The second half of the real-estate debacle was supposed to come in the second of half of 2010. The first part came in 2008, when the value of residential mortgage-backed securities fell hard and fast taking property values down at the same time. That first blow to real estate values was thought to be a harbinger of worse things to come when commercial real estate values started to plummet.

So far, though, the fall in commercial real-estate has been avoided because banks are modifying the property loans to keep from classifying them as non-performing. Commercial real estate developers get a longer maturity or a better-than-market interest rate or both.

The Wall Street Journal reports that some $23.9 billion in non-residential loans had been restructured in the first quarter of this year. That represents more than three times the level of 2009 and seven times the level of 2008.

Banks face a real dilemma. On one hand, if they foreclose on the loan the result will put more property back into a market that is already depressed. On the other hand, if the bank extends the loan is merely hoping that the economy will improve and putting off a final reckoning.

As the WSJ points out, Japanese banks followed this second pattern in the 1990s. When improvement in the economy did not materialize, the country’s economy stagnated and still has not recovered fully.

To make matters worse, the longer a bank holds on to a struggling loan, the longer it will take for the bank to make new loans.

The issue affects small and mid-size banks the most. In May 2009, the WSJ estimated that commercial real estate loan losses could reach $100 billion by the end of this year, and might even total as high as $200 billion.

Research firm Foresight Analytics estimates that banks hold about $176 billion in faltering commercial real-estate loans. The firm also notes that commercial real-estate values are 42% below the peak in October 2007. More than 9% of commercial property loans are delinquent, according to Moody’s. None of these numbers augurs well for the rest of this year.

Commercial property lenders are caught in a ‘damned-if-they-do, damned-if-they-don’t scenario. More restructurings are likely through the rest of this year as banks seek to save their capital from disappearing. That may not be the best approach, but it is likely the least of two evils.

Paul Ausick

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