Problems Could be Looming In the Commercial Market (Market Forecast by Tom Reed)

Streetsmart NWA produces quarterly reports pertaining to the real estate market in Benton and Washington counties. The reports focus on the single-family residential, multifamily residential and commercial sectors of the market.

For several quarters now the primary focus in the real estate market has been on the single-family residential sector. Articles addressing declining sales numbers, as well as declines in housing starts and year-over-year median home prices have been very visible.

When is the housing market going to bottom has been a frequently asked question. The thought process has been, and rightfully so, that problems in the housing market prompted the current recession and a rebound in this sector is necessary to strengthen consumer confidence and help turn the tide of deteriorating economic conditions.

Many economists feel that the bottom of the housing market is near, and there are certainly some signs in both the national and local markets that support this opinion.

While we have been carefully watching for improvement in the residential sector, problems could be on the horizon with respect to some commercial properties. Potential problems in the Northwest Arkansas market may seem small compared to those facing some of the larger MSAs, however, you can be assured that the local banking community is not taking the situation lightly.

Commercial real estate loans typically have shorter terms than single-family residential loans. It is common for amortization periods to be over a 15- to 25-year period, with the interest rate and loan term fixed for a 1- to 5-year period.

This type loan would require refinancing or an extension at the end of the initial term. Potential problems are primarily centered around the large volume of loans that were originated at the peak of the market in late 2005 and early 2006 and are now approaching the end of the initial term.

The financial institution holding the note and mortgage is obviously concerned with the value of the asset at the time of refinancing. Declining values have not been isolated to the residential sector, many commercial properties are also suffering.

In the Washington/Benton County market both the professional office and retail sectors are experiencing higher than desired vacancy levels. In Q4 2008, the overall vacancy rate in Class “A” and “B” professional office space, based upon our research, was between 18 percent and 19 percent.

The overall vacancy rate for Class “A” and “B” retail space for the same time period was between 15 percent and 16 percent. As a result of these high vacancy rates, there is little or no pricing power. Overall capitalization rates are moving upward due to increased risk.

The obvious result is downward pressure on property values, particularly with respect to marginal properties. The lodging industry is also experiencing difficulty, with declining occupancy levels and average daily room rates. There is also concern in the restaurant sector as consumers are dining out less frequently. In Northwest Arkansas, commercial development land is of primary concern as values are adversely affected by extended absorption periods.

This brings us back to refinancing or extending the loan on the commercial property at the end of the initial term. If the original loan-to-value ratio was at the upper limit and the property value has declined, it is certainly possible that the loan amount now exceeds the financial institution’s desired loan-to-value ratio, or in a worse case scenario the current market value of the property. To refinance or extend the loan, will the borrower be required to bring funds to the closing table? On the large commercial loans, this could easily involve millions of dollars. The problems that could result from this would likely be devastating and send the economy in a further downward spiral. Obviously, the impact on the banking community would be severe as large commercial projects are forced into delinquency and face foreclosure. Hopefully, logic will come into play on performing commercial loans facing refinancing or extension.

We are fortunate in Northwest Arkansas to not be facing the severe deterioration in commercial property values that many growth markets have experienced. However, we are obviously facing our share of problems. It is imperative that we return to strong job growth to absorb office and retail space, and enhance property values.

(Tom Reed is a partner in Streetsmart NWA of Fayetteville. He may be reached at 479-575-9100.)