The Business Press: Defaults, foreclosures loom on commercial real estate front

By Chris H. Sieroty 

Contributing Writer

As the collapse of the housing market in Inland Southern California slowly begins to stabilize, economists and real estate analysts are concerned that increased foreclosures in the commercial real estate market could prolong the region’s efforts to recover from the current recession.

The problem was expected to get worse as a large number of loans approach their renewal date over the next few years and companies and individuals will no longer be able to meet the original loan conditions or refinance.

“The commercial real estate market has already burst beginning more than a year ago,” said Christopher Thornberg, an economist and principal with Beacon Economics. “The key to commercial real estate is that it’s a very slow pop, and it can take years to break.”

He said the major problem facing the local commercial real estate market was cash flow versus debt servicing as property prices in the two-county region were already too high to begin with. But Thornberg added that debt service is relatively cheap at the moment, and much of the debt on commercial properties “is on a three- or four-year balloon,” with problems expected to occur when the loans start to come due.The region’s commercial market experienced a big decline in market conditions in the first quarter of the year, according to a CoStar Inland Empire report. The vacancy rate jumped from 7 percent in the fourth quarter of 2008 to 8.1 percent in the first quarter of 2009, while net absorption was negative 1.37 million square feet and vacant space increased by 416,856 square feet, according to the report.The region’s net absorption rate turned dramatically from the fourth quarter of 2008 from a positive 760,304 square feet. The report attributed the increase to large retailers vacating space in the first quarter of 2009, including Mervyn’s, which vacated approximately 245,000 square feet of commercial space during the first quarter.

“Vacancy rates are way up in the Inland Empire,” Thornberg said. “That’s a big problem, because retail was overbuilt. Retail is worse than other parts of the market, but they are equally bad off. The office market is tiny and realistically will bounce back. Warehousing is an issue. But warehousing is going to be (all right) as trade flow starts up again, which eventually it will.”

Scott Talbott, senior vice president of government affairs for the Financial Services Roundtable, a Washington, D.C.-based trade group for banks and other financial institutions, said about $1.3 trillion in commercial real estate loans nationwide are coming due between this year and 2013.

“It has become the next round of bad news,” Talbott told The Business Press in a telephone interview. “A decline in property values along with fewer potential tenants looking for space translates into a decline in income for landlords and higher vacancy rates which have combined to create a perfect storm for commercial real estate.”

He cautioned that a commercial mortgage collapse could prolong the region’s recovery. Increases in foreclosures, bankruptcies and falling real estate prices could lead to additional bank losses, while many financial institutions have been setting aside additional resources to cover loan losses from mortgage and credit card defaults.

Additional defaults on commercial properties could lead to additional taxpayer assistance for regional and local banks, he said.

“It’s going to be difficult to refinance those loans because underwriting standards have tightened up and because of the credit crunch banks are not willing to lend as they have in the past,” Talbott said. “There is 3.3 trillion square feet of commercial real estate nationwide. The delinquency rate was 1.8 percent at the end of 2008, but expect delinquency rates to rise this year.”

The reality of bankruptcies and foreclosures is already on display in San Bernardino and Riverside counties.

On April 16, General Growth Properties filed for bankruptcy protection. Based in Chicago, the company, which owns 158 malls nationwide, including Redlands Mall, Galleria at Tyler in Riverside, Montclair Plaza and Moreno Valley Mall, was forced into bankruptcy when it was unable to renegotiate its debts as they came due.

“We are starting to see some notices of default throughout the region,” said Eric Frickle, of Eric Conrad Frickle Commercial Realty Services. “My opinion is it’s going to get worse in the Inland Empire before it gets better, because I just don’t think all the problems have worked their way through the pipeline yet.”

According to figures compiled by RealtyTrac Inc., 1,715 commercial properties in Riverside and San Bernardino were in various stages of foreclosure. Most of the commercial properties listed by the firm were described as defaults — 675 in Riverside County and 512 in San Bernardino County — which were about to be foreclosed.

The downturn in the commercial market has forced brokerage firms to seek additional financing to meet debt payments.

CB Richard Ellis Inc., the world’s largest commercial property brokerage, raised $450 million June 19 as part of the firm’s effort to cover loans to stay solvent during the real estate downturn. Based in Los Angeles, the company raised the money by selling bonds but was forced to offer a high rate to attract investors. The bonds, which mature in 2017, have a yield of 11.625 percent.

The company will use the proceeds of the bond sale, along with $150 million raised from a common stock sale on June 10, “for the repayment of some of its outstanding (debt) under its credit agreement.”

Frickle said lenders have tried to work things out and modify loans before properties go into foreclosure.

“We are starting to see banks trying to renegotiate (loans) because they don’t want to take this stuff back and recognize those losses if possible,” he said.

In terms of the commercial office market, Corona has experienced a construction boom in recent years when housing-related industries were rapidly expanding in the area. Today, the Corona office market contains about 3.9 million square feet of which some 1.25 million, or 32 percent, is vacant.

To put the problem in perspective, Frickle said, in 2005, which was a banner year, the net absorption rate was 340,000 square feet.

“When you look at the historical average absorption over a longer time frame (five to 10 years), the extent of the problem becomes more apparent,” he said. “The excessive vacancy rate will translate into additional defaults in the future, as more construction loans for empty new buildings come due in the next year. This will have a trickle-down effect on other properties, hitting those who bought late in the cycle the hardest as they struggle to make debt service with lower rents that result from landlords competing for tenants.”

Renegotiating leases

As vacancy rates continue to increase, some landlords have been willing to renegotiate leases with national and small-business tenants to keep commercial space occupied.

“We have been very busy renegotiating current lease agreements to take advantage of the depressed market,” said David Salazar, managing director of Cresa Partners in Ontario. “It began about nine months ago when companies began to realize the recession was real and needed to find a way to reduce costs.”

Salazar explained that some companies that may have two years left on a current lease at 40 cents a square foot have been able to reduce the rent to 30 cents a square foot by extending the lease by five years.

“It’s a win-win for businesses and landlords,” he said. “We recently worked with BBSI and we were able to adjust their rent by 25 percent, while extending their lease and acquiring additional space.”

Based in Vancouver, Wash., Barret Business Services Inc., or BBSI, is a human resources management company with offices in Ontario, San Bernardino and Temecula. Matt Maxwell, BBSI’s branch manager in Ontario, said his office hired Cresa Partners to renegotiate its lease when they wanted to acquire an additional 2,000 square feet to add a training center for their clients.

“We felt that expanding our business without revisiting what we were spending in this economy would not be wise,” Maxwell said. “We were paying about $1.80 per square foot, but to take the suite over, we wanted to lower our rate. In the end, we are paying about $1.30 per square foot on a three-year lease.”

In the High Desert, a number of businesses and landlords have reached updated lease agreements. But requirements to renegotiate a lease have been tightened because of claims of fraud by landlords who say businesses owners are trying to take advantage of a depressed commercial real estate market to receive better lease terms, said Donald Brown, president of the Lee & Associates office in Victorville.

“Probably 90 percent of the companies wanting to renegotiate are not in financial stress, but are just not wanting to honor their leases,” Brown said. “It’s unfortunate that they are trying to do this at the landlord’s expense.”

Brown said that for a rent-reduction application, many landlords are asking financial information going back two years.

But as analysts worry about increased foreclosures and bankruptcies, there are some signs of recovery in the Inland commercial real estate market.

“We expect the economy to begin recovering in the third or fourth quarter of this year,” said Brown, whose office represents properties from the Cajon Pass to the Nevada state line. “Right now our leasing agents are talking with potential clients who are looking to take advantage of the (down) market to lease property. It’s a tenant market right now, and we are advising them to take advantage of the best rates in the region.”

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