The economic recession has taken a severe toll on the commercial real estate market. The loss of almost 8.3 million jobs since the onset of the recession has led to higher vacancy rates across all classes of commercial property. As a result, rents have dropped. The lower cash flows from commercial real estate have contributed to the decline in commercial real estate prices. The value of commercial properties is down 40 percent from their 2007 high.
A worrisome problem facing the commercial real estate market is that $1.4 trillion in commercial mortgages and construction and land development loans are scheduled to mature between 2010 and 2013. The decline in property values has caused loan-to-value ratios to soar. Due to stresses in the commercial real estate market, lenders have become more conservative in their underwriting standards.
The decline in commercial real estate prices coupled with lower loan-to-value ratios have increased the size of the recapitalization gap facing owners of properties that have maturing mortgages. The following example illustrates the recap gap financing problem.
Assume when the commercial mortgage was originated the price of the property was $100 million and the loan-to-value ratio was 70 percent. The owner would have to come up with $30 million in equity and could finance the remaining $70 million.
Now assume property values have fallen by 25 percent. This property is worth $75 million. The owner of the property has $5 million in equity. Additionally, lenders have tightened their underwriting standards by lowering the loan-to-value ratio to 60 percent. This means the owner of the property can only finance $45 million through debt. The recapitalization gap is $25 million. This is the amount of money that the owner needs to come up with to refinance the commercial mortgage.
The worry is that some owners of commercial real estate have been so battered by this recession that they don’t have the equity to put.
The National Association of Real Estate Investment Trust is estimating that the aggregate recapitalization gap for all commercial mortgages was an estimated $1.2 trillion at the end of 2009.
(Graph Concept Attribution: CB Richard Ellis, Annual Trends Report 2010.)