A friend reports that almost 40% of the retail storefronts in his small town are vacant, and he wonders how long the property owners can withstand that sort of vacancy rate. During this recession, much of the news has centered on residential mortgages and big banks, but the possible effect on commercial real estate and smaller banks may hold bigger economic surprises yet.
As we noted in an earlier column, retailers across the country are closing stores or negotiating with their landlords for smaller spaces. The retailers must do so in reaction to the slowdown in consumer spending that followed the drop in housing values and resultant credit crunch. Now the ripples are affecting commercial real estate, but they won’t stop there. According to a report by the Congressional Oversight Panel, nearly $1.4 trillion in commercial real estate loans will need to be refinanced over the next five years, but nearly half of those loans are for more than the market value of the property.
Unlike thirty-year home mortgages, commercial real estate loans generally cover terms of only three-to-seven years. Cash flow from tenants pays the bills, but consider the current scenario: tenants are going out of business or negotiating for smaller spaces, and loans secured during the height of the real estate boom are completely underwater, leaving landlords scraping to meet their debt obligations and holding too little equity for refinancing.
Also impacting refinancing is the condition of small banks, which handle much of the commercial real estate lending in your community. Here is where the inter-connectedness of the economy can get trapped in a vicious cycle, according to the Oversight Panel’s report, because a bank overexposed to commercial real estate might hoard capital to offset future losses: “The lack of lending may mean that small businesses that rely on the bank as a source of credit will be forced to shut their doors. This drives up vacancy rates on commercial real estate in the local region, which puts more downward pressure on real estate prices. And those falling prices can lead to additional write-downs in the bank’s commercial real estate portfolio.” Such write-downs, of course, might cause a bank to hoard cash, intensifying this vicious cycle.
A quick enough resurgence of consumer spending might mitigate some of the potential damage to commercial landlords and small banks, but another economic shoe may well drop, causing a big shake out in the commercial real estate and banking sectors. As Panel Chair Elizabeth Warren notes, “The largest loan losses are projected for 2011 and beyond, but the stress tests conducted on big Wall Street banks last year examined their stability only through 2010.”