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Wednesday, May 6, 2009

Some More Thoughts on the Looming Commercial Mortgage Disaster

The periods between 2005-2007 were especially booming periods for commercial mortgages. This is important to understand because commercial mortgages are overwhelmingly done as balloon loans. What this means is that borrowers pay a monthly payment for a set period of time, usually from 5-7 years, and then the balance is due, the balloon. So, what this means is that the years from 2010-2013 will see an explosion of balloons coming due on commercial mortgages. In fact, about $1.4 trillion will come due in those three years.

Commercial real estate has tanked along with real estate in general. It's important to understand that commercial real estate value is inherently a function of the cash flows generated by the commercial property. The most simplified way to understand this is that the value of a property must carry a mortgage that allows for cash flows to be 120% of all expenses. While there are certainly variations, this is a baseline point.

Well, since the collapse in commercial real estate, what we have seen is several things in commercial properties. First, vacancies are up. Second, rents are down. Look at this way. The original loan was done with the assumption that rents would be at say $700 monthly, but now they are at $500 monthly. Furthermore, it was done with the assumption that the commercial property would be 90% occupied, but now it is only say 70% occupied. Since both drive down cash flows, what this means is that any new loan will be significantly less than the one that was taken out originally. Keep in mind that balloon payments will be coming due starting in full force in 2010. As such, a property that carried a million dollar mortgage in 2007, might only qualify for a mortgage of $750,000. Yet, that same property will have a balloon payment near one million dollars. As such, in order to avoid foreclosure, the borrower, or seller if it is sold, would need to make up the difference in cash. Now, multiply that by $1.4 trillion and you see the scope of the potential problem.

Essentially, this is all a race against time. In order to avoid this financial disaster what needs to happen is for the economy to bottom out, credit to loosen, so that both vacancies and rents increase and so that all of these potential differences will be available. Of course, we are talking about differences of 20-30%, and currently, banks are themselves struggling to raise capital just to stay afloat.

If the economy doesn't recover enough, then banks will be faced with an extra $1.4 trillion in "toxic assets" on their books. In commercial real estate, far fewer loans are securitized, about a quarter. About half are held by the banks themselves. Often, they are the very same banks currently struggling to stay afloat. Just think about what this means. Bank of America for instance is being told, reportedly, it needs another $30 billion in new capital. This doesn't take into account the potential for a flood of commercial mortgage defaults. Imagine the dire straits that BofA would face if they held a significant portion of a portfolio of $1.4 trillion in new "toxic loans".

This would all come at the worst time. There is now a growing narrative that things are bottoming out and soon they will improve. If they don't improve soon enough, the American public will be lead to believe that the worst is over only to be hit in the head with a brand new disaster starting in the first quarter of 2010. President Obama would likely be touting a recovery for several months until a brand new crisis unfolds. All of these banks would start to finally see the end of the tunnel only to be hit in the head with a brand new round of mass defaults. Whatever recovery we may or may not see will be wiped out and then some by the economic disaster that will follow the commercial mortgage bust.


Anonymous said...

Wouldn't it be great if commercial mortgages were like NFL contracts? Where you can set it up with a balloon payment in the last couple of seasons but you know you'll never have to pay because you can just cut the guy halfway through the contract?

refinance mortgage said...

Although a loan does not start out as income to the borrower, it becomes income to the borrower if the borrower is discharged of indebtedness.