More bumps ahead for U.S. real estate

Recent encouraging developments have caused the home price index to stabilize, yet, interestingly, prices of commercial real estate in the United States continue to decline.

More broadly, the U.S. real estate market has undergone several periods of correction since the second half of 2006 before reaching relative price stability, whereas commercial real estate markets around the world, which were initially spared the ravages of the U.S. subprime mortgage debacle, only began to experience market corrections in the fourth quarter of 2008. With plummeting commercial real estate loans and surging overdue rates (30 days in arrears), concerns over defaults are mounting.

Although bankruptcies of large financial institutions stemming from bad commercial real estate loans seem unlikely, additional defaults of small and medium-sized regional financial institutions that have high exposure to commercial real estate loans are quite likely, creating a greater likelihood of bank closures and tightening of lending conditions.

However, due to typically low securitization rates (the securitization rate is 80 percent on subprime mortgage loans and 28 percent on commercial real estate loans), exposure to risk on such loans tends to be concentrated in a relatively small number of financial institutions. So, even if losses were incurred with respect to commercial mortgages, the likelihood of those losses triggering worldwide insolvencies is relatively low, excluding financial institutions directly involved in substantial commercial mortgage lending in the U.S.

As for commercial mortgage-backed securities, about $140 billion are set to reach maturity by 2012. Thus a failure to refinance these securities will most likely entail significant defaults. However, a considerable portion of CMBSs that are set to expire after 2010 is made up of mortgages issued during the 2005-2007 bubble. These have high vacancy and overdue rates. Therefore, even if the credit market improves, these particular CMBSs, worth $67 billion, will have difficulty being refinanced on account of falling real estate prices and a lower loan-to-value ratio. Worse yet, even if refinancing were possible, more costs would be incurred (i.e., additional collateral for rollover at expiration should be provided because the LTV ratio is based on the initial time of lending).

Excessive pessimism should be avoided, as the importance of commercial real estate in the U.S. economy will urge financial authorities to take significant measures if matters escalate. For example, to address the stagnating commercial real estate market, the U.S. Federal Reserve has already increased the ceiling of its term asset-backed securities loan facility to $1 trillion and is expected to use those resources to revive the CMBS market. However, market recovery is likely to be delayed until 2011 at the earliest because, although financial authorities are expected to continue to support the easing of liquidity in the commercial real estate market, the market cannot at present survive at all without government support.

Defaults on U.S. commercial real estate are likely to delay the recovery of the real economy rather than trigger an abrupt hard landing or another financial crisis. While it is not likely that large financing institutions will go bankrupt and thus provide major shocks to the economy, it will delay recovery of both the real economy and consumption by leading to a tightening of lending by banks. Indeed, the credit supply of U.S. commercial banks has been continuously contracting. Notably, consumer lending and lending in commercial real estate in 2009 fell remarkably on a year-on-year basis.

In addition, the worldwide economic recession is leading to rising unemployment, a contraction in demand, rising vacancy rates, falling rents and worsening profitability in commercial real estate. As for Europe, where residential real estate remains stagnant, if an economic recovery is delayed, defaults related to commercial real estate are likely to gain greater attention.

Since a high correlation exists between vacancy rates and unemployment rates (a lagging indicator), economic recovery and lower unemployment are the keys to stabilization in the commercial real estate market.

The writer is a research fellow in the Macroeconomic Research Department at Samsung Economic Research Institute. For more SERI reports, please visit www.seriworld.org.

By Yu Jung-suk