Commercial Real Estate Begins To Mirror Residential Market

The residential real estate crisis is over. Home prices are stable. The number of people who are in the market for a home is up. Tax credits and home prices, which are still historically low, are the cause for a rise in home shopping all over the country. All of that is true until it is not. The most recent data on mortgage defaults and pending home sales indicates that the housing market may be in for another sharp fall.

Most analysts believe that the commercial real estate loan market is about to reach the place that the residential part of the market was a year ago. “Losses from commercial real estate will be quite high by historic standards,” the former Comptroller of the Currency, Eugene Ludwig, told Bloomberg. Some experts think it will be even worse than that. Many community and regional banks could be ruined by defaults on the commercial mortgages that they hold.

The press does not give the commercial real estate market as much ink as it does the residential sector. But, the problems with malls and office building are in many ways more acute that they are for homes. The federal government at least has tax credits for home purchases and mortgage modification programs in place as it tries to place a foundation under falling prices. There are no such plans to keep commercial real estate loans from defaulting, although perhaps there should be.

Most of what goes on in commercial real estate is boring. People, usually wealthy people, buy shopping centers and office buildings. They pay little enough for the properties so that the rent that they receive as owners each month more than offsets mortgage payments and maintenance. Loan payments tend to stop in residential real estate when people lose their jobs or find that their mortgages are larger than the value of their homes. Commercial real estate holders stop payments to banks when their tenants default on leases. The more that small businesses, law firms, and shop keepers become financially stressed, the further behind they get in rent. Many tenants in trouble move out. But, the owners of the commercial real estate cannot move out with their tenants.

The one very critical thing that home mortgage holders and commercial property borrowers have in common is that they know when what they own has become worthless. A developer who buys a mall for $10 million with a $9 million mortgage knows when his mall is only worth $6 million. He has a number of reasons to walk away from his loan unless he has personally guaranteed it. Most commercial real estate owners are not willing to take that risk.

The federal government’s challenge with all property holders, commercial or residential, is that those holding the mortgages cannot survive financially since real estate values have taken an unprecedented drop. Owners give up hope and the banks take the losses. That leaves the government with two distinct choices. One is to close hundreds of banks as they succumb to high default rates on commercial real estate. The other is to revalue the principles on real estate loans. Banks would have to write down the value of the collateral that they hold, the value of the malls and office buildings. Or, the federal government could allow banks to carry these assets on their books at the original value, at least for five years, which would give the assets a period to recover some of their value.

The Administration has already miscalculated the effects of it home mortgage program that created a system that allows home owners to get lower monthly payments. But, those home owners and the banks do not get to drop the value of these homes or keep them on bank balance sheets at their original sale prices. This has caused countless numbers of people to walk away from underwater mortgages. Commercial real estate holders are doing the same thing. The government can solve these problems, but it requires legislation that puts a moratorium on the revaluation of all real estate, if only to buy some time for the property and banking sectors to recover.

Douglas A. McIntyre