Stay Tuned Real Estate Problems are Going Commercial

The state of the residential housing market in the Metro Detroit Area is not surprising. The Detroit area led the U.S. in homes in foreclosure in the third quarter, with one in every 80 households at risk, more than four times the national average. However, some metro areas making the top 10 in foreclose rate were a bit of a surprise. Denver comes in at number three, Dallas makes the list at number five, and Atlanta is number eight. As recent as three years ago, these three metro areas were being heralded for their growing economies and generation of jobs.

So far, the foreclosures have been the result of mortgages that have been approved for the less affluent, no matter which metro market they live in. Any loan to a borrower can become subprime if too little is put down and there is too much debt. And unfortunately that is what has happened in the commercial real estate market where we have yet to see the full effects.

Commercial property from Carolina to California are entering foreclosure or about to default on their mortgages. These properties are not closed factories or distribution centers, but hotels, malls and medical centers. Fitch Ratings Ltd., worldwide evaluators of companies’ credit, predicts that in 2009 the number of late payments and defaults will double over the current rate in the U.S.

It seems as if in the last few years Michigan leads the nation in most downward economic trends, so we shouldn’t be surprised when the wave of commercial foreclosures hits. Because we are an auto based economy, we are familiar with the cyclic trends that result. This experience will serve us well in managing through this next down cycle. Yes, cities will lose tax revenues, school budgets will have to be scaled back and the secondary economy will take a hit -“ but I bet those folks living in Atlanta, Dallas and Denver will not be prepared for what is around the corner.

Historically, when an economic downturn became a trend, business owners negotiated with their bank or refinanced their loans. But due to the credit crisis, refinancing of commercial loans is currently not much of an option, and many banks no longer hold the loans they made. Starting about 10 years ago, banks have had a propensity to bundle mortgages and sell them to investors. Pension funds, hedge funds and insurance companies were buyers of these securities that at the time seemed safe. Today they are bracing for losses that will have far reaching impact through our financial system.

With the seizure of the credit markets and investors not placing their money into much if anything, especially real estate, the commercial market will be tested for a long and deep recession. This holds especially true for the Detroit area where the potential bankruptcy of one or more of the Detroit 3, and the corresponding impact on the supply base would have a tidal wave effect on our commercial market.

According to Commercial Mortgage Alert in 2007, $197 billion of mortgage-backed securities were issued compared to $16 billion only 12 years earlier. Currently there is approximately $3.7 trillion of commercial mortgage backed securities and collateralized debt obligations in the U.S; many of these securities mature in 2010 and 2011. And in the most recent years, the commercial underwriting standards have not been as stringent as they were in the late 1990s and early part of this decade. These securities have been sliced up according to the level of risk and parceled out to investors. You may recall that Lehman Brothers in their final days placed its lifeline on the value of its commercial real estate portfolio.

As businesses continue to fail, these securities are placed in greater and greater risk. And as Alan Todd, head of commercial-mortgage back securities at J.P. Morgan Chase says, “Not only have we been in a rising tide, but we haven’t been through a cycle yet.” Fortunately the turmoil that we have been through in the last year has taught us some valuable lessons, and these lessons will serve us well as we progress through the cycle. Looking at the current climate, it seems as if these lessons have taken hold. Although lenders are much more conservative in their approach, a pragmatic practice in investing in development is the guiding principle. Hopefully this principle will become a permanent staple of our decision making.

Sheldon Stone is a partner with Amherst Partners, LLC in Birmingham, Mich. He can be reached at [email protected].