The next shoe to drop in the mortgage and credit crunch saga will be commercial real estate.

WASHINGTON - One of the troubling features of the U.S. subprime mortgage mess is the number of times experts have insisted the worst is over.

First, we were told the housing slump had bottomed out. Not.

Then, we were assured that subprime mortgage problems were contained and wouldn't affect banks and brokers. Wrong again.

And what about the experts who pointed out that housing is only a small piece of the economy, leaving the mighty consumer unscathed? Logic suggests this hypothesis is also flawed. Several major retailers, including Starbucks and J.C. Penney, are now sounding the alarm about future sales.

Now some economists are taking comfort in the notion that no matter how bad it gets in residential real estate, the commercial side of the business is still healthy.
Well, maybe not so much.

There are disturbing signs that the commercial real estate market may be headed for a repeat of the crash that rocked housing.

The same factors that got housing lenders into trouble are rampant in commercial real estate: poor underwriting standards, loose lending to marginal projects and reckless, interest-only, minimal-equity loans, according to Nouriel Roubini, a New York University economist who was among the early voices of doom about the subprime fallout.

"The next shoe to drop in the mortgage and credit crunch saga will be commercial real estate," Mr. Roubini ominously predicted last week in his popular blog. "The bubble in commercial real estate construction, like the bubble in residential construction will soon turn into a painful bust."

Data on the commercial market isn't as extensive as it is on the residential side. But there are some clear warning signs.

Most worrying: Prices have apparently peaked after a five-year boom, putting stress on lenders and borrowers alike.

The value of U.S. commercial real estate owned by big pension funds fell 2.5 per cent in the third quarter of 2007, according to an index released last week by the Massachusetts Institute of Technology's Center for Real Estate.

The index provides the first hint that weakness in the housing market is spilling over into commercial real estate, MIT's David Geltner said.

"The fall in our index is the first solid, quantitative evidence that the subprime mortgage debacle, which hit the broader capital markets in August, may be spreading to the commercial property markets," he said.

The index's quarterly decline is the first in four years and the largest reversal since the fourth quarter of 2001, when the economy seized up after the Sept. 11 terrorist attacks.

Commercial real estate typically follows the housing market. So as subdivision "ghost towns" pop up around overbuilt cities such as Las Vegas, San Diego and Phoenix, logic suggests the commercial and office complexes that normally follow these developments will also falter.

"If the towns are empty, the stores and malls and offices will be empty, too," said Mr. Roubini, a former senior adviser to the White House Council of Economic Advisers and the U.S. Treasury Department. Recent trends in business investment similarly point to less demand for factory and warehouse space, he added.

If all that isn't worrying enough, there's evidence that lenders are overstretched. Commercial real estate loans represented a precariously high ratio of 118 per cent of underlying real estate values in the third quarter, according to a recent Moody's report.

Many U.S. cities are still dotted with construction cranes. But when the current pipeline of projects dries up, financing may evaporate. The value of commercial mortgage-backed securities - the bonds that underpin most commercial loans - tumbled 84 per cent to $6.3-billion (U.S.) between March and October.
Mr. Roubini estimates that falling commercial prices could eventually open up a $100-billion to $150-billion crater of bad loans for banks.

That's not as large as the banks' exposure to soured home loans, but it would weigh heavily on an already-stressed banking industry, causing lenders to further restrict credit.

"The coming bust of commercial real estate will lead to another round of massive losses for the banks who made these loans and the investors who bought these toxic mortgages," he warned. "The financial markets massacre is just starting and a generalized liquidity and credit crunch will become full-blown in the next few months."

Early reassurances from the likes of U.S. Federal Reserve Board chief Ben Bernanke and countless Wall Street luminaries have proven pretty unreliable So maybe it's time to pay attention to some of the darker voices out there - just to be on the safe side.

From Tuesday Nov 20, 2007 Globe and Mail