The problems in the real estate sector are beginning to look like a bad flu epidemic that just keeps circling the globe and returning to infect those who have already suffered the virus.

Back in 2007, subprime mortgages deflated and an ensuing credit crisis gripped the banking sector. Immediately, the residential real estate bubble collapsed and home values decimated, dropping as much as 50 percent in particularly hard-hit cities.

What at first seemed to be strictly a residential real estate problem by 2008 crossed species into the commercial real estate sector. Whether one accumulated office buildings, hotels, shopping centers or apartments, the story was the same: Vacancy rates were climbing and lease rates dropping like a stone. Commercial buildings that have changed hands in the past year have done so at valuations sometimes less than half that experienced at the peak of market just two years before.

However, due to such factors as long lease rates, billions of dollars in assets securitized into commercial mortgage-backed securities and a banking sector that has been reluctant to confront valuation declines, the commercial real estate marketplace has been on a slow pace of rectification. That should all change in 2010.

The problems in commercial real estate seem to be approaching a tipping point, which means the banking system will have to address these problems in the coming months. And that, some folks predict, will have a second-round, return impact on the residential real estate market.

The question is, will this viral infection be more of the same bad news for investors or will immune systems in the banking systems finally be able to transform the trend lines into something more salutary?

Lesley Deutch, vice president of John Burns Real Estate Consulting and head of its Florida office in West Palm Beach, has been an industry Cassandra trying to get the residential sector to wake up to the fact that commercial real estate distress will have a "big" impact on housing.

According to Deutch, commercial real estate property values are now down 35 percent from peak and are expected to fall even more as leases expire and existing tenants either vacate space or renew their lease at lower rates. This is particularly troublesome for the major banks, which own nearly 45 percent of all the commercial mortgage debt outstanding. In comparison, banks own only 21 percent of single-family mortgage debt outstanding — and that lower percentage has tied lenders up in knots for the past three years.

Deutch, for all her prescience, is not sure which way it will turn out for residential real estate. Her biggest fear is that those banks with high commercial real estate exposure may just simply squeeze down lending for all property types in all segments of the market. …CONTINUED

"If you see a bank that has a good-sized portfolio of commercial loans sitting on its balance sheet that are not performing, then it won’t be lending much to anyone," says Deutch. "When distress on the commercial side becomes even more acute over the next 12 months, across the board, banks will be even more reluctant to lend."

There is also a slim chance that the banking system’s problems with commercial real estate could end up to be a boon for residential real estate investors. As Deutch reasons, the problems of distressed commercial real estate are so serious and will absorb so much of bank resources and time that they will have to dispose of the immediate, on-going problem of distressed residential real estate.

A lot of distressed residential still sits on bank books right now and the banks have pushed it all aside, in effect saying we will deal with it later, says Deutch. With this other problem of commercial real estate coming on, the banks don’t have the resources to deal with both issues.

"As soon as commercial real estate distress hits the banks in full force, solvent banks will need to dispose of residential assets to concentrate on distressed commercial real estate," Deutch asserts.

"That would be a good scenario. Our client base, for example, keeps asking, ‘Where are the distressed opportunities?’ and we are running out of things to tell them because more distressed residential should have come to the market by now."

Deutch believes if the banks start dumping distressed residential real estate this will create land-buying opportunities over the next several months. And, "builders acquiring land on the cheap means the beginning of recovery," she says, optimistically.

I checked in with Jack Mahoney, executive vice president of Highridge Partners Inc. in El Segundo, Calif., since his company has been actively buying up finished lots throughout California. I was curious whether he would agree with Deutch’s assertions.

While he concurred with Deutch about commercial real estate woes, he didn’t think the situation would alter the market for residential land.

"The huge overhang of commercial real estate distress has barely begun to be addressed by the holders of commercial debt," says Mahoney. "It is probably safe to say a very larger percentage of the major commercial assets are worth significantly less than the debt. Every market has these zombie projects where many of the owners of these properties do not have the capital or motivation to do new leases at the reduced rents in the market and lenders do not want to or can’t admit the situation either."

All this leads Mahoney to conclude, "Given the size of the impending problem, however, it could be a very long time until builders can build new homes profitably, which means the discounted value of the land in most cases is less than zero. I can’t see how that situation creates motivation on the banks to dispose of the land on their books in any way."

Steve Bergsman is a freelance writer in Arizona and author of several books, including "After the Fall: Opportunities and Strategies for Real Estate Investing in the Coming Decade."


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