Commercial Real Estate Seen As ?Problematic’ to Recovery (Opinion)

As we enter 2010 there is much concern nationally with respect to the health of the commercial sector of the real estate market.

The residential sector had been the primary concern, and rightfully so. At the end of June 2009 there was indicated to be approximately $11 trillion of residential debt outstanding, compared to approximately $3.5 trillion associated with commercial real estate.

The belief was that problems in the housing market prompted the recession and a rebound in this sector was necessary to improve consumer confidence and overall economic conditions. There is certainly improvement in the single-family residential sector, and we are likely near the bottom of the single-family housing market.

In the second half of 2009 heightened attention became focused on CRE as the fear was problems in this sector would significantly slow recovery or possibly even result in a “double dip” recession.

As Dennis P. Lockhart, President and Chief Executive Officer of the Federal Reserve Bank of Atlanta, stated in a November speech to the Urban Land Institute, “The downturn in residential real estate did not remain contained in that sector. Trouble was transmitted to the rest of the economy via credit markets. The housing downturn triggered a crisis on Wall Street that soon became a recession on Main Street, and, as job losses mounted and delinquencies rose, fed back again to financial markets.

“Also, personal consumption retrenched because of the real estate price shock, tighter credit, and fear of job losses hitting close to home.”

The Federal Reserve has estimated that almost half of total CRE loans are held by banks with total assets under $10 billion. It can easily be seen how deterioration in CRE values impacts the financial condition of these smaller banks, as well as the success of small businesses, which depend heavily on community and regional banks for financing. Small banks account for almost half of all small business loans.

CRE loans typically have amortization periods of 15 to 25 years, with the interest rate and term fixed for a shorter period, possibly 1 to 5 years. This type loan would require refinancing or an extension at the end of the initial term. The value of the asset must be considered at the time of the loan extension.

Deterioration in value could result in the inability of the bank to extend the loan, possibly sending the property into foreclosure. This is especially true for CRE loans originated at the high point of the market, with high loan-to-value ratios.

Office and retail vacancy rates have increased, while effective lease rates have typically decreased. In addition, overall capitalization rates for CRE have moved upward. The end result is lower values.

In Benton and Washington counties in the fourth quarter of 2009, the preliminary overall vacancy rate for Class “A” and “B” professional office space, based on our survey, was slightly above 21.5 percent. Class “A” and “B” retail space reflected an overall vacancy rate slightly above 15.5 percent while office/retail properties indicated a preliminary vacancy rate near 19.5 percent.

These are investment grade properties. Obviously, these high vacancies impact CRE values, which, in turn affects the health of the local banking community.

The general belief is that while the situation with CRE is a problem for parts of the banking industry, it is not believed to be a broad risk to the financial system. However, problems in the CRE sector are likely to slow the pace of economic recovery.

As is continually indicated, job creation is critical to absorption of CRE, which would positively influence CRE values. The Fayetteville-Springdale-Rogers MSA was reported to have had a 1.2 percent decline in non-farm employment between November 2008 and November 2009.

It is very important that we return to positive job growth.

Tom Reed is a partner in Streetsmart NWA of Fayetteville, which produces reports pertaining to the residential, multi-family and commercial sectors of the market. He may be reached at 479-575-9100.