Plan C: The Treasury is Preparing for a Commercial Real Estate Crisis

In the recent past, I’ve seen a lot of buzz on the internet about how a commercial real estate crisis is our next big economic problem. There has not been much in the way of commentary from reputable sources in the last several weeks, so I decided to dig a bit deeper.

Interestingly, there seems to be a wave of positive economic news coming from the media these days and discussion about the problems in the residential mortgage industry have, at least for now, died down. Whether the positive economic news is accurate is another issue. Thus, the shift of attention from the residential mortgage problems to commercial real estate makes sense.

Also, as I researched the information for this post, I concluded that commercial real estate is complex and I think the average consumer isn’t really interested in figuring out what’s wrong with commercial lending. Many of these people are still trying to save their homes.

Commercial real estate loans are structured differently from residential mortgage loans. Most commercial real estate loans have a shorter term, say, ten years. At the end of the loan term, the loan is not paid in full as a result of making monthly payments over the loan term. Instead, a percentage of the loan is due and payable as a lump sum or balloon payment.

The basic problem is that many of the commercial real estate loans that were made over the last decade will be coming due over the next couple of years. Many borrowers planned to refinance the loan, but with the commercial lending markets drying up, many borrowers face foreclosure if they cannot obtain financing.

Similar to residential mortgages, many of these commercial loans were made without regard for acceptable underwriting standards so that they could feed the demand for commercial mortgage backed securities (“CMBS’”).

I’m already seeing commercial property owners asking for help with commercial loan audits to help them get a commercial loan modification. I’m also currently auditing a loan on behalf of a commercial investor being sued by the second position lender for a deficiency after a foreclosure.

In an article published in early July, the Washington Post discussed the Treasury’s “Plan C”, of which commercial real estate is seen as one of several problems that could derail economic recovery. The Post reported:

“The officials in charge of Plan C — named to allude to a last line of defense — face a particular challenge in addressing the breakdown of commercial real estate lending.

Banks and other firms that provided such loans in the past have sharply curtailed lending.

That has left many developers and construction companies out in the cold. Over the next few years, these groups face a tidal wave of commercial real estate debt — some estimates peg the total at more than $3 trillion — that they will need to refinance. These loans were issued during this decade’s construction boom with the mistaken expectation that they would be refinanced on the same generous terms after a few years.

The credit crisis changed all of that. Now few developers can find anyone to refinance their debt, endangering healthy and distressed properties.”

Or, as explained by Jon Greenlee, the Fed’s Associate Director, Division of Banking Supervision and Regulation, in his testimony before the Federal Reserve on July 9, 2009:

“The decline in the CRE market has been aggravated by two additional factors. First, the values of commercial real estate increased significantly between 2005 and 2007, driven by many of the same factors behind the residential housing bubble, resulting in many properties either purchased or refinanced at inflated values. Prices have declined about 24 percent since their peak in the fall of 2007 and market participants expect significant further declines. Second, the market for securitized commercial mortgages (CMBS), which accounts for roughly one-fourth of outstanding commercial mortgages, has been largely dormant since early 2008 while many banks have substantially tightened credit. The decline in property values and higher underwriting standards in place at banks will increase the potential that borrowers will find it difficult to refinance their maturing outstanding debt, which often includes substantial balloon payments.

The higher vacancy levels and significant decline in value of existing properties has also placed pressure on new construction projects. As a result, the construction market has experienced sharp declines in both the demand for and the supply of new construction loans since peaking in 2007.

The negative fundamentals in the commercial real estate property markets have broadly affected the credit performance of loans in banks’ portfolios and loans in commercial mortgage backed securities. At the end of the first quarter of 2009, there was approximately $3.5 trillion of outstanding debt associated with commercial real estate. Of this, $1.8 trillion was held on the books of banks, and an additional $900 billion represented collateral for CMBS. At the end of the first quarter, about seven percent of commercial real estate loans on banks’ books were considered delinquent. This was almost double from the level a year earlier. The loan performance problems were the most striking for construction and land development loans, especially for those that finance residential development. Notably, a high proportion of small and medium-sized institutions continue to have sizable exposure to commercial real estate, including land development and construction loans, built up earlier this decade, with some having concentrations equal to several multiples of their capital.”

In May 2009, the Federal Reserve’s Term Asset-Backed Securities Loan Facility (“TALF”) opened up to commercial mortgage-backed securities that were issued in 2009. This bailout might sound good, but these securities aren’t the ones with the problems. It’s the securities that were sold in before the economic crisis and based on the old economic model that’s troubled, and the government isn’t buying those.

Given all of this information, there’s no question in my mind that commercial loan defaults are going to be a problem for economic recovery. The question is, how bad will it be? Some estimates range in trillions of dollars and others say that real estate has bottomed out. I think the government is facing pressure from Main Street for a recovery, so much that they’re not going to let commercial real estate fail and further hamper the economic recovery.

What do you think? Please post your comments!