Earlier this week, a friend remarked to me during dinner that perhaps the current recession – which, I imagine, works its way into countless dinner conversations in the U.S. these days – seemed to be easing. Could we be out of the woods?
I quickly pointed out that before recovery could occur, we would need to push through the impending commercial mortgage crisis. My friend asked the next logical question: ‘Well, when is that going to happen?’
‘You know, it seems like we've been on the verge of it forever,’ I said, suddenly realizing a certain common thread in industry news coverage. ‘I've been reading the same predictions for almost a year now.’
The brunt of the commercial mortgage crisis has apparently been just around the corner for quite some time.
The loan delinquency statistics have crept (or, in some cases, leapt) upward, the property fundamentals have fallen further, and the government-intervention programs have been amended and extended.
But uniformly ominous warnings – remarkably similar to the ones we heard months and months ago – just keep coming.
A sampling of news headlines from the past couple weeks: ‘The Tsunami Is Curling Over.’ ‘Commercial Real Estate Lurks As Next Potential Mortgage Crisis.’ ‘Commercial Real Estate's $1 Trillion Time Bomb.’ ‘Another U.S. Shock Lurking In Commercial Property.’ ‘Commercial Real Estate Tsunami Ahead.’
If nothing else, you can't claim that no one warned you this time. The question is, just how much longer will the industry be suspended in this borderline-crisis state?
Approximately 3% of income-producing CRE loans are currently under distress, according to Federal Deposit Insurance Corp. (FDIC) data cited by Property & Portfolio Research (PPR) in a recent report.
PPR identified three key catalysts for distress – or, more specifically, a ‘tidal wave of distress,’ in the research firm's words. Only one of the three is needed to unleash the crisis.
First, aggressive regulatory changes from the FDIC or the Financial Accounting Standards Board might push CRE over the edge, according to PPR. A sizeable decline in property cashflows will also do the trick, as will rising interest rates.
‘Loans that were made (or extended on) a floating-rate basis have survived due to low rates,’ the report explains. ‘Picture a hotel loan purchased on a floating-rate basis in 2007 at 50 basis points over the three-month LIBOR. The RevPAR of that hypothetical hotel has fallen by 50 percent.
‘Certain default, right? Nope, because 50 basis points over three-month LIBOR is nearly free, so the call option is intact,’ PPR continues. ‘An increase in interest rates will remove a lot of options.’
In the meantime, what else is holding back that tidal wave, tsunami, next shoe to drop, and every other metaphorical representation of the impending commercial mortgage crisis?
A likely culprit may be government intervention and the behaviors many observers believe these measures have encouraged among banks.
‘The unprecedented level of public policy support, with $4 trillion already provided for a total $12 trillion pledged to restore the financial markets and create economic stimulus, has effectively halted an economic free fall,’ remarks Kenneth Rudy, president of Jones Lang LaSalle's capital markets practice, in a recent report.
"However, it has also stalled a recovery in the commercial real estate capital markets, as banks continue to extend maturities for their borrowers, avoiding foreclosure in a practice that is becoming commonly known as 'delay and pray,'’ he adds.
‘Delay and pray’ – also known as ‘amend and extend’ or ‘extend and pretend’ – allows a borrower to extend loan maturities that would not be payable in the current climate. In exchange, the borrower accepts more severe terms, such as higher interest or stricter loan covenants, explained Agnes Crane in a recent Reuters blog.
Crane calls the commercial real estate market a ‘standout for such tactics.’ Of course, as both borrowers and lenders know, such strategies can only work for so long, thus finally creating that long-predicted crisis.
– Jessica Lillian, Commercial Mortgage Insight
