Commercial real estate market trails residential in recovery

The Twin Cities commercial real estate market is in a weak state concludes the Federal Reserve Board's latest survey of economic activity, called the Beige Book.

The report, released Wednesday afternoon, said while the Twin Cities residential real estate picture has some bright spots, the commercial side is still in a funk.

As part of his work at the Minneapolis Fed, economist Toby Madden checks in around the bank's upper midwest region, chatting up business contacts, asking them for their take on the economy, which he reports in the Beige Book.

Based on the gloom at one of Madden's recent appearances in the Twin Cities, it's no surprise that this region's entry in the Beige Book paints commercial real estate as weak.

Last month, Madden addressed a couple hundred real estate owners and brokers at a conference in Minnetonka. The audience sat poker-faced, sipping their morning coffee, which did not seem to pep them up.

Madden asked who in the audience thought commercial real estate prices would go up a year from now. No one raised a hand.

The industry's grim outlook is making some federal regulators nervous. FDIC chair Sheila Bair said bad commercial real estate loans are a growing threat to banks.

By many accounts, commercial real estate, like residential real estate, got to be overpriced in the past few years. And as with the residential market, commercial real estate buyers had easy access to credit, so they were able to buy the properties despite the high prices.

The residential market crashed, but these days, the market appears to be recovering. That's not the case for commercial real estate.

"We're probably halfway down, and we probably won't hit the bottom until the fourth quarter of next year," Mark Reiling of Collier Turley Martin Tucker's commercial real estate services division, said.

Reiling said commercial real estate lags other economic activities in a downturn.

As companies shed workers, they don't need as much space. With manufacturing down, warehouses store less stuff and sit empty. As consumers hold back on spending, retailers idle their stores, but it's hard for them to get out of lease obligations quickly.

"So we're still in the process of space being shed," Reiling said. "That will continue to occur for the next year and a half or so."

Vacancies are surging. Mike Ohmes, the executive vice president of brokerage services at Northmarq in Bloomington, said in the first six months of the year, commercial vacancies grew by about 4 million square feet.

"That for us is really unprecedented," Ohmes said. "We've never seen a six-month period of time, in the fifteen years we've been tracking statistics here in the Twin Cities, where we had that much space become vacant in a six month period of time."

Ohmes said Twin Cities vacancies have increased across all property types. The office market is at 18 percent, compared to a healthy market of 10 percent. The retail vacancy is at 8.5 percent, the highest it's been in 14 years.

The owner of Woodbury Lakes, a mall in Woodbury, went into foreclosure last month, and it may be because there are a number of vacant storefronts within the mall's property. Those vacancies make it hard for owners to pay their bills, sometimes they have to turn the properties back over to the lenders.

So far, the number of problem commercial mortgages in the Twin Cities is about average compared to the rest of the country. But delinquencies are on the rise nationally, and delinquencies can lead to foreclosures.

Mike Ohmes at Northmarq said those numbers could spike even more because of another thorny issue: many businesses find credit is tight when they need a new mortgage.

"If they can't find a replacement loan, they're between a rock and a hard place," he said.

Unlike residential mortgages, commercial real estate mortgages come due after 5-10 years. At that time, a borrower typically renews the loan, but that's getting harder as lenders clamp down to protect their own finances. "I think [what] is going to be the big wild card is how much commercial income property is going to be foreclosed because of maturing loans," said Terry Kriesel, head of commercial real estate for Bremer Bank, based in St. Paul.

Kriesel said, when commercial real estate loans come due, Bremer tries to work with borrowers to extend the loans. However, his bank is being more cautious about commercial real estate loans. He said this year's loan volumes are down about 30 percent from last year, partly because regulators are scrutinizing banks so closely.

"The regulatory agencies that rule over commercial banks have determined that commercial real estate in general is a higher risk industry than other types of commercial loans," Kriesel said. "So there is some hesitancy from commercial banks to lend on commercial real estate because of the regulatory factor that looms over the industry quite frankly."

A recent survey of senior loan officers conducted by the Fed indicated that a greater number of lenders are tightening lending standards for commercial real estate loans than for most other loan categories.

Many experts say the bank regulators have good reason to worry. Minnesota state economist Tom Stinson said if commercial real estate loan losses start to pile up, that will harm banks and keep credit tight for everyone.

"It affects individuals, households, businesses borrowing to buy new materials," Stinson said. "So it's a much broader concern."

If that happens, Stinson said, the economic recovery, which is already expected to play out slowly, could take even longer.

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