Loan Defaults, Vacancy Rates Rising for Commercial Market Loan Defaults:
With Vacancy Rates Rising, Financing Shrinks

While everybody's talking about the battered housing market, there's a rumble growing about the other shoe that's about to fall. Foreclosure problems that destroyed residential real estate in 2008 are set to hit the commercial real estate market even harder this year, analysts are warning.

Commercial property values have fallen 30 percent to 40 percent from their peak a couple of years ago and the market is fraught with peril. Loan defaults have soared. Financing has dried up. Rising vacancy rates combined with declining rents are weakening cash flow. "For Lease" signs hang at almost every shopping center and office park. Construction has been delayed or halted on some of the newer developments.

The problem is banks and lenders were so loose in making construction loans. Shopping centers that are overpriced and lack an anchor tenant to draw customers are the first to die when times get tough. National retailers are going out of business and smaller operators are chasing cheaper rent at other centers. Commercial real estate loans will likely be the next big problem for banks, which hold about half of the estimated $3.5 trillion in commercial mortgage-backed securities, or debt backed by commercial property as collateral.

Delinquency rates on commercial loans jumped to 4.4 percent in the first quarter from 1.6 percent in the previous quarter. A slew of default notices are coming. Some borrowers have "staying power" to pay interest, but few can make large principal reductions, let alone amortize them in monthly payments. The impairment write-downs result from appraisals performed on an income basis. Empty building, no income, low appraisal ... if the loan is higher, write off the difference.. With financial institutions either unwilling or unable to roll those loans over and hesitant to rewrite them at lower rates, the country will probably see a wave of commercial foreclosures starting in 2009.

This will put even more commercial space on an already saturated market. Investors remain scarce. Those who are not flush with cash are finding it difficult to get a loan, and those with cash are waiting for the market to hit bottom. Retail delinquencies are rising at 20 to 30 basis points per month. At 1.81 percent, total retail delinquency has surpassed its previous peak of 1.63 percent set in September 2002. Deutsche Bank estimated that $15 billion in commercial mortgage-backed securities are maturing in 2009 and $30 billion are maturing in 2010 and a high concentration of risky five-year, interest-only loans from 2005 to 2007 are on the way.

Prospects for retail are particularly worrisome given the historically large declines in consumer spending and increases in retailer bankruptcies. The commercial market is in big trouble, as witnessed by mall developer General Growth Properties filing for bankruptcy and Triple Five Development defaulting on a $27.6 million loan on vacant land for its proposed Great Mall of Las Vegas. Commercial value is way down, in some cases to where there's little or no equity, so you can't refinance out of debt, hence bankruptcy.

There's a lot of "vulture money" waiting for property to lose value as soon as the bank files a notice of default. Malls are getting killed by empty anchors. Nobody is offering financing for somebody else to come in, so you've just got vacant places. The other thing is the smaller tenant is being killed because anchors aren't pulling in traffic. Investors won't be able to buy the property unless they have cash. There aren't very many banks that will make commercial loans during these economic times.