As residential housing market data registers a blip on the EKG, commercial real estate has become the hot-button issue for those concerned about the potential losses lurking on bank balance sheets. Despite undergoing a 40 percent decline in property values from peak prices in 2007 -- the Case-Shiller home price index has registered "only" a 33 percent drop -- commercial real estate does not generally garner the same media attention. It's clear, however, that there are plenty of reasons to be concerned that future defaults will wind up being another $100+ billion problem.

CB Richard Ellis Group (CBG), the world's largest commercial real estate services firm, said in an investor presentation that vacany rates on office, industrial, and retail properties have increased 31 percent since the end of 2007, and are set to rise an additional 10 percent by the end of the year. CEO Brett White said on the earnings conference call that "the leasing business remains very much depressed and [moribund] and the sales market is just in a very-very similar condition as it was in the first quarter."

In a similar vein to my interview about the glacial pace at which loan losses are being recognized, Bloomberg notes that transactions for Manhattan office property are down more than 90 percent in the first half of 2009 compared to the previous five years. Whereas an average of 32 buildings changed owners during the era of easy credit, only three have been sold this year, and two of those required seller financing. The Federal Reserve recently extended its TALF program to encourage liquidity in the asset-backed securities market by six months, with the new end date in the middle of 2010.

The Fed's move calls into question whether they are more concerned than their recent FOMC statement -- which had few material changes but expressed confidence in a stabilization -- would suggest. David Rosenberg, Chief Economist and Strategist at Gluskin Sheff, wonders, "If the economy were on a solid foundation towards a sustainable recovery, then why did the Fed move to extend the TALF program?" Rosenberg sees $1 trillion in short-term commercial mortgage debt that needs to be refinanced by the end of 2010, leading him to conclude the chance the Fed stops its easy money policies and raises rates before then "is as close to zero as you can ever possibly get."

Another problematic aspect in finding a bottom in commercial real estate will be the treatment of already-distressed properties. Year-to-date, $83 billion in such defaults have occurred, but that number is expected to double by the end of 2009, and lenders have foreclosed on less than 10 percent of defaulted loans. That translates to many commercial real estate holders looking to sell, leading to substantial excess supply -- a scenario like that in the residential market, where Deutsche Bank estimated that close to half of mortgages could be underwater by 2011, but with a greater reliance on short-term financing. Bear Stearns and Lehman Brothers were lessons in what happens when illiquid, overvalued assets are aggressively matched with short-term liabilities. Could commercial real estate be the test to see what we've learned since then?

James Cullen edits and writes at CollegeAnalysts.com. He has no personal position in the stocks mentioned above.


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