The commercial crisis and what you can do about it

We keep hearing about an upcoming commercial crisis (it's here now). What is this all about? It has to do with the owner's mortgages and the inability to refinance debt when it becomes due. Over the next three years approximately $530 billion dollars of debt needs to be paid off or refinanced. Owners who want to refinance their mortgages may not be able to do so. Not because they missed any mortgage payments, not because they do not have sufficient cash flow to pay their annual debt service, but because the value of their building has diminished and the banks regulators are following Fair Value mark-to-market Accounting Rules. For example: five years ago Mr. Smith bought a building for $1 million. At the time the building was valued using the "Income Approach" and CAP Rates were 10%; the NOI on the building was $100,000. A down payment of 25% was required and $750,000 was financed. The mortgage was amortized over 20 years, 7.5% interest with a 5 year balloon. The balloon is now due; the outstanding loan amount is now $650,000. Mr. Smith figured that when the balloon mortgage became due he would just refinance. Property values have gone down about 20% so his building today is worth $800,000. Under mark-to-market accounting rules "comps" (what other buildings have actually sold for) are used to determine today's value. Underwriting at banks has become more conservative and today they want a minimum of 30% down or a loan-to value ratio of 70%. Meaning the maximum loan they will make on this building now is $560,000 (70% of $800,000). Assuming he does refinance for the $560,000 available, Mr. Smith then has to come up with $90,000 cash in order to satisfy the current note due of $650,000 or default on his loan. Even though Mr. Smith may still have $100,000 NOI and sufficient cash flow to pay a higher loan; the mark-to-market accounting system is guiding the underwriting thinking of most banks. This simple example shows what is looming on the horizon for many landlords with substantial mortgages on their property. Historically commercial mortgage loans are grouped together to create CMBS - Commercial Mortgage Backed Securities. These are then packaged into bonds and sold to investors. There is much concern regarding if they will they have future value or default? This question is reflected in this statistic: in 2007 there were $230 billion dollars in CMBS being marketed; in 2008 there were only $12 billion dollars in CMBS created; in 2009 that security is practically non-existent. The government is focused on these problems. They have created the PPIP - Public-Private Investment Program to encourage investment to buy-up commercial loans. We have a new IRS rule, thanks largely in part to lobbying efforts by the National Association of Realtors. It now allows the commercial real estate borrower to discuss possible modification of loans that are at risk of default without triggering tax penalties. This applies to REMIC, loans placed in Real Estate Mortgage Investment Conduit structures. Which is about 60% of all commercial loans. Commercial loan refinancing is a big problem with over a Trillion Dollars that must be refinanced by 2012. We know values are down, vacancy rates are up and landlords are struggling. On the positive side this creates competition and gives tenants some great opportunities. This market also creates great opportunities for real estate brokers. Businesses are still growing or shrinking, leases expire; there is activity in the market. Some buildings may have to be sold and investors are looking for good deals. Edward Smith, RECS, is the Long Island metro regional director of Coldwell Banker Commercial NRT, Eastport, N.Y.