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Shopping Mall Maelstrom
New York: July 20, 2009
By John Stephenson

House prices are still falling, but stock markets appear to have put in their lows. Last week, investment bank Goldman Sachs posted some blockbuster numbers and the stock market appears to have taken notice. With the financial crisis appearing to be in the rear view mirror, recession-weary consumers and investors are asking: is it over? Maybe, but a looming crisis in commercial real estate could quell the party for investors before it has really begun.

Unfortunately, the picture for U.S. commercial real estate isn't a very pretty one. Commercial property values have collapsed and vacancy rates have exploded as the recession wears on. Lending and credit are next to impossible to come by and owners of decent properties are facing the possibility of foreclosure.

According to Deutsche Bank real estate analyst Richard Parkus “The severity of the current downturn in commercial real estate is likely to exceed, possibly by a large magnitude, (the crash) of the early 1990s.” And the epicenter of the current crisis is New York where nearly $8 billion of mainly office properties are in various stages of financial distress.

Already the developing crisis in commercial real estate has claimed one high-profile corporate casualty. General Growth Properties of Chicago was the second-biggest U.S. shopping mall owner until its collapse in April, 2009. Saddled with $27 billion in debts and growing vacancies coupled with sagging rents, lenders balked at refinancing the massive debts forcing the company into Chapter 11 bankruptcy protection.

By the end of June, there were 5,315 U.S. commercial properties in default, bankruptcy or foreclosure—more than double the number of properties that were in trouble in 2008. In cities such as Boston , Dallas , Detroit , Los Angeles and Las Vegas the situation is similar with many properties lurching towards distress. Hardest hit have been the hotel and retail-focused properties.

Prices for office towers across the U.S. are down some 35 to 45 per cent from their peak in 2007, and further declines are likely. Contrast that with the nearly 32 per cent decline that residential real estate has suffered from its peak and the situation for commercial real estate is looking dire. In Manhattan and elsewhere, some buildings are being unloaded by desperate owners at discounts of up to 70 percent.

But the really bad news is that the crisis may be just beginning. A boatload of commercial real estate loans made during the heady boom years of the past decade, are coming due in the next several years and many of these loans will not get refinanced. This year alone, there is roughly $400 billion of loans coming due and by 2012 that amount will soar to more than $1.8 trillion according to Washington-based Real Estate Roundtable.

Figure 1: A Boatload of Commercial Real Estate Loans is Coming Due!

Source: U.S. Real Estate Roundtable

With plunging rental revenues and slumping property prices, banks are balking at refinancing commercial mortgages when they come due. And the market for commercial mortgage-backed securities has all but dried up as the global financial crisis has cratered the market for real estate finance.

This spells looming trouble for the nation's banks as another wave of bad mortgages is set to swamp their finances. Already banks are reeling from the problems associated with the securitization of subprime residential real estate and now in a vicious one-two punch, commercial real estate could be the next shoe to drop. But unlike the subprime fiasco that cratered the Wall Street banks that underwrote and traded these securities, the commercial real estate problems are more apt to hit the smaller regional banks the hardest.

The average exposure of the four largest U.S. banks to commercial real estate is a meager two percent. But the 30 to 100 largest banks have an average exposure of 12 percent to commercial real estate—an exposure that may prove fatal for some regional lenders.

The worst of the financial crisis may be over, but we aren't out of the woods yet. A commercial property bubble is set to explode which could touch off another round of bankruptcies and bailouts for the nation's banks. It will only be safe for investors to wade back into the world of stocks when the regional banks have begun to show increasing earnings momentum. Once the regional banks begin to lend profitably to small and medium-sized businesses, it will once again be time to become fully invested.

For now, investors should sit tight and buy selectively on dips. The recovery in the stock market, when it begins in earnest, will center on the great commodity stocks and the beaten-up financial sector. There's been some green shoots in the financial markets of late, but it's still to early to call the great recession over and done with.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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