More Woes for Commercial Real Estate

The recession forces us to ask ourselves some hard questions… like, what kind of lifestyles can we truly afford? Yet some dilemmas born of this mess don’t require much deliberation. We’ll start today with an example: Does America REALLY need a strip mall on every corner?

A record 8-10% of all available space in U.S. shopping malls sat vacant in the fourth quarter, real estate research company Reis claims today. That’s up almost two percentage points from the same time a year before, even despite asking rents falling 3.6% (another record) over the last year. Effective rents are down in all 77 markets Reis covers — you guessed it, yet another record.

“Although it appears that we have reached the end of the technical recession,” read a statement from the firm, “continuing high unemployment and inconsistent consumer spending patterns will weigh on retail properties for at least another 18-24 months.”

Construction spending on malls, hotels and office buildings will fall 13% this year, the American Institute of Architects forecast this morning. That’s a higher estimate than the group’s previous forecast back in July.

“Even a 13% decline is too optimistic,” forecasts Dan Amoss. “Through several examples, we can see that the Treasury Department’s unofficial policy for dealing with underwater commercial real estate loans is ‘extend and pretend.’ This means that as long as underwater borrowers are making monthly payments, most bank examiners will look the other way and allow banks to maintain commercial real estate (CRE) loans at artificially high values and look the other way if banks roll over maturing loans that are underwater on a mark-to-market appraisal basis. This will only make the ultimate credit losses even larger, but it’s the politically expedient thing to do.

“One consequence of the current practice of dealing with CRE loans: The bid/ask spread for commercial properties will remain wide. The market will not clear at lower prices, as it should. Rather than a sharp fall followed by a ‘V-shaped’ recovery in property values financed by capital from new owners, we’ll see a slow decline in values for perhaps a decade (like Japan). Since banks are delaying foreclosure auctions, the asking prices for most commercial properties have not yet fallen far enough to meet low bid prices. We’re hearing this from distressed commercial real estate funds that were set up to buy bargains. They’re frustrated at the lack of deal flow.

“This is bad news for CRE construction companies because low property turnover translates into idle construction activity. With an extended overhang in supply of commercial property, which will be slowly released from bank balance sheets, demand for new commercial construction will remain weak.”

The Daily Reckoning