U.S. property plunge - how low will it go?

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Canadians may look at the devastated commercial real estate market in the United States and see an opportunity to buy in cheap, as values in many markets have dropped by nearly half or more since their boom-era peak.

But a complicated interplay among struggling owners, the distressed banks that made their loans, and predatory buyers already on the scene is making it difficult to call a bottom. And, more importantly, it may be helping to postpone a day of reckoning.

It's not as if there hasn't been plenty of bad news already.

Whether one believes that commercial real estate follows the residential real-estate market or follows the general economy as a whole, both fell sharply over the past two years, leaving the commercial market nowhere to go but down. (Indices of commercial property prices from both Moody's and the National Council of Real Estate Investment Fiduciaries show declines of 35 per cent to 45 per cent from August of 2007 to August of 2009.)

And whether one believes commercial real estate was overbuilt, nearly no one's building now. Commercial construction values fell on a sequential basis by 31 per cent from the second quarter to the third quarter, and by the same rate from the third quarter to the fourth, says Michael Englund of Action Economics, based in Boulder, Colo. The decline seems to be mitigating in the first quarter of 2010, but will still likely be in the 20-per-cent range, Mr. Englund said.

"It's not clear where the bottom will be, but it's clear the market has collapsed," he says.

It has created a climate, says Pete Bolton, managing director of the Phoenix office of Grubb & Ellis, where "all the buyers now are all vulture funds. No one out there's saying, 'I'm going to offer them a very fair price.' If [the owner]bought it for $100 a square foot, they're not going to offer them $80 – they're offering them $30."

Owners who have the cash flow and lending arrangements that allow them to sit back and wait can just say "no." But for property owners who mortgaged at recent market highs of two or three years ago, and who have a very concerned lender, it creates a different dynamic.

Some of the offers are so bad, Mr. Bolton said, that both the distressed owner and the lender are willing to pass. "The bank says, 'No, we're not going to take that offer' and the owner says, 'Good, I'm going to hang out with the bank here for a little while.'''

Banking regulators, mindful of the havoc that could ensue, have announced "prudent commercial real estate loan workouts" – which cynics are calling "extend and pretend" loans that merely extend financing on a troubled piece of commercial property and pretend the borrower will be able to pay some day.

In late October, the Federal Deposit Insurance Corp., in conjunction with other bank regulators, announced a policy statement under which "performing" loans – those where the borrowers were still making payments – would not be declared problematic solely because the value of the underlying collateral declined.

Here's how the October guidance works in practice, says Matt Anderson of Oakland, Calif.-based Foresight Analytics. Say a bank has a $5-million loan on a commercial property that now has a market value of $3-million.

Previous regulatory standards would likely force the bank to classify the entire $5-million loan as non-performing. But regulators offered banks the opportunity to split the loan into two pieces for regulatory purposes, as long as adequate payments were still coming in from the borrower.

The first piece would be a $3-million loan that's fully collateralized at the new, lower property value; piece two would be a $2-million portion that represents the vaporized market value. The $2-million loan would likely be deemed non-performing.

To critics, softening the standards to keep even more American banks from failing just kicks the current commercial real estate problems down the road.

To hear banks tell it, however, the idea of the friendly regulator throwing them a lifeline on such troubled deals is a fiction worthy of the next Tim Burton movie. They insist that despite the public statements, regulators are approaching their balance sheets with a new-found zeal.

R. Michael Menzies, a Maryland banker and chairman of the Independent Community Bankers of America, testified before Congress on March 25 that "community bankers are saying that the field examiners are overzealous and unduly overreaching and are, in some cases, second guessing bankers and professional independent appraisers and demanding overly aggressive write-downs and reclassifications of viable commercial real estate loans and other assets."

A variety of bankers' trade groups have proposed, so far without success, an even more generous accounting than the FDIC's October standard. It would see current mark-to-market losses amortized over 10 years. (That would chop the $2-million loss in our example into 10 pieces of $200,000 each, protecting the income statement and the bank's regulatory capital ratios.)

"On the one hand, the regulators are going and giving banks more flexibility on how to deal with commercial real estate exposure, the loans problematic from a valuation standpoint," says Mr. Anderson of Foresight Analytics. "On the other hand, the regulators are putting a lot of pressure on the banks with commercial real estate exposure."

Highest U.S. office vacancy rates

Detroit: 29.3 per cent

Detroit's fourth-quarter 2009 office vacancy rate, up from 25.9 per cent a year earlier.

Austin, Texas: 25.3 per cent

Austin's fourth-quarter 2009 office vacancy rate, up from 19.7 per cent a year earlier.

Palm Beach County, Fla.: 25 per cent

Palm Beach County's fourth-quarter 2009 office vacancy rate, up from 22.8 per cent a year earlier

Phoenix: 24.5 per cent

Phoenix's fourth-quarter 2009 office vacancy rate, up from 21.4 per cent a year earlier

Inland Empire, Calif.: 24.3 per cent

Riverside and San Bernardino-area fourth-quarter 2009 office vacancy rate, up from 21.3 per cent a year earlier

Source: CB Richard Ellis North America Office Vacancy Index