May 12th, Jim Wasserman of the Sacramento Bee in an article (Region's Commercial Real Estate Market on Knife's Edge) reports:

Distress in the commercial real estate market is reaching crises proportions just as the residential market starts to right itself. Bankers and market trackers say more owners of office buildings, shopping centers, apartment buildings, hotels, and industrial space are struggling to make their mortgage payments, and increasingly defaulting.

This should be no big surprise, commercial real estate trends typically lag that of residential, so a severely correcting commercial real estate market is due, especially for those markets that had a severely correcting residential market.

On December 30th, I wrote my 5 predictions for 2010. I stated, "Commercial real estate will decline, and that was not a difficult forecast based on the lag time from residential coupled with deteriorating fundamentals". That all seems to be playing itself out as expected.

It's going to get ugly, and we're not seeing the worst of it yet", said Garrick Brown, Sacramento based Vice President for research at commercial broker Colliers International. "Anybody who bought from 2005 through 2008 and financed more than 50% might be on a tight rope.

I want to congratulate Garrick for being so frank about the commercial real estate nightmare. Too often industry experts are afraid to say significantly negative things about real estate values. And, more importantly, he's dead on the money.

You can extend his time frame back to at least 2003 from 2005 for a couple reasons. First, most people in commercial real estate put as little cash down as possible just like the residential market, and from my experience in lending in the Valley of California from 2003 to 2007, that's typically 75% leverage on commercial real estate, much higher than 50%. Secondly, most of the residential market in the Valley of California has corrected to prices well prior to the 2003 price levels, so it should be expected for commercial real estate to contract to price levels well prior to 2005. Lastly, in every bubble correction, we have wiped out all bubble gains, so it's conceivable we could retrace back to at least 2001 prices, maybe beyond.

The reason we haven't seen the worst of it yet, is the issue is just working itself through the system. Property owners are facing lower lease rates and higher vacancies. They typically burn personal cash balances to make payments in denial about the financials of their property just like the residential trend. Furthermore, you won't see the worst of the price collapse until the banking system is loaded with commercial real estate foreclosures and REOs, which is also just like the residential market.

You can expect the process to be slow on the bank front. My experience working for smaller banks, which finance commercial real estate, is they typically work with borrowers more frequently, and try to structure or restructure repayment terms. In the business it's called: "Extend and Pretend". That sounds good, and in a normal recession it has worked quite well in the past. However, in this recession because of bubble prices, it seems more like false hope, and putting off the inevitable, which delays the process of foreclosure. It also delays the day and time you recognize that loss as a bank, so there's banker motivation to push it out, too.

One of the solutions, you didn't see much of in the residential nightmare is the selling of notes to investors. Often in the smaller bank world, they will sell the note secured by a deed, maybe at discount, to an investor to just get out of the situation. It's usually after a period of trying to renegotiate with the borrower, so this also will prolong the foreclosure process.

Jim notes, "Commercial rents in over built areas are down 20-40%". That gels with what I'm seeing in my area of CA, where lesser desired or over built areas are off 10-35% in lease rates'. We also see much higher vacancy rates. I can see it out of my window in my complex, several empty store fronts.

I'm also seeing the rent structure changing. More tenants are negotiating gross rental contracts versus triple net contracts, which pushes building expenses back onto the building owner from the tenant, which further compresses net income and the building's value, the two most important numbers for the property owner.

At the top of the commercial real estate market, it was common for a building to sell with a Cap. Rate (capitalization rate) of 4%. Let's take a hypothetical view of cash flow and values, and values when gross rents drop by 25%.

All it takes is a 25% reduction in rental rates with no change in vacancy or Cap. Rates to have the value drop to 100% debt versus property value. Let's look at a more extreme valuation where the rental income decreases by 40% and Cap. Rates increase towards 8%.

The reason I show this equation is twofold. First, the worst areas are actually experiencing a decline in rents of 40%. Secondly, when a small bank sells a distressed commercial building there aren't many investors playing in that market, and most of them are very prudent and will not buy a building with a 4% Cap. Rate. They typically want to see something closer to 8% which provides a more appropriate return for the risk. It's this scenario if that "few" are talking about, and it's this scenario where commercial real estate values are "massively" overpriced. Lastly, the above does not reflect an increase in vacancies or cap rates going higher than 8%, both reduce the building's NOI and thus the value, even further.

Yesterday, I had a lunch with a client who has 25 years in the commercial real estate market in California. He had a few interesting comments.

Some markets have experienced lease rates falling back to 1986 levels which he said confirms the 40% drop in lease rates. More important though, he said he's seeing some financially distressed buildings sell at cap. rates of 9-12%. He also mentioned their some big money bidding 40 cents on the dollar in these financially distressed situations.

Using 9-12% in cap. rates in the table above would further compress values! The fundamentals behind commercial real estate are the worst in many years, and eroding quickly.

It's my expectation that the areas with the steepest declines in residential values will see the steepest declines in commercial real estate values, the process of unwinding commercial real estate values will continue into 2012, "single purpose" buildings like auto centers, boating and RV centers, hotels/motels, closed bank branches, and commercially zoned land get hammered the most, and people will eventually get comfortable with walking away, as is the case with residential.

Lastly, and most importantly, this will be a national issue, and it will be most devastating on the smaller/regional banks throughout the U.S. They typically carry a large percentage of their balance sheet in real estate loans and commercial real estate loans as a sub-segment. This will pressure more bank closures over time by the FDIC.

Hope all is well.