It only gets worse this year for commercial real estate

A closed Circuit City store in New Jersey is an example of the commercial real estate problem
A closed Circuit City store in New Jersey is an example of the commercial real estate problem Tom Gralish/Philadelphia Inquirer/MCT

WASHINGTON — Commercial real estate is expected to remain a drag on the U.S. economy through 2010 and beyond.

"You do see stress in the market. We've seen delinquency rates increasing; we've seen by a whole variety of measures increased stress in the commercial real estate market," said Jamie Woodwell, the vice president of commercial real estate research for the Mortgage Bankers Association.

Commercial real estate encompasses everything from shopping malls and storefronts to industrial parks and hotels. Delinquencies on bonds backed by pools of commercial real estate loans continue climbing to record levels.

At the end of 2009, 4.9 percent of all pools of these loans — called commercial mortgage-backed securities — were delinquent. That's a five-fold increase over the year before, Moody's Investors Service said in a mid-January special report.

The rating agency's "delinquency tracker" found that at year's end, more than 8 percent of the bonds for apartment-complex mortgages and more than 9 percent of the bonds for hotel mortgages were delinquent.

With occupancy rates plunging, several high-profile defaults on pools of hotel loans underscored the risks. These include, according to Moody's, pools that contained the Four Seasons Resort and Club outside Dallas, the Westin O'Hare near Chicago's airport and Holiday Inns in Louisville, Ky.

Even New York City isn't immune. In one of the biggest commercial real-estate deals yet to unravel, an investor group said Monday that it had defaulted on the debt used to finance its $5.4 billion purchase in 2006 of the huge Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan. The 11,000-unit, 56-building property is now valued at less than half what the investors paid for it.

"2009 saw delinquencies on all property types and in all regions surpass previous highs" in the history of the tracker, Moody's analysts wrote. "We expect loan performance to deteriorate further in 2010 and project that the (tracker) will reach 8-9 percent by the end of 2010."

Fitch Ratings, in a note last week to investors, said that default rates on commercial mortgages could reach 12 percent by 2012. Fitch's numbers came in a negative report last Wednesday for U.S. life insurers, which invested heavily in bonds backed by commercial mortgages. Fitch said that U.S. insurers stood to lose $20 billion from their commercial real estate investments.

The Urban Land Institute, a research center, said in an emerging trends report this month with consultant PricewaterhouseCoopers that respondents to its survey predicted that "commercial real estate vacancies will continue to increase and rents will decrease across all property sectors before the market hits bottom in 2010 and projects value declines of 40 percent to 50 percent off 2007 market peaks."

The Congressional Oversight Panel, which Congress has charged with overseeing the use of taxpayer bailout money to the financial sector, is holding a field hearing Wednesday in Atlanta to explore problems in commercial real estate markets.

The silver lining is that the commercial real estate sector's problems are proving to be less of a drag on the economy than experts had expected. Fears that they'd rise to the magnitude of the subprime crisis, with some analysts predicting 60-percent plus default rates, appear to be waning.

"It's going to be a weight on the economy ... for three or four years, but it's not going to be the thing that undoes the economy," said Mark Zandi, the chief economist for Moody's, a forecaster in West Chester, Pa.

One reason that commercial real estate has been less disruptive, he said, is that these problems were expected as the economy soured, and were quantifiable. They didn't sneak up on the nation as the subprime mortgage crisis did.

"We do share that view. 2010 is going to be another rough year. We don't necessarily subscribe to some of the most pessimistic views ... of a flood of commercial release estate defaults," said Rick Sharga, the vice president of marketing at RealtyTrac, which provides foreclosure-research data.

The sector's pain is spreading at different paces for different segments. Office space, for example, hasn't been hit as hard as hotels have, since office buildings tend to lease space to companies in the service sector. Service industries have suffered less than manufacturing has, which generally includes older companies that own their real estate.

According to the Moody's delinquency tracker, the default rate for mortgages for office space stood at 3.19 percent at year's end. That's not great, but it's far better than the 8.14 percent default rate for hotels or the 4.52 percent rate for retail establishments.

About 19 percent of the outstanding bonds backed by commercial mortgages came due last year or will this year. That's a much more manageable pace than the crush of adjustable-rate subprime residential mortgages that matured from 2006 to 2008.

Many commercial real estate loans mature over 10 years, so the large volumes of loans written from 2005 to 2007 — when bank underwriting standards were particularly weak — are still a few years off. Their delinquency rates may well depend on the strength of the U.S. economy's recovery. If the economy doesn't return to strong growth, refinancing many of these properties, now or later, may prove difficult.

"Clearly the shape of the recovery will have a big impact on future performance of mortgages," said Woodwell, of the Mortgage Bankers Association.

Because of the strength in the services sector, office space is the segment of commercial real estate that's likely to come back first, while the health of outstanding industrial and retail mortgages will depend on how fast and strong consumption returns.

Apartments and other multifamily dwellings are expected to be the last segment to return to health, because they depend on how fast the large inventory of unsold homes is cleared off the residential real estate market.

(Curtis Tate contributed to this article.)


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