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Waiting for the “Other Shoe” to Drop: Will the Predicted Wave of Commercial Loan Defaults Actually Happen?

During the worse of the financial turmoil last year, there was a widespread consensus opinion among many financial experts that a massive wave of commercial loan defaults was inevitable. Based on previous experience, it appeared likely that the huge wave of defaults and foreclosures already happening in the residential real estate markets would be followed by a similar collapse in commercial real estate. After all, that had typically been the pattern in previous downturns. I even published an issue of this newsletter last August predicting that it would happen.

Now after a year of watching and waiting for that “other shoe to drop” the time has come for a reassessment of the situation. There has certainly been a higher than normal level of defaults in the more than $2.5 trillion of commercial real estate debt coming to maturity over the past year. As predicted, the very tight banking environment has made it difficult for most landlords to re-finance these loans. However, we have not yet experienced that widespread “spiraling downward” effect where a runaway number of defaults forces tighter credit conditions, thereby spurring an even larger number of defaults.

The default rate on all commercial mortgages is still expected to more than double to a peak of 5.5 percent by the end of this year, but many experts had previously been forecasting that commercial loan defaults could hit 10 percent by the end of 2010.

Although it’s tempting to just breathe a sigh of relief and assume that we’ve dodged the bullet; it’s a whole lot smarter to take a closer look and understand what’s happening so that we can decide on the best course of action going forward.

First, from a macro economic standpoint, it appears the global financial markets have generally “avoided” the complete meltdown that was envisioned at the height of the panic. On the other hand, while the banking system has apparently been stabilized and interest rates continue at record low levels, we certainly aren’t seeing a return to a normalized lending market yet.

Of course, the commercial real estate market is still far from healthy. After a 90% drop off in total transactions, from $557 billion in 2007 to $54 billion in 2009, the market can’t be expected to just bounce back to robust growth. But it’s also pretty evident that we’ve found the bottom from which the commercial market can start slowly rebuilding. It won’t be a “V” shaped recovery, but lenders are at least feeling like they can probably now ride out the horizontal leg of an “L” shaped recovery over some extended period of time.

The stabilizing of financial market confidence has also given bankers a bit more leeway in how they can work with landlords as their existing mortgages come to maturity. In addition, landlords are not as highly leveraged compared with the last recession. Those landlords who can’t pass lenders’ due diligence tests are still going to end up defaulting and losing their properties but, in a growing number of cases, banks are modifying near term debt maturations with short term loan extensions. For the banks this “extend and pretend” approach has the benefit of maintaining continuity for the landlords over a finite period of time; thereby avoiding foreclosure actions that would force the bankers to write off the loans and either operate the properties or unload them in the face of a down market.

Given a new chance in which success depends on relatively short-term performance, many landlords have now become very focused on occupancy rates. As properties are slowly becoming stabilized, driving up occupancy is a landlord’s primary consideration, which means tenants are gaining additional leverage to cut a favorable deal.

From a tenant’s perspective, it is important to conduct their own due diligence to make sure that the landlord is on solid footing. Signing a multi-year lease in a highly leveraged building that is riding on thin ice could be a disaster for tenants. First, do the necessary research or ask your advisor about the landlord’s financial position and the capital structure for the prospective property. A landlord holding a troubled asset may downgrade the operation and maintenance of the building to conserve cash or they may not follow-through on tenant improvement commitments.

However, when a landlord has just obtained a loan extension and needs to drive up occupancy, tenants can definitely take advantage of the window of opportunity. Under these circumstances, credit worthy tenants can gain significant leverage in the lease agreement. For example, published rental rates typically have negotiating room, in addition to free rent and other concessions in order to secure rent payers.

As always, the bottom line in lease negotiations is to first do your homework in order to fully understand the motivations and limitations that define the landlord’s position; then to leverage that information to your best advantage. Since it appears that “the other shoe” did not drop entirely and destroy the commercial real estate market, surviving landlords must now find their way forward by improving their occupancy levels. Even though it didn’t drop, the shoe is “now on the other foot” and it’s giving savvy tenants additional negotiating strength to drive the best deal.

Scot Ginsburg is a senior vice president of Hughes Marino, an award-winning commercial real estate company specializing in tenant representation and building purchases with offices across the nation. Contact Scot at 1-844-662-6635 or scot.ginsburg@hughesmarino.com to learn more.

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