As the US economy was smarting from the housing crash of 2008, the anticipated “next shoe to drop” was supposed to be in commercial real estate. While foreclosures on individual homes measure in the hundred thousands of dollars, foreclosures in commercial properties such as hotels and shopping malls measure in the millions! Widespread commercial foreclosure would have been another disaster to the US economy.
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But now, five years later, it is clear that such a disaster never occurred. While values for commercial properties did decline almost 40 percent nationwide, the effect on the economy was muted. Now commercial values have risen almost to their pre-crash levels.
How did the economy dodge such a massive bullet? Three primary factors helped commercial real estate avoid the devastation seen in the residential sector.
When a homeowner loses his job, or otherwise finds himself unable to make his mortgage payments, he must either default or sell the home. If the home value has fallen below what he owes on his mortgage, there is often no choice but to let the home foreclose. But in commercial real estate, the property in question is producing income.
Even if the value declines, the owner is less likely to be forced into a sale. Many commercial real estate owners were able to ride out the decline because of the income they were receiving from their business or tenants. They could wait for values to recover.
Residential loan regulations often prevent lenders from being able to negotiate delinquent mortgages with homeowners. Lenders are tied to the rules established by the government through Fannie Mae, FHA, etc. The measures meant to aid struggling homeowners had such a narrow reach that many were left out in the cold.
But in commercial real estate, the banks that holds the loans have more flexibility. They have both the ability and the motivation to provide a loan modification to a commercial real estate owner.
Consider a mall owner with a five million dollar loan. The mall’s value has fallen to three million. The space in the mall has become 30 percent vacant and rents can no longer cover the payments for the loan. Since the bank has the authority to re-write the loan (unlike in a residential mortgage), they can give their borrower more favorable terms to help them stay afloat. The last thing a bank wants to do is foreclose on a mall and have to manage such a massive property.
Commercial real estate did not get quite as over-built as did residential real estate. The likely reason why is that people don’t buy commercial properties with the intention of “flipping,” meaning to sell quickly and take a profit only from appreciation. Property flipping was rampant in the residential sector from 2003 – 2007. But those financing commercial construction need to analyze the income the property will produce. You cannot build a shopping mall “on spec.”
One cause of the housing crash was the abundance of inventory. There were more houses built than there were people who could really afford to own them. This excess inventory never really manifested in commercial real estate, because every building project had to be based on a clear financial strategy.
While commercial real estate values did decline significantly in the wake of the financial crisis, there was not significant commercial foreclosure activity. Even when commercial vacancies became widespread in some areas, it occurred in a way that did not place significant supply on the market. Now commercial construction has picked up again, and is even outpacing residential construction in the current recovery.
It appears this was one financial bullet we safely dodged.
Photo Credit: BancroftServices