Distressed Properties or Distressed Owners?

People around the world have been led to believe that there are a great many distressed properties in the commercial real estate market of the United States. The reports about the U.S. market on television and in the papers rarely distinguish between the residential market and the commercial market and, as a result, the very serious problems in the residential market are generally assumed by most observers to be present in the commercial market as well.

In Falcon Real Estate’s view, it is necessary to make a clear distinction between the two markets. The residential market did suffer from a tremendous amount of imprudent lending which resulted in overbuilding in both the housing and condominium markets. When the sub-prime credit crisis hit the mortgage markets, the sale of new homes and condos declined dramatically, as did prices throughout the residential market. As a result, there are many distressed housing developments and condominium projects, particularly in the major markets of Florida, California and Nevada.

Conditions in the U.S. commercial market, however, have been very different. Speculative development of most categories of commercial real estate was held to a minimum ever since the tremendous over-building in the early 1990’s. Lending standards have generally been maintained by the major banks across the country, so that developers had to present reasonable projections in order to qualify for construction loans. And one of the major problems faced by most developers was the fact that building costs had risen much more rapidly than had rental rates, so that it was difficult to justify new speculative construction on an economic basis. As a result, even as the economy of the United States has gone into a slowdown today, the basic fundamentals of the commercial market remain in relatively good shape. Vacancy rates continue to be at reasonable levels and rental rates continue to hold near their 2007 peaks.

But the sub-prime credit crisis has had a serious effect on the commercial market. The conduit mortgage market has essentially closed down, and those institutions that are making loans for their own accounts have instituted much tighter lending requirements. This has resulted in many owners of commercial real estate being unable to finance or re-finance their holdings, even though their properties might be performing almost exactly on budget. Other owners may have purchased properties on the basis of overly optimistic rental projections and, as rents have plateaued in 2008, they are finding it difficult to service their mortgage debt. Therefore, although the actual properties are performing relatively well, it is the owners of these properties who are currently distressed. And it is from distressed owners that buying opportunities will arise in the months to come.

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The U.S. Mortgage Markets

The principal source of commercial mortgage money in the United States for a great many years has been the so-called conduit market. In this case, banks such as Citibank, Credit Suisse, UBS, Bank of America and others, would negotiate a mortgage loan on an office, retail or industrial building and, after the loan had been funded, the bank, having earned its fee, would immediately sell it. The conduit market had certain standards and it was not possible for the banks to deviate very far from those standards if it hoped to re-sell the mortgage. When the sub-prime crisis hit, the conduit market completely closed down, with many banks actually laying off the employees who had worked in their conduit units.

Mortgage loans today are being made primarily by insurance companies and other institutions that will retain the loans for their own portfolios. These lenders have instituted much more conservative lending standards, providing only 50% to 60% loan-to-value amounts, as opposed to 70% or above as before. In addition, interest rates are now set at up to 300 basis points above the comparable maturity U.S. Government bond, as opposed to about 100 basis points previously, and much larger leasing and capital improvement reserves are being demanded today. But these lenders are only able to satisfy a relatively small proportion of the nationwide demand for mortgages, leaving many real estate owners and prospective owners unable to obtain financing. Therefore, the problems in the credit markets are spilling over into the commercial real estate market forcing the sale of many properties that, because of the lack of sufficient financing, can only be done at depressed prices.

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