Some Outlooks for CRE Loans Turn Less Dire

As residential housing appears to have stabilized in the U.S., commercial property is still the elephant in the room.

Defaults on commercial real estate are rising and vacancies are widespread, but while regional banks, in particular, remain heavily exposed to this sector, it's unlikely to have the impact that the residential housing collapse did on the economy.

Sectors closely aligned with the fortunes of commercial real estate — home builders, banks and real estate investment trusts — have enjoyed strong gains this year, perhaps already having factored in expected weakness in this business.

Steve Stahler, the president of the Stahler Group, points out that commercial real estate and residential housing are vastly different animals.

"In the residential market, many unqualified, credit-unworthy people received mortgages and the companies way overbuilt, exacerbating the problem," he said.

"As far as commercial real estate goes, they didn't overbuild and the buyers of these properties were creditworthy. This makes it a bit more contained."

Empty homes cannot be filled as easily as vacant commercial properties can. Stahler said he's seen certain higher-end retail locations replaced by more middle-of-the-road franchises, reflecting changing consumer buying habits.

Granted, there are some scary numbers out there: U.S. banks are estimated to have exposure of about $1.8 trillion in commercial real estate loans, much of which will come due in the next few years.

According to research from Deutsche Bank Securities, commercial real estate values have plunged 35%-45% from their peak in 2007, as vacancy rates for office, retail, apartment and industrial properties have risen steadily into the mid-teens.

Property owners will encounter obstacles in securing refinancing from wary, stricter lenders, likely leading to a wave of foreclosures and bankruptcies. A recovery is not expected for several years.

Amid this decline, regional banks will likely sustain the biggest losses from commercial property defaults, given that they lack the kind of diversified cash flow that larger banks have, and they are unlikely to receive a government bailout. Some regional institutions have nearly half of their loan portfolios in commercial real estate — and have accordingly added to their loan-loss reserves. By contrast, the largest banks have modest exposure to commercial loans.

Stahler concedes that many regional and smaller banks will indeed have to incur heavy writedowns related to commercial real estate losses; but potential buyers — perhaps cash-flush foreigners — will have their pick of extremely attractive U.S. properties to choose from.

"The perception that commercial properties will collapse is untrue — there will definitely be buyers," he noted. "For one thing, the cap rates on many of these properties are actually increasing."

Michael Yoshikami, the president of YCMNET Advisors, believes commercial real estate will suffer some significant losses, but probably not enough to derail an economic recovery for the broader market.

Unlike residential housing, he said, commercial real estate properties were not as highly leveraged. Commercial locations are also rented or leased, which means they always produce income streams.

Also, the U.S. commercial property market is only one-third the size of the housing market.

Still, since the eventual size of losses in commercial real estate are murky — perhaps as much as $200 billion over the next few years — it will probably remain a highly volatile sector, given the precarious state of the credit markets and business/consumer spending.

Clearly, commercial real estate faces a problem of excess capacity — but if the market works as it is designed to, price drops and bankruptcies will eliminate the most distressed properties, and eventually the laws of supply and demand will again reach equilibrium.

How long that takes will, of course, depend on the resurgence and sustainability of the overall economy.

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