Troubled Commercial Real Estate Fixes Are Half Done

It will take two to four more years to resolve bad commercial property debt built up since the financial crisis of 2008, analysts estimate.

The task is taking so long amid an "extend and pretend" policy that lets banks carry toxic loans on their books. It's what has so far prevented a more severe commercial real estate meltdown, according to a number of industry observers.

They maintain that defaults peaked in 2009, and warn that property values now stabilizing could begin falling again if regulators start pressuring banks to reconcile nonperforming loans faster.

From 2007 through May this year, property research firm Real Capital Analytics has tracked $320 billion in distressed commercial real estate, which includes defaults, foreclosures and bankruptcies.

To date, more than half of that amount has been dealt with in some fashion: Banks have repossessed properties underlying some $39 billion in loans and restructured about $53 billion in loans. Meanwhile, more than $85 billion in loans has been resolved through a sale or refinancing, leaving $143 billion worth of distressed assets in limbo.

"It's pretty clear from where we're sitting that the worst is over," said Dan Fasulo, head of research at Real Capital Analytics.

Patient Approach

Since mid-2009, regulators such as the Federal Deposit Insurance Corp. have stuck to an extend-and-pretend policy, which lets banks restructure or extend troubled loans and carry them over time.

Regulators consider the approach preferable to foreclosures or forced sales of distressed assets, which could force lenders to take potentially catastrophic losses. They're wagering that an improving economy will eventually inflate property values and help cure bad-loan ills.

At the same time, the Troubled Asset Relief Program (TARP) and other measures have let banks beef up their balance sheets to absorb potential losses to prevent a greater number of bank failures.

The consensus among most real estate experts is that commercial property values nationwide declined an average of 40% from the peak of the real estate cycle in late 2007 through mid-2009.

While many markets continue to bounce along the bottom, values for some trophy properties in major markets such as New York, Washington, D.C. and San Francisco are nearing past peak levels. But values for select properties in smaller cities are inching up, too, Fasulo says.

"Even if values haven't come back all the way, they have rebounded a lot," he said. "It's a different conversation for lenders and owners if the properties are only down 10% than if they're down 30%."

The decision to let banks wait for an economic recovery before dealing with bad loans was in direct contrast to how regulators handled the commercial property recession 1988-92, says John Leary, president of New York-based Leary Counseling and Valuation, which handles real estate disputes and appraisals.

Back then, regulators pressured banks to realize losses right away and ultimately set up the Resolution Trust Corp. to auction off distressed assets from failed banks. Leary suggests that regulators responded with a slower approach this time because the recession was considered to be more severe.

"We had a bigger mess," Leary said. "So the idea was to take it slow and see what happens."

Slower Going

Speaking at a conference sponsored by the National Association of Real Estate Editors in San Antonio last month, Douglas Wilson, CEO of San Diego-based real estate workout specialist Douglas Wilson Cos., argued that forcing lenders to mark the distressed assets to market would have proved disastrous for real estate as well as the economy.

Wilson and Leary said at the conference that extend-and-pretend, combined with the deep recession, add to a two-tiered recovery. It's marked by rebounding values in big metropolitan downtowns and stagnation in most other markets.

The plodding strategy has frustrated investors, many of whom raised funds to try to nab distressed assets for pennies on the dollar, Wilson said at the event. The opportunities have largely failed to materialize.

While he agreed with the policy overall, Wilson also acknowledged that it could lead to the same slow growth that has afflicted Japan for years. In reaction to a bursting of equity and real estate bubbles late last century, that country in the 1990s took a similar passive position when dealing with lenders, among other measures.

Wilson noted that the pace of resolving distress hadn't changed much in the past couple years.

"We're in a bit of a paralysis — it's like a slack tide that's not going in or out," he said. "But I don't foresee a change in the current strategy."