Commercial Real Estate possible crisis in simple language

[AllentownJake]

A commercial real estate loan is generally financed differently than a mortgage. Since the real estate is used primarily for a business, most of the purchase is financed.

Under normal conditions:

If you decided to purchase a $1,000,000 building and you could show steady revenue projections to the satisfaction of the bank, the bank will finance the entire $1,000,000. Terms are generally different. You make interest payments and take a lump sum payment from you at the end of the term of the loan. In reality it is like a mortgage backed bond. The terms are generally 4-5 years.

Now, in normal conditions, you can refinance the loan every 4-5 years, make the last payment which includes the principle in the payment, and either take more money out in the form of borrowing the entire value of the property, or finance less of the property and establishing equity in the appreciation of the property. Most of the time the entire value of the property is financed.

Now, if the price of the property declines, this becomes an issue. Banks will not lend past the value of the collateral in this market, which is the building. So if your $1,000,000 building is now $800,000 than you have three options.

1) Cough up $200,000 and refinance $800,000

2) Default

3) Give the bank some money in addition to the property, to avoid a legal battle.


Now if your business is doing well in that location, and you expect the property to return to over $1,000,000 in value over the course of the loan. Option 1 might be acceptable.

If your business is doing poorly, option 2 and 3 look more acceptable. If you have other assets for the bank to go after in litigation, option 3 is the most likely outcome. If you don't your business declares bankruptcy and the bank gets the property. 2 and 3 will result in a loss to the bank.

Banks are not real estate investment companies. They generally aren't keen on holding property. It has expenses (insurance, property taxes, maintenance) banks generally sell real estate at auction, which means they sell it below appraised value. This is fine by the bank, since holding the property brings about expenses and a real estate asset without tenants drains liquidity and a sale creates it. Though the bank must make up the capital lost on the balance sheet in the loss on the property to remain solvent, overall.

Unlike residential real estate, the business owner makes a business decision. They either leave or agree to pay. If they leave, the bank gets the keys. There generally isn't scenes with the Sheriff.

Supply and Demand take over when there are lots of defaults and lots of banks looking to unload property. More properties at auction, lower asset values, more defaults.

[flvegan]

1. Assignment of Leases and Rents

We'll be seeing a LOT more of this sort of loan modification coming.

[AllentownJake]

2. That is still a loss for the bank

Which requires an adjustment to the balance sheet which requires capital to be raised.

[flvegan]

3. It can be, depending, but it's better than taking a massive loss on a default.

Commercial lenders tend to seek a performing loan, I've found, especially in judicial foreclosure states.

[rampart]

4. copied, with credit, to a local forum

thanks jake. i can only add that commercial real estate is difficult to appraise and is often overvalued.

[Me.]

5. Aren't There Large Tax Breaks & Incentives Involved

So many new buildings in NYC certainly aren't filled anywhere near to capacity yet they keep building so where's the benefit? Also many commercial spaces empty because the rents are astronomical

[AllentownJake]

6. If a project secured financing before the crash

and was in the process of being built, they kept building. Also businesses build their own properties for all sorts of reasons instead of taking on an existing one. If it is cheaper to design your own building than to refurbish one for your needs...or equal in price.

There is also the fact that if you are making the interest payments, but are still underwater on the end lump sum payment, there is really no incentive to sell the property at a loss right now, because you have to pay the bank for the loss. Remember there is generally not much principle involved here.

Focus on starts.

The rents won't come down till a new owner takes over the property with a new loan. There is a required revenue stream for the owner to meet interest payments. Generally speaking those spaces probably are delinquent on interest payments.

[Me.]

8. Columbus Ave. In NYC Used To Be A Shopping Mecca

Restaurants etc and the rents rose accordingly. And landlords kept raising them. It seems now they'd rather leave the building empty, as businesses who could no longer take on the rise, like the local copy center, left. The buildings have remained empty for months.

[jtuck004]

7. Not to mention this little ditty

http://www.reuters.com/article/idUSN0235590020090402

They eased the rules last year on mark-to-market, because showing everything with its new real value would blow us all out of the water. So a good portion of the stuff that is on the books is a theoretical price based on someone's likely overinflated view of a property's worth. Keeps the bank's assets from looking as bad as they really are, until the business or homeowner defaults. Part of the reason we are seeing foreclosures not being processed as fast as they could be. Everyone is trying their best to prop things up and avoid another blowout...