Revisiting the Looming Commercial Mortgage Disaster

Congress Woman Carolyn Maloney held a hearing on the growing commercial real estate crisis. To understand what a threat the current state of the commercial real estate market is one only needs to read the testimoney of James Helsel of the National Association of Realtors.

Here are some of the pertinent numbers that will contextualize the problem. Starting in 2007, commercial real estate transactions dropped from $498 billion in 200, to $143 billion in 2008, to $15 billion year to date. At the same time, there were $230 billion in Commercial mortgage backed securities issued in 2007, $12 billion in 2008, and NONE so far this year. The market for securitized Commercial Mortgage Backed Securities is thus literally non existent.

At the same time, commercial loans are maturing in the hundreds of billions with commercial loans maxing out at $1 trillion in 2012. So, we have trillions of dollars worth of loans that will need to be refinanced or sold over the next three years and we have a non existent commercial real estate market on top of it.Next up to speak was Jeff Deboer, President of the Real Estate Roundtable. Deboer shared several more sobering numbers. First, commercial real estate valuations have fallen by approximately 35% from their peaks, depending on the type of property. Rents have fallen by 20% and all of this has contributed to a drop in commercial real estate transactions of 80%.

It's important to again explain the governing philosophy behind commercial real estate lending. Lending in comercial real estate is driven almost entirely by cash flows and thus income from the properties. The general rule of thumb is that a commercial bank will do a loan in which the loan will contribute to cash flows on that property of 120% of all expenses (in the industry this is called a debt services coverage ration or DSCR). So, a 20% drop in rents means that we will see a corresponding drop in the loan amount that bank will accept.

At the same time, the more liquid the commercial real estate market is, the lower the DSCR. In other words, when there is a very robust commercial mortgage market, you are more likely to find banks offering DSCR's closer to 110% of debt. Of course, we now have a non functioning commercial mortgage market. As such, banks are increasing the DSCR as a stipulation for qualification.

So, we have falling income and that contributes to lower acceptable loan amounts. We have rising DSCR and that contributes to lower mortgage amounts. No wonder commercial real estate transactions are nearly non existent. In fact, Helsel relayed a truly frightening story from a commercial realtor in Atlanta. The realtor was looking to procure a purchase transaction in a warehouse. During normal commercial markets, banks generally want the buyer to come up with 25% and they will loan the other 75%. In this case, the buyer had 75% and was only looking for 25%. The realtor and buyer went to no less than ten different banks looking for a loan and were denied.

To put this into perspective, one needs to understand that commercial mortgages are often done as balloon loans. What this means is that the payment is done as though you have a thirty year loan, yet the loan is due after 3,5,7, or 9 years. So, the borrower will need to refinance or sell before the term is due. Now, imagine having $1 trillion worth of these mortgages due and not being able to refinance them. That means the country is facing in excess of $1 trillion in commercial mortgage defaults over the next three years.

This doesn't even take into account that it's simply impossible to grow an economy if apartment buildings, offices, warehouses, etc. can't be financed. How exactly will this country have economic growth if businesses can't expand? Try and buy a warehouse and you will need at least 75% of the money in cash. Deboer testified that transactions for $50 million and higher are simply non existent. In other words, any really large commercial transaction must be done in cash.

The worst part is that the options here are limited. Deboer suggested several changes in the tax code. For instance, Deboer suggested that the Foreign Investment Realty Property Tax Act (FIRPTA) be suspended. This act taxes profits from real estate by foreign entities at current domestic tax rates. He also suggested lowering capital gains tax rates. Both of these would help the commercial real estate market, however they wouldn't fix the underlying problem.

We have more than a trillion dollars worth of commercial mortgages that will need new loans in the next three years. We have a non existent commercial real estate mortgage market, no securitization, and thus no transactions. This is not only the next shoe to drop but it is dropping right now.