Default Risk: Not Just for Homeonwners Anymore

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Homeowners are not the only ones having difficulty paying their mortgages. Owners of commercial properties, from office buildings and industrial parks to malls and resorts to hospitals and medical buildings are all feeling the pressure. And as of Tuesday, the cracks are officially beginning to show.

Bloomberg reports that, according to RBS Greenwich data, delinquencies on debt backed by comercial real estate reached 0.78 in October. Further, payment on approximately 35 percent of all sub-prime mortgages backing bonds are 30 or more in arrears. Two large borrowers, Westin and Promenade, are about to default on $334 million in loans bundled into bonds. Both loans were made by J.P. Morgan Chase & Co.

These loans may be among the largest and first on the verge of default, but they are not the only one. Extrapolating on the level of enrivonmental site assesments (ESAs) which are the first step in most commerical real estate transactions, the commerical real estate market is slowing down. The number of ESAs conducted across the U.S. fell by 17 percent during the third quarter of 2008 compared to the same quarter in 2007, MarketWatch reports. The deepest decline occured in the West where ESA activity was off by 25 percent. The only region showing an increase in ESA activity was the Northeast with a gain of 11 percent. Unfortunately, the Northeast regional only accounts for about 4 percent of all ESA activity in the nation. Preliminary indications for October reveal a decline in ESA activity of 21 percent nationwide hinting that conditions will continue to worsen as the year ends.

At the local level, select metropolitan areas including Washington, DC, Boston, MA and California’s Inland Empire experienced increased ESA activity according to MarketWatch. Washington, DC also appears on Forbes‘ list of top five places to invest in commercial real estate in 2009. Seattle, WA leads the list, which is based on a survey of 700 real estate professionals conducted by the Urban Land Institute, followed by San Francisco, CA, Washington, DC, New York, NY and Los Angeles, CA. The $209 million Westin loan is backed by hotel properties in Tucson, AZ and Hilton Head, SC while the Promenade Shops at Dos Lagos in Cornona, CA back another $125 loan. If either do default it is likely to have a chilling effect on the commercial real estate markets in those cities and possibly beyond.

Some fear defaulting on these two large loans will user in the next phase of the financial crisis. Up to this point the commercial mortgage-backed securities (CMBS) market has survived the credit crunch sweeping the nation with minimal delinquency rates.

“It’s pretty unheard-of for tow large loans to go this bad early on,” Richard Parkus, head of CMBS research at Deutsche Bank told the Wall Street Journal. “This has shaken the market up.”

As it should.

“It blows my mind how fast this has happened. We had thought commercial real estate would be ok because it wasn’t overbuilt,” the Associated Press (AP) quotes Robert Bach, chief economist at Grubb and Ellis as telling the panel at the company’s 2009 Real Estate Forecast.

Falling consumer confidence, higher unemployment rates and fewer people traveling are all beginning to take their toll on commercial real estate. Loans, like the Westin and Promenade loans, made at the height of the commercial real estate market with the presumption that they would continue generating increasing amounts of cash are not just having trouble meeting payments when they come due. They are also finding it difficult to refinance the loans or sell the properties. And even if consumers started spending again immediately the commercial real estate market, which lags about a year behind the consumer economic cycle, will continue to decline.

“It’ll be awhile,” Bach told the AP. “Defaults on these loans could continue for several years.”