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LOS ANGELES — Even as the housing market starts to show signs of recovery, fortunes for commercial real estate are looking increasingly grim — and that could spell trouble for the fragile U.S. banking sector.
The weak economy and rising unemployment have forced businesses to cut back on rental space, resulting in declining revenue for many landlords. And tighter underwriting standards and falling real estate values have made it much harder for them to refinance.
The rate at which property owners are defaulting on loans is climbing at an unparalleled pace. Many banks are stuck with shopping malls, hotels and offices buildings they've repossessed and can't sell. Scores of banks have been closed down this year, many of them, including Horizon Bank in Pine City, Minn., and Omni National in Atlanta, because of sour commercial loans.
"The bottom line: defaults are exploding," said Richard Parkus, an analyst with Deutsche Bank. "It's terrible. It's going to be worse than in the early '90s."
The delinquency rate on commercial property loans pooled together into investments, estimated at around $750 billion, hit nearly 3 percent in the second quarter, nearly tripling from where it was at the end of last year, according to Reis Inc.
"We haven't seen the end of these delinquencies and defaults," said Edward Leamer, a senior economist at the University of California, Los Angeles.
In all, there is about $3.5 trillion worth of commercial real estate loans held by banks, or tied up in commercial mortgage-backed securities or held by other institutions.
More than $2 trillion in commercial mortgages are expected to come due between now and 2013. But due to the tightened underwriting standards and falling real estate vales, many property owners will face an uphill battle qualifying for refinancing.
About half of the security-backed loans that have come due this year were refinanced, said Chris Stanley, a senior associate with Reis.
"That's a fairly low rate historically and signifies that people are still having trouble getting financing," Stanley said.
In some cases, landlords facing mounting debt payments are walking away from some of their properties if they can't find a buyer.
Just this week, Maguire Properties Inc. said it would stop making payments on more than $1 billion in loans for seven office buildings in Southern California. The company said it would try to sell the buildings or turn them over to the lenders. In June, Maguire sold off an office tower at a 35 percent discount.
Given the hurdles to refinancing, many publicly traded real estate investment trusts have taken another route: issuing stock and using the cash to help pay off their most pressing debts.
Between March and July, more than 50 REITs raised roughly $16.2 billion, according to Ronald Kuykendall, spokesman for the National Association of Real Estate Investment Trusts, the industry's trade group.
Still, concerns over the health of the commercial real estate market has given investors some pause.
An initial public offering Wednesday by Starwood Property Trust Inc., which manages commercial mortgages and related investments, received a lackluster response from investors. The stock opened and closed at $20 a share, but traded slightly lower most of the day.
"The key issue in the commercial real estate market today is there is a lot of debt that is going to need to be refinanced," said Kuykendall. "The winners and losers in the market will be determined by who has the capability to eliminate those near-term debt obligations."
The commercial real estate market's fortunes depend largely on free-flowing credit markets and cranked up spending by businesses and consumers — neither of which economists expect will happen anytime soon. That means more commercial loan defaults.
Deutsche Bank's Parkus expects the market won't begin to turn around until 2012 at the earliest. By then, commercial property prices will have declined by as much as 50 percent from the peak in early 2007, he estimates. It will likely be worse in hard-hit areas like Manhattan's office market.
"We're going to be down a lot more," Parkus said.
