The commercial real estate downturn skirted the sidelines for the first three years that residential markets were declining in 2006-2008, but once it hit, it hit hard. As the following chart indicates, commercial property values were on a steady uphill climb throughout most of the past decade – peaking in February of 2008, and then dropping precipitously through 2010.
Today we are facing trillions of dollars in underwater commercial mortgages, threats that foreclosures will flood the market and further depress values, and questionable accounting practices that mask reality while delaying the commercial market’s recovery.
While residential mortgages are typically financed over 15 to 30 years, commercial mortgages tend to be refinanced every three to seven year years. Studies by Deutsche Bank indicate over one half of these loans made during the 2000-2008 commercial run up in values are either non-compliant or non-conforming and will face extreme difficulties in qualifying to be refinanced . The stop-gap strategy adopted by most commercial lenders today however has tended to be one of “Extend and Pretend” that the loan is compliant and no loss in principal value has taken place.
This deceptive strategy of protecting the bank’s balance sheet and keeping the market from being flooded with foreclosed commercial properties – is a short-term economic fix, but one that stands to substantially prolong the U.S. commercial property recovery. Japan faced a similar asset valuation bubble in the 1980’s and implemented the same “Extend and Pretend” philosophies which resulted in an economic malaise of Japan that today has been termed the “Lost Decades” of Japan from 1990-2010.
U.S. banks, fearful of the balance sheet impact of these non-compliant loans, have exerted enormous pressure on The Financial Accounting Standards Board (FASB), and have forced an amendment to accounting principles for the U.S. Banking Industry that allows banks to use “Cost” accounting for their troubled loans vs. “Mark to Market” accounting. This flawed policy will allow banks to keep loans on the books at the loan amount, irrespective of any loss in valuation due to the market decline. In other words, banks will continue to “Extend and Pretend” vs. “Extend and Amend” and account for the principal losses of their commercial loan portfolios. A compromise solution would be to require banks to phase in “Mark to Market” accounting for 20-25% of their loan portfolio each year thus working out the problem loans over a 4-5 year period, thereby averting the Japanese scenario of the “Lost Decade.”
The reality of the current commercial market is considerable adversity. However,in adversity is opportunity and a commercial client base that is begging for Strong Leadership. More so than ever before, clients are looking for commercial brokers who have the knowledge, expertise and skill set to help them effectively navigate the commercial real estate landscape. A sensible return to accountability and trust in our banking system would be a good first start.