Foreclosures: Are Commercial Properties Next?

Mention the word “foreclosure” and the usual reference is to residential real estate, but now the term is beginning to have a new meaning, one with a troubling economic impact.

Big properties are facing tough times and some are already gone. Just in April:

  • In Boston, the hallmark John Hancock Tower, the tallest building in New England, was sold at auction for $660 million. That’s a big number but not nearly as big as the building’s $1.3 billion 2006 price tag or the $935 million that investors paid in 2003.  
  • General Growth Properties, Inc., a firm which owns 158 shopping centers across the country, filed for bankruptcy under Chapter 11, meaning that the centers will continue to operate as the company seeks to refinance old debt.
  • In New York, 1330 Avenue of the Americas, a 40-story office tower, has been taken over by a creditor. Harry Macklowe, the owner, had previously been forced to sell the GM building in New York for $2.9 billion — a huge price and far more than the $1.4 billion paid for the building in 2003. The sale was necessary, according to The New York Times, to pay off $7 billion in debt that could not be refinanced in today’s market.

 

The Death Spiral Massive and rising unemployment levels, reduced consumer spending, frozen credit markets and the Internet revolution all mean that shopping center and office property demand have fallen. The result is similar to the hurdles now faced by homeowners in declining residential areas.

Less Income: As chain stores have gone out of business, massive volumes of retail space have become available. Converting such space into community college classrooms or multi-store boutiques does not produce the dollars such sites once generated. Moreover, current tenants can barter for lower rates as malls generate less traffic. The result is less money for owners to repay existing mortgages.

New Debt: Assuming that debt payments can be made, commercial owners next have the problem that many properties have been financed with short-term debt, loans lasting three to five years. If such financing cannot be replaced with new debt, owners must then sell the property or pay off the loans from other sources.

Less Equity: Many owners lack the capital or current borrowing capacity to refinance, while at the same time they can’t sell because property values have declined and are now worth less than outstanding debts.

No Loans, No How: Even in situations where owners have good credit and equity, loans are still largely unavailable because of the credit squeeze.

Tenant Risk: As residential tenants have discovered, bankruptcy courts have the power to terminate leases when a landlord leaves. Ditto for tenants in malls and offices. As a result, tenants are now asking landlords to escrow money intended for improvements.

“Prospective tenants,” says The New York Times, “are asking for financial statements from landlords, hoping to avoid companies that might default on their mortgages and leave tenants at risk of losing the space. Tenants are also more wary of subleasing space, and are tending to flock to buildings with stable owners.”

“The bottom line,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the country’s leading online marketplace for foreclosure properties, “is that a lot of commercial property owners share the same financial situation as homeowners in the nation’s foreclosure hubs: They can’t make their payments with less income and they can’t sell or refinance with reduced equity. Properties are being re-valued and in some cases foreclosure and bankruptcy loom ahead.”

Homeowners
At first it might seem as though the tribulations of billion-dollar commercial property owners are far removed from local homeowners, but that’s not the case. Malls and office towers provide jobs and pay local property taxes. Shut them down or reduce their value and community economics can change very quickly — and not for the better.

When people buy homes they also “buy” communities. They look for good schools, shopping, job centers, medical facilities and roads. The reason identical homes five miles apart have different values is not because the climate varies, it’s instead because one has a better level of community services.

The catch is that the definition of a “community” can evolve. The classic example in the U.S. concerns small towns in the 1890s. If you wanted to buy manufactured goods you were dependent on local retailers.

The Internet
Small-town economics changed with the development of the rural mail delivery system. Using catalogs and the Postal Service to deliver goods, merchants no longer needed a physical presence to compete in local communities. Seen another way, local merchants no longer competed in a vacuum. Probably the most visible way that the definition of a “community” changed was with the introduction of rural free delivery in 1896 and the rise of major catalog companies such as Sears Roebuck that could deliver goods anywhere.

“The significance of Sears’s strategy is best seen in the prevailing prices of goods before his firm made a dent in the consumer market,” says Thomas V. DiBacco in his book, Made in the U.S.A. The History of American Business. “Men’s suits cost $10 before Sears, but only $5 in his catalog. In 1897 bicycles ran anywhere from $75 to $100 in retail stores. When Sears first sold them, the price was affordable. According to an 1898 magazine, Sears sends a ‘bicycle Catalogue free to anyone who asks for it, and, we are told, shipping several hundred bicycles every day to every state, direct to the riders at $5 to $19.75, on free trial before paying. If Sears, Roebuck & Co. continue to wage their bicycle war throughout the season it will be a boon to all those who want bicycles, but a sad blow to bicycle dealers and manufacturers.’”

What happened in the 1890s happened again in the 1990s. The dawn of the Internet as a marketing and communications platform meant inevitably that the value of localized commercial real estate would decline. Why? People who telecommute need less office space, people who buy online don’t have to spend time or gas going to a mall, and companies nationwide have been reducing employee ranks as revenues and profits have declined.

It’s rural free delivery all over again, this time with electrons.

The Surplus
The problem for commercial property owners is that in too many areas supply grossly exceeds demand. Since you can’t lower an existing office tower or knock down part of a mall to reduce supply, commercial owners and their lenders have a problem which is likely to get worse rather than better.

Unfortunately, problems in the commercial sector take us back to the major U.S. banks and brokerages which finance such properties. In the same way that lenders relied on past earnings and credit ratings to make new residential loans — and assumed that residential property values would inevitably rise — the same thinking was true with commercial lending. The catch, of course, is that office towers and mall values cannot perpetually rise.

“Nationally,” reports Delta Associates, “the total value of distressed commercial real estate in February 2009 was $49.2 billion, including properties in distress, foreclosure, or lender REO.” This total is up 92 percent from December 2008.

Delta also says that “in addition to delinquencies, a rising tide of mortgage maturities — in excess of $300 billion in 2012 and 2013 — must be addressed by the commercial mortgage market in the years ahead. The situation is likely to be made more difficult by a weak economy, tight capital, and lower values.”

But is it possible that the Delta estimates are low? Think of what was initially described the limited “subprime” mortgage meltdown that grew into the broad financial meltdown we have seen during the past year.

Trends
With Lehman Brothers, for example, we now know that this single failed company at one time had $36 billion in commercial mortgage exposure, according to The New York Times. Today other huge bankers and brokerages also own major portions of buildings, malls and office parks which are now less and less in demand. The so-called “stress tests” released last month by the Federal Reserve estimates that at least $53 billion in commercial real estate loans are at risk during the next two years as well as $60.1 billion in “commercial and industrial” loans. The stress test figures are restricted to just 19 of the nation’s largest financial institutions, meaning that total commercial losses could be substantially larger.

The Mortgage bankers Association reports that commercial loan originations in the first quarter of 2009 are down 88 percent for hotels, 80 percent for health care properties, 76 percent for retail properties, 66 percent for office properties, 61 percent for multifamily properties, and 50 percent for industrial properties.

You can see where this is headed. In the same way that big investors will ultimately buy huge distressed commercial properties at bargain prices, a lot of smaller commercial properties — warehouses, strip malls, small apartment projects, stand-alone stores — will soon enter the marketplace as more commercial loans are defaulted.
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Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.

 

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