A Slow-Motion Wreck for Commercial Real Estate

For about a year now, we've been hearing that commercial real estate is the next shoe to drop, the next big financial debacle. And for about a year now, the oft-predicted crisis has stubbornly refused to materialize. It's not that everything's fine in the commercial real estate business. Everything's awful and will probably get more awful. But unlike 2008's Wall Street panic, this particular financial unraveling looks as if it will play out over a period of years, not weeks.

"It's a train wreck in slow motion," says Richard Parkus, head of commercial real estate debt research at Deutsche Bank. "Because it's in slow motion, people get this sense that it's really not happening. It is happening." To get a sense of just how the train wreck is unfolding, I took a tour last month of the warehouses and industrial parks of eastern Los Angeles County. Chris Bonney, the president of the City of Industry, Calif., office of commercial brokerage Lee & Associates, was my guide (and my driver). With the phenomenal growth of foreign trade passing through the ports of Los Angeles and Long Beach in recent decades, City of Industry, Pomona and their neighbors had become distribution boomtowns. But now, every time Bonney turned a corner, it seemed that he had another sad tale to tell. (See the best business deals of 2009.)

First he showed me a small industrial park built not long ago by a local businessman. It's got tenants, and the owner has been making his mortgage payments. But when his loan comes due — commercial mortgages generally run three to 10 years, not the 30 that homeowners get — he almost certainly won't be able to refinance because building prices have dropped and lending standards have tightened. Which means he will either have to cough up a lot more up-front cash or lose the property.

That's one common predicament. A few miles to the east, Bonney pointed out a dusty lot that represented another stage of real estate pain. The bank that financed the purchase of the lot had decided to bite the bullet and take possession of it rather than give the developer a construction loan for a building no one would occupy. There already was a newly constructed — and empty — building across the street. The bank that made the construction loan for that building would soon have to decide whether to "extend and pretend," as the industry saying goes, or take a loss. After that, we visited a neighborhood of giant new warehouses. On one side of the street was yet another building with an underwater construction loan that the bank was stuck with. Opposite was a facility that a vulture investor pounced on last year, thinking it was cheap, only to see prices continue their decline. (See the five big questions about retirement.)

Industrial properties are just one segment of the commercial market — the others being offices, retail sites, apartment buildings and hotels. But the problems Bonney showed me apply across the board. First, commercial mortgages are about to hit a refinancing wall. Deutsche Bank's Parkus estimates that more than 65% of the loans that have been packaged into commercial mortgage backed securities won't qualify for refinancing when they come due. Second, banks are already facing painful choices about what to do with short-term land and construction loans that will never be paid off in full. Finally, the vulture investors who usually swoop in and refire markets after a bust are still hanging back.

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