It Isn't Over Yet: Commercial Real Estate Bubble To Burst?

Aug. 10 (Bloomberg) -- The collapse in commercial real estate is preventing Federal Reserve Chairman Ben S. Bernanke from declaring the economy and financial markets are healed.
Property values have fallen 35 percent since October 2007, according to Moody’s Investors Service. That’s making it tough for owners to refinance almost $165 billion of mortgages for skyscrapers, shopping malls and hotels this year, pressuring companies such as Maguire Properties Inc., the largest office landlord in downtown Los Angeles, to put buildings up for sale.
The industry is likely to be high on the agenda when Bernanke and his colleagues sit down in Washington tomorrow for the Federal Open Market Committee meeting on monetary policy. Lawmakers including Barney Frank and Carolyn Maloney are pushing the central bank to extend an aid program designed to restore the flow of credit.
If nonresidential real estate remains in the doldrums, the Fed may be forced to leave emergency-lending programs in place and keep its benchmark interest rate close to zero for longer than some investors expect, given positive signs elsewhere in the economy.
Commercial property is “certainly going to be a significant drag” on growth, said Dean Maki, a former Fed researcher who is now chief U.S. economist in New York at Barclays Capital Inc., the investment-banking division of London-based Barclays Plc. “The bigger risk from it would be if it causes unexpected losses to financial firms that lead to another financial crisis.”
‘Close Attention’
The Fed is “paying very close attention,” Bernanke, 55, told the Senate Banking Committee on July 22, the second of two days of semiannual monetary-policy testimony before the House and Senate. “As the recession’s gotten worse in the last six months or so, we’re seeing increased vacancy, declining rents, falling prices, and so, more pressure on commercial real estate.”
The pressure may be easing in other areas of the economy. Gross domestic product shrank at a better-than-forecast 1 percent annual pace in the second quarter after a 6.4 percent drop the prior three months, and residential housing starts rose unexpectedly by 3.6 percent in June as construction of single- family dwellings jumped by the most since 2004, according to data from the Commerce Department.
Employers cut fewer workers than anticipated last month as the jobless rate fell to 9.4 percent from 9.5 percent in June -- the first decline since April 2008, based on Labor Department figures.
‘Danger Zone’
Amid such glimmers of improvement, commercial real estate is a “particular danger zone,” said Janet Yellen, president of the Federal Reserve Bank of San Francisco, in a July 28 speech in Coeur d’Alene, Idaho. The market may be “under stress for some considerable period of time,” William Dudley, chief of the New York Fed bank, said the following day in New York.
Nonresidential construction may decline as much as 9 percent this year and another 5 percent in 2010, predicts Kenneth Simonson, chief economist at Associated General Contractors of America, an Arlington, Virginia, trade group whose members include Essen, Germany-based Hochtief AG’s Turner Construction Co. in New York, one of the largest U.S. builders. In the second quarter, it accounted for 3.6 percent, or $509 billion, of U.S. gross domestic product on an annual basis, down from 4.3 percent in the final three months of 2008.
A dozen lawmakers questioned Bernanke on the topic during his July testimony. Some asked about extending the Term Asset- Backed Securities Loan Facility, the emergency program the Fed began in March to restart the market for securities backed by auto, credit-card and education loans. The central bank expanded the facility in June to cover as much as $100 billion in loans to support commercial mortgage-backed securities.
One-Year Extension
Forty-one House members -- including Frank, 69, a Massachusetts Democrat who chairs the Financial Services Committee, and Maloney, 61, a New York Democrat who heads the Joint Economic Committee -- signed a July 31 letter seeking a one-year extension through December 2010 and asking for a decision by mid-August.
Fed policy makers will prolong the program if they judge financial markets are still “some distance from normal operation,” Bernanke said during his July 22 testimony. “We will certainly be monitoring the situation.”
The Fed likely will change the end date -- just not right away, said former central-bank Governor Lyle Gramley.
Market Developments
“They’re probably going to want to wait a while to see how markets develop,” said Gramley, 82, now senior economic adviser with Soleil Securities Corp., a New York-based investment- research firm.
A six-month continuance is more likely than the one year industry officials want, said former Fed Governor Laurence Meyer, Washington-based vice chairman with consultant Macroeconomic Advisers LLC of St. Louis.
That would still be useful and “provide more of a runway” for the TALF to be effective, said Jeffrey DeBoer, president of the Real Estate Roundtable, a Washington group representing 16 trade associations and property owners including New York-based Vornado Realty Trust, the third-largest U.S. real-estate- investment trust by market value.
Any sales of mortgage-backed bonds would be the first new issues in the $700 billion U.S. market for commercial-mortgage- backed securities since it was shut down by the credit freeze in 2008.
About $3 billion are in the pipeline, and the success of these sales may foster as much as $25 billion in total deals in the next six months, said Kenneth Rosen, who runs a $310 million hedge fund in real-estate securities and heads the University of California’s Fisher Center for Real Estate and Urban Economics in Berkeley.
Signs of Improvement
The market is showing some signs of life: The Bloomberg REIT Office Property Index of 14 companies, while down 56 percent from its February 2007 peak, has gained 41 percent in the past six months. Also, the yield gap, or spread, on top- ranked commercial mortgage-backed bonds relative to U.S. Treasuries is about 4.49 percentage points compared with 8 percentage points at the start of May, according to Barclays data.
The Fed’s efforts to revive credit may be overpowered by continuing job losses, even as the pace of those losses slows. U.S. employers eliminated 247,000 workers from payrolls last month, according to an Aug. 7 Labor Department report, bringing the cumulative reduction to about 6.7 million since the start in December 2007 of the worst contraction since the Great Depression.
‘Negative Fundamental’
“Demand for commercial space comes from employment and the income generated by that employment,” said University of Pennsylvania Professor Joseph Gyourko, director of the Wharton School’s Samuel Zell and Robert Lurie Real Estate Center in Philadelphia. Mounting job losses are a “really significant negative fundamental,” signaling that “conditions are going to be tough for the industry for a while,” he said.
That may spill over into mounting losses at some banks. Forty-seven percent of loans at the 7,000-plus smaller U.S. lenders are in commercial real estate, compared with 17 percent for the biggest banks, according to New York-based Goldman Sachs Group Inc.
Regions Financial Corp., the Birmingham, Alabama, lender that accepted $3.5 billion in U.S. rescue funds, had $36.9 billion in nonresidential real-estate and construction loans at the end of the second quarter, 38 percent of its overall total. Regions posted a net loss for the period of $188 million compared with a profit of $206.3 million a year earlier as more developers and home builders fell behind on payments.
Third Straight Loss
Salt Lake City-based Zions Bancorporation, which operates in 10 Western states, reported its third straight quarterly loss July 20 on a surge in commercial-property defaults. Thirty-five percent of its loans for the period were in nonresidential real estate and construction, and its provision for loan losses rose to $762.7 million from $297.6 million in the first quarter.
One developer based in U.S. Representative Walt Minnick’s district is in a bind because a lower appraisal means he can’t renew the full amount of a $10 million, three-year loan he took out for a recent project, the first-term Democrat from Idaho said in an interview last week. The person may be forced into bankruptcy, said Minnick, 66, without identifying the developer.
“That is a microcosm of what is happening to commercial property” everywhere, he said. “It’s the next shoe to drop.”
Relinquish Control
Maguire bought 24 properties and 11 development sites for $2.88 billion in 2007 from New York-based Blackstone Group LP, the world’s largest private-equity company. Later that year, credit markets froze, blocking the Los Angeles-based company’s efforts to refinance its mortgages. Now Maguire may relinquish control of seven Southern California buildings with $1.06 billion of debt, the company said today, adding it’s not planning on filing for bankruptcy.
New York-based Brookfield Properties Corp. faces a $1.8 billion debt maturity in October 2011 arising from the 2006 purchase of Trizec Properties Inc., which made it the second- biggest owner of U.S. office buildings by square footage. Brookfield has said it expects to refinance some of its obligations and sell buildings to cover the rest.
Commercial real estate remains “an important downside risk,” said Gramley, a Fed governor from 1980 to 1985. “I don’t think it’s going to be a blockbuster negative, but it’s one additional reason why this recovery is going to be of modest dimensions.”

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