Investors, brokers, and appraisers are all waiting on the lending institutions to place large volumes of distressed commercial properties on the market at deep discounts from perceived current market values. Memories of the RTC days are still with us and many industry professionals see it all happening again. However, 20/20 hindsight frequently colors the memory with a “rosy hue.” The actual experience of the 1980’s was not all together a pleasant one for many. That was a time when the savings and loan industry collapsed for a variety of reasons, including fraud and poor tax policies that led to severe overbuilding and poor lending procedures with lax underwriting. Looking back many view the RTC era as the Redistribution of The Commercial property act and have forgotten how many real estate fortunes were wiped out during this period.
While it is true that we need to study history so past mistakes are not repeated, although the parallels of greed and poor underwriting of the recent past and that of the late 1980′s are strong, a careful examination of the current fundamentals of the market and the reasons for the recent financial industry near collapse are warranted. Commercial real estate was not the “principal villain” in the recent lending industry drama. The overvaluation of residential real estate, poor underwriting standards, an overzealous pace of development, and a short sighted and voracious appetite for fees at all levels are what gave birth to TARP. As we will look back in a few years, real estate professionals will remember TARP as This Action is for Residential Properties.
Commercial real estate enjoyed a significant run up in value since 2002. Much of the increase was due to favorable lending and the steady flow of debt capital. For the most part lending was sound and underwriting was prudent. This prudence was due to regulations which were adopted in the early 1990′s as a result of the savings and loan debacle. No, it was not without problems and some poor decisions were made but loan to value ratios, debt coverage requirements, and competent review of underwriting remained mostly intact for commercial real estate through 2008. This prevented significant overbuilding and the resulting oversupply of product being dumped on the market as it turned downward.
Today, those waiting for commercial real estate markets to crash will see an increase in activity from failed projects and problem loans. More projects will fail in the next year or two than have in the past five due to the current recession and the consequential eroding values. However, those planning on a meltdown of commercial real estate markets will have to wait for some as yet unknown catalyst, other than what has occurred in the past year.
Lenders are gearing up their special loans and workout departments but the inventory of problem loans that are based on commercial real estate, other than mixed use and residential subdivisions, are limited in the Utah market. Lenders are justified in reviewing all commercial real estate loans and the concern that values are eroding is appropriate, due to declining net operating income and persistent problems with refinancing existing loans. The decline in value and number of commercial properties in default is not yet significant as to be a problem for most lenders.
Buyers looking for financing, and property owners that are trying to refinance maturing mortgages, are stymied by lenders’ reluctance to make new loans in the current environment. This is due to the lack of recent transactions that would indicate current values and provide appraisers and lenders some basis to appropriately value loan security.
Unfortunately this abundance of caution can create a cycle that will repeat itself until investors and lenders regain confidence that indeed the sky is not falling and commercial real estate has a fundamental value in the production and distribution of goods and services. Yes we are experiencing a change to the “brick and mortar” basics of real estate. But the complete replacement by the virtual office or retail website is not going to remove all demand for “bricks and sticks.”
Knowledgeable investors and businesses will view the current downturn as an opportunity to make good real estate decisions on fundamentally sound commercial real estate, whether it is to secure investment property or renegotiate leases and “lock-in” lower rates into the future. There is one certainty that will be a result of what is now happening; the cost to build and replace real estate in the future will be greater. How much more and how fast those costs will rise…only time will tell.
In short, commercial real estate values are softening as a result of the current recession. This is being exacerbated by the pullback of lenders from all real estate loans to build up their balance sheets. An ongoing lack of liquidity in the real estate market will lead to further erosion in values. If continued the lack of credit will push more projects into default and onto lending institutions distressed assets balance sheets.
Fear can paralyze in a single moment, confidence can only be acquired one step at a time. It is time to take one cautious step forward with a “measured” plan, based upon competent advice, backed by solid data.
John G. Taylor, MAI CCIM is an Investment Specialist with Commerce CRG. He can be reached at 801.303.5415 or firstname.lastname@example.org.