Commercial real estate crisis threatens recovery

By Scott S. Powell and David Lowry


The Federal Reserve has limited options since it has doubled the size of its balance sheet and taken unprecedented action in monetizing government debt to deal with the credit crisis over the past year.

Now, it is faced with managing the dual challenges of shrinking the money supply to head off inflation and extricating itself from more than $5 trillion of credit exposure from the bailout programs instituted so far.

At the same time, the U.S. Treasury Department is on a path to continue funding government bailouts and budget deficits by issuing debt at the fastest pace in peacetime history.

So what is Washington going to do about the second wave of the credit crisis caused by the unfolding collapse in commercial real estate and the potential explosion of bank failures across the U.S.?

A bailout of bank deposit insurance seems inevitable. The question is what can Congress, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency do to mitigate this rapidly unfolding problem?

Commercial real estate, valued at some $3.5 trillion, has experienced a 39 percent decline in prices from the peak only two years ago, according to the MIT Center for Real Estate.

This drop is greater than the 27 percent commercial real estate decline associated with the longer savings and loan crisis of the late ’80s and early ’90s that precipitated government Resolution Trust Corporation seizures and auctions.

The same conditions that caused the residential bubble — including the Fed’s easy credit, lax lending standards and booming mortgage-backed securities underwriting on Wall Street — also drove commercial real estate overvaluation.

The 18 percent price decline in second quarter was the largest quarterly drop in the 25 years since MIT first published the commercial real estate price index. Most commercial properties bought or refinanced in the last five years are now upside down on their loans — with current property prices having fallen below the finance or purchase price. Real Capital Analytics reports that owners have lost their entire down payments on about $1.3 trillion worth of property.

Nearly half of all the commercial real estate mortgage loans in the U.S. are coming due within the next five years. Deutsche Bank believes that 65 percent or more of these loans will fail to qualify for refinancing. Existing high vacancy rates will continue without new job creation.

Meaningful lease activity in commercial real estate will stay in the sublease market at rents between 50 to 85 percent of existing scheduled lease rates.

Eventually these lower sublease rates will become the effective and real market rates, putting yet further downward pressure on commercial real estate values.

The problem is that without immediate changes in bank regulations and laws governing Real Estate Mortgage Investment Conduits (REMICs), this next wave of the credit crisis will sabotage economic recovery — driving up bank failures and bailouts by the FDIC. The recession could become a depression.

For once, government must reverse the iron law of unintended consequences, avoid fighting the last war and become part of the solution.

First, banks should not be forced to reclassify loans that have had minor modifications to assist borrowers, as is presently required.

Current regulations contribute to failure rather than averting it. Renewal of current loans at higher loan to value ratios may also be appropriate and reduce unnecessary foreclosures. So long as loans are performing, banks should not have to take charges against earnings and capital before actual losses are incurred. We need to get off the path leading to unnecessary seizure of banks that need not be taken over.

Second, Congress should move quickly to amend the Tax Reform Act of 1986 to allow modification of loans within REMIC pools.

More than a quarter of commercial real estate in the U.S. is financed with commercial mortgage-backed securities, but because existing REMIC laws do not allow for change in any of the individual loan’s collateral within the pool, borrowers cannot modify or improve the underlying property without triggering a default or foreclosure, even when they utilize their own capital.

As a result, commercial property owners often cannot make changes in a dynamic environment and accommodate tenants’ evolving needs.

Amending REMIC laws to allow property modification and expansion would not only preserve jobs, it would also create new construction jobs to make those improvements while also providing states with much needed sales and business tax revenue.

It may also help revive Wall Street’s shuttered commercial mortgage-backed securities underwriting departments, which are now desperately needed to add capital capacity to facilitate the financing of property turning over from foreclosure auctions and forced sales.

Make no mistake — there will be dozens more failed banks and an enormous loss of wealth from the bust of commercial real estate. But immediate government leadership in key areas would greatly reduce the scope of bailout due to the commercial real estate collapse and help dodge a killer bullet to our economy.

Scott S. Powell founded AlphaQuest, a hedge fund consulting firm, and is a Visiting Fellow at the Hoover Institution. David Lowry is an owner/developer of Southern California commercial real estate and a former San Diego official.