is worth. Bankers call this “being upside down.” Owners have two choices: Sell and take a huge loss, or refinance and come up with a big bundle of cash to make up for the lost value.

Moreover, when decision time comes, many commercial property owners won’t have a sympathetic banker to talk to. Unhappy investors who bought bonds created by investment banks from bundled mortgages (Wall Street calls these “mortgage-backed securities”), or who bought bonds backed by the interest payments on them, hold about a third of all commercial loans.

Heavy losses on commercial real estate will cast a pall over consumer lending, causing banks to make home mortgages, car loans and credit cards even harder to obtain. It also will induce bankers to offset commercial loan losses by accelerating foreclosures and sales of foreclosed homes, thus putting additional downward pressure on home prices.

Traditional voter lassitude during local elections undoubtedly played a role in the voting that gave us the current lopsided administration. The next election is 120 days away. A village board with members more responsive to the will of the people would mark the beginning of the return to more proportional representation.

— Robert Scott, Croton-on-Hudson


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