Economic Recovery Will Mitigate Damage in Commercial Real Estate

The national real estate virus wasn’t just residential in nature. It infected the commercial sector as well. There have not been as many dire headlines as residential has had because the commercial side peaked later and as such has not yet felt the full effects of the downturn. According to common wisdom it will shortly and this will raise the curtain on a second act of banking failures across the country.

As is our usual take on conventional wisdom, we doubt it.

We do not dispute that regional banks have significant exposure to the sector. Nor that many loans are under water and coming due, around $2 trillion by the end of 2010. Bank losses are projected as high as $300 billion in the next year yet they have made few provisions for write downs.

With vacancy rates approaching 20% many landlords are experiencing a cash crunch and struggling to stay current on their mortgages. And with real estate valuations having declined substantially from their peak many buildings will not qualify for refinancing.

In order to forestall damage to their balance sheets banks will likely take a short term approach and extend the loans when they come due. Over time this is an awful strategy and is a key to what led Japan to its “lost decade,” in which the government allowed the fiction that moribund loans on bank balance sheets were still performing. These so called “zombie banks” were so financially constrained they were unable to lend and in the absence of a healthy financial sector the economy stagnated for more than a decade.

Industry executives are in a panic. The Real Estate Roundtable is an industry group that would like a mortgage modification program similar to that which has been introduced to a certain degree on the residential side, where the government incentivises banks to write off some portion of mortgages they hold that are under water.

But in the face of all this talk of Armageddon came a report on Tuesday of a rebound in the sector. Prices rose 4.4% in the 3^rd quarter for the first gain in over a year and the largest in over two years. While one quarter doesn’t signal a trend it is notable that the number of transactions increased for the second quarter in a row. A bottom might well be in for the sector.

Further, MIT’s Center for Real Estate tracks supply and demand sentiment and their demand index moved 12% higher, marking the first gain in two years. The demand index reflects what potential buyers are willing to pay and it is now increasing.

These developments do not alleviate a clearly tenuous situation in commercial real estate (CRE). Prices could move higher for several quarters and would still be well below mortgage values on many properties. But in a world that has become convinced that the economy cannot improve without government intervention we have yet further evidence that economies heal on their own. And tentative signs of a bottom in CRE could well stem the most dire predictions of failure in the sector as the general recovery gains momentum, vacancy rates stabilize, landlord cash flow improves and the number of troubled properties begins to mitigate.