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February/March 2010 – Web Exclusive

On Hold: The Slump in Commercial Real Estate

“Prices went crazy in 2006 and 2007. Some people just lost all sense of reality.”

– Mark Dotzour, Chief Economist,
Texas A&M University
Real Estate Center

Weathering the Storm:  A Series of Reports on  the Texas Economic Climate

by Bruce Wright

Mark Dotzour
Chief economist
Texas A&M University
Real Estate Center

It hasn’t attracted as much attention as the nationwide collapse in residential real estate, but the market for commercial buildings is hurting every bit as much. Prices have plunged since the recession began, and a lack of available credit has brought commercial activity almost to a standstill in many areas.

To examine commercial real estate trends and get an idea of what lies ahead for Texas, Fiscal Notes recently spoke with Mark Dotzour, chief economist for the Real Estate Center at Texas A&M University.

FN:
Perhaps we could begin with a brief recap of the national situation in commercial real estate.

MD:
The problem with commercial real estate is largely one thing – prices went crazy in 2006 and 2007. Some people just lost all sense of reality. The prices were not justifiable at the time, and they weren’t sustainable.

Today, based on two or three different indicators, it looks like commercial prices have fallen somewhere between 35 and 40 percent overall since the 2007 peak.

FN:
And the problem is the same as for people whose homes are “under water,” right?

MD:
Yes. Many commercial real estate loans made during the peak period are under water, and will represent a loss at some point in time. The bottom line is that most people who bought a property at the peak will have a hard time refinancing their loans in the future. And it also means that banks that made those loans probably have a big loss on their hands.

FN:
How much of a problem is this for the banking industry?

MD:
To me, perhaps the clearest indicator that the problem is severe is the fact that the banking system has gone out of its way to change its accounting rules to, as they say, kick the can down the road, rather than recognizing the losses they have on their books.

But those banks are damaged. We had about 180 banks fail in the U.S. in 2009. My guess is that we’ll see another 400 or 500 fail in 2010, largely due to difficulties related to commercial real estate loans.

FN:
Who looks to be hit hardest?

MD:
The big pressure is going to be felt in the regional and community banks. When GMAC and other companies were offering car loans with zero-percent interest, banks didn’t make many car loans. And with Wall Street making most of the mortgage loans, banks didn’t do many of those either. So the only things that were left were loans to local businesses and commercial real estate loans.

FN:
What about the role of federal regulation?

MD:
That’s another issue. When these banks get heavy losses in their real estate loans, the federal Office of the Comptroller of the Currency, or OCC, starts putting pressure on them.

And when the regulator walks into your bank and says “You’re not going to make another real estate loan,” it doesn’t matter if it’s a good one or a bad one – you’re not going to make a good one either. The OCC has created an environment where banks are afraid to make many real estate loans, good or otherwise.

FN:
So federal regulation is actually discouraging lending?

MD:
Back in July 2007, one Texas firm bought some toxic assets from Merrill Lynch and CIT Group for about 25 cents on the dollar. As soon as that happened, I thought, “Man, the market’s going to clear and we’re going to be off to the races” – but the Federal Reserve said they weren’t going to allow that to happen again. They called those prices “fire-sale” prices.

It’s an example of how the federal government has precluded the private market from clearing. And when the private market doesn’t clear, nobody buys and nobody sells. The whole thing comes to a standstill – and that’s where we’ve been since July 2007.

FN:
Why would they pursue these policies?

MD:
Everyone knows the losses are there. But the losses are big enough that the government can’t afford to take them all at once. So that’s why they’re extending and prolonging the process, to spread the losses over a period of years, rather than to take them all and move on.

But I’m worried that the banks are going to get risk-averse, not just for commercial real estate loans, but for small business loans – and small business is where our job growth comes from at the end of any recession. That’s called entrepreneurship, and that’s what we do in America. But we need credit to do that. Right now, banks are pulling in credit rather than extending it.

FN:
The “credit crunch.”

MD:
Right, we still have a credit crunch in this country, but it’s at a different level from where it was a year ago. Then it was the biggest banks – now it’s at the regional and community banks, which are under duress from commercial real estate loans, and may become averse to making small business loans.

And when the banks aren’t making loans, that’s what can retard the recovery. That’s the bigger risk. Without credit to small businesses, the recovery is going to be postponed.

This whole idea of kicking the can down the road, of extending and pretending on loans, is helping to reduce the number of bank failures, but I’m not sure it’s helping the economy very much.

FN:
Well, what happens next? What can get commercial real estate moving again?

MD:
These bad loans need to be called, and the properties foreclosed and sold to somebody new, at a lower price. That’s basic free-market economics.

Any improvement in commercial real estate will depend on putting tenants in buildings, and that’s a function of job growth. Everyone’s sitting on hold now, until the economy starts generating jobs.

Generally, when corporate profits start to pick up, businesses become more likely to hire workers, and corporate profits have started to pick up over the last six months. I think, though, that we won’t see much hiring nationally until 2011. Until then, it’s a jobless recovery.

Say you’re a businessperson who’s laid off a bunch of people, and your sales start to pick up and your profits go up pretty dramatically. But you’re not certain it’s going to continue, so you just work the people you have harder. So that’s the “recovery” so far – profits are up, the stock market goes up, but hiring doesn’t. That’s what I expect to see in 2010.

FN:
What do you see ahead for Texas?

MD:
Texas will start generating jobs before the rest of the country, I’m pretty confident. As long as oil stays north of $60 and gas stays north of four or five bucks we’ll rebound quicker than the rest of the country.

The fundamentals of commercial real estate in Texas are pretty good. The credit markets seized up in the summer of 2007, before we got into the full swing of an overbuilding cycle in Texas. That kind of stopped us, and it was a real blessing, because it relieved us from the traditional oversupply you get at the top of a cycle. So rents won’t have to fall as far, because there’s not a whole bunch of empty buildings sitting around, scrambling for tenants. FN

For information about commercial real estate developments in Texas, visit the Texas A&M University Real Estate Center’s online newsletter.

Read the entire “Weathering the Storm” series:

Long Climb, Steep Fall

After years of steady increases in U.S. commercial property values, prices have plunged sharply during the recession. The Moody’s/REAL Commercial Property Price Index, a widely used measure of average commercial property prices, fell by nearly 44 percent between its October 2007 peak and October 2009.

Prices climbed slowly from 2001 to 2008, then dropped off sharply from October 2008 to October 2009. Data is in the table below.
Moody’s/REAL Commercial Property Price Index
YearIndex
20011.001
20021.037
20031.124
20041.204
20051.400
20061.606
20071.708
20081.885
20091.605
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