Commercial Real Estate: Scoring the Risk of Office, Retail, and Industrial Tenants: Residential Real Estate Has Been the Focus during This Recession, but Commercial Real Estate Will Likely Be Getting Its Fair Share of Attention as Well. Here Is a Breakout of the Prospects for Office, Retail, and Industrial Space

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THE COMMERCIAL REAL estate (CRE) market has been in a quiet crisis likely to generate more headlines in the coming year, especially as housing loans are detoxified. As in the residential real estate sector, CRE problems were exacerbated by degraded underwriting standards beginning in 2005 and complex loan bundling in commercial mortgaged-backed securities (CMBS) that hid high risks. Just as they did with housing loans, lenders or regulators will struggle to extricate the good CRE loans from the bad ones.

In this article, we'll look at the crisis in commercial real estate, focusing first on segmenting CRE and scrutinizing the key operating characteristics, customers, and elements that create a successful lease.

Thereafter we will focus on key tenant industries and the demand for office, retail, and industrial space, examining the likelihood of tenants failing over the coming year and leaving banks with significantly overvalued assets. As is often the case, there are winners and losers among some 500 key tenant industries (of around 700 industries in the U.S. economy).

Forewarned is forearmed, meaning lenders can begin to stress test their CRE portfolio, isolate assets in stronger industries, and take ameliorative action to head off the potential for bad loans. Industry risk is only part of the answer and should be considered along with financial statement analysis and the strength of the lender-borrower relationship. However, industry information offers the broad view necessary to find interrelationships between suppliers and buyers and to understand the movement and effect of key macroeconomic drivers over which a business has no control.

In Context: What's Already Happened

Investment in nonresidential structures boomed over most of the past decade. Commercial rents rose and office vacancy rates fell. Speculation and cheap money, as well as the "safe" collateral offered by the physical asset, encouraged many institutions to lend. The more they lent, the more the value of the underlying asset increased. To top this off, underwriting standards between 2005 and 2007 deteriorated, and the use of CMBS to bundle loans obfuscated the poor quality and high risks inherent in some of the loans. This happened across the country at large and small banks alike.

The longer maturity dates on commercial real estate loans relative to residential loans mean that the growing problem in CRE has been background noise compared to the housing crisis. Many CRE loans were heavily leveraged floating-rate loans, requiring interest payments only for the first three to five years with balloon payments due in 2009 or 2010. The worst is yet to come as these loans come up for refinancing. Banks will have to take losses unless owners put up more capital. Meanwhile, continuing its upward climb, the North American office vacancy rate rose to 15.7% during the second quarter of 2009, up from 14.8% in the previous quarter. Some industries are more likely to provide a rent payer than others, and some are more likely to secure new capital than others as investors seek medium- to long-term profits from fundamentally sound industries (despite short-term external problems).

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The government has launched stimulus efforts to revive the commercial sector. In May 2009, revisions were made to the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF), launched in November 2008. The program offers five-year loans to buy new AAA-rated commercial mortgage-backed securities. This "lifeline" is an attempt to boost the downtrodden commercial property sector by making older loans eligible for an emergency program and reviving troubled credit markets. From June 2009, the Federal Reserve's $200 billion TALF was opened to CMBS issued in 2009.

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