Marketplace Today Blog

By Paul Gores
Milwaukee Journal Sentinel

While regulators say the banking industry shows signs of improvement, some analysts worry that lenders face another big hurdle: defaults on loans for commercial real estate such as retail shopping centers, office buildings, hotels and warehouses.

At its worst, a surge of losses on commercial real estate loans — coming on top of lingering residential loan problems — could result in a crisis that threatens the nation’s fragile financial system and damages the economic recovery, a federal panel that has been monitoring markets and the bank bailout said in a recent report.

At the least, souring commercial real estate loans will further stress many banks, including community banks that financed the strip mall and two-story office building down the street.

Wisconsin isn’t immune and already has seen noncurrent loans tied to commercial real estate grow. Commercial loans considered nonperforming — doubtful to be repaid in full — more than doubled in the state last year, rising to nearly $1.3 billion from $557.5 million in 2008, the latest data from the Federal Deposit Insurance Corp. shows.

Nationally, nonperforming commercial real estate loans more than doubled to $37.7 billion last year from $15.2 billion in 2008.

“There are plenty out there right now that aren’t doing well,” said bank analyst David L. Donihue, managing director of Maximizing Shareholder Value & Co. in Leesburg, Fla. “I think the biggest challenge in the next two years is going to be commercial real estate.”

Commercial real estate construction booms tend to follow housing booms that drive up prices for both types of property, which means when the boom fizzles in high-growth areas, the downfall can be steep.

Slow-growth Wisconsin probably won’t experience the kind of commercial real estate problems facing states such as Florida, California and Arizona.

“We did not have anywhere near the amount of speculative overbuilding that other areas of the country have had,” said James T. Barry III, president of the Milwaukee commercial real estate brokerage firm Colliers Barry.

Still, some in Wisconsin are wrestling with the issue.

Michael T. Stoetzel, a partner at Clifton Gunderson LLP in Middleton, said commercial real estate trouble “has already had some impact in various areas of Wisconsin.”

“In the areas where it is not a problem, the borrower likely has an anchor tenant that is A-rated,” Stoetzel said. “Without that large anchor tenant, the property may not be cash-flowing as well.”

Commercial mortgages usually are from three to 10 years, and at the end of the term, the entire outstanding principal is due. That’s when commercial property owners typically refinance — an event that has the Congressional Oversight Panel worried.

In a report issued last month, the federal panel estimated that about $1.4 trillion in commercial real estate loans will reach maturity between 2010 and 2014, and nearly half are under water.

That means the borrower owes more than the property is worth and could lead to foreclosure if the borrower can’t refinance at manageable terms.

The panel says commercial real estate values have fallen more than 40 percent since 2007 as vacancy rates have climbed in the weak economy.

“Commercial real estate values are down much like home prices fell,” said Terry McEvoy, a bank analyst with Oppenheimer & Co. in Portland, Maine. “You have to refinance it under a different value under the appraisal. Therein lies the risk.”

Losses on commercial real estate loans could jeopardize the stability of many banks, especially midsize and smaller banks, the panel warned.

But McEvoy said the losses from commercial real estate don’t figure to be as devastating as those stemming from the housing slide.

“The good news is it doesn’t hit all at once in 2011, and that does give the market time to see an improvement in the fundamentals, which would be driven by job creation and a decline in unemployment,” he said.

Bank investor and adviser Jon C. Bruss said he thinks the concern by the Congressional Oversight Panel is overblown. He said commercial real estate losses “are nowhere near what was created by those banks that were in the subprime business.”

Bruss, chief executive of Fortress Partners Capital Management in Hartland, argued that borrowers with commercial real estate loans often occupy at least part of the building they own and are well-heeled enough to stay current on their loans and wait for a market revival.

McEvoy, likewise, pointed out that a borrower like a strip mall operator might have four tenants instead of five in the tough economy but still enough rental income from those four tenants to make payments on a loan.

The two biggest banks in Wisconsin, Milwaukee’s M&I Bank and Green Bay’s Associated Bank, both experienced increases in noncurrent commercial real estate loans in 2009.

At M&I, the amount of commercial real estate loans in arrears rose to 4.75 percent from 1.16 percent a year earlier, while at Associated, noncurrent commercial real estate loans shot to 8.56 percent from 4.13 percent in 2008, according to the FDIC.

Associated’s new CEO, Philip Flynn, made it a priority to ferret out and deal with endangered commercial loans when he joined the bank in December.

M&I, which has suffered a series of quarterly losses largely because of problems with residential construction and development loans, particularly in Arizona, said it doesn’t expect major issues with commercial real estate.

“We continue to have confidence that our commercial real estate portfolio will perform reasonably well, with a significant portion of it residing in our core Midwest markets,” said M&I Chief Financial Officer Greg Smith. “Although we may see some deterioration in this portfolio, we do not expect to see a substantial increase in nonperforming loans related to this portfolio.”

As with most elements of the economy, an improvement in jobs would go a long way toward lessening commercial real estate losses.

“Historically, unemployment is an indirect factor on [commercial real estate] and certainly puts significantly more pressure on businesses that rely on consumer and tourism spending,” said Clifton Gunderson’s Stoetzel.