Are ‘zombie buildings’ the next economic calamity?

Introduction

While the overall U.S. financial system is showing signs of stability, a rapidly rising tide of troubled loans for commercial real estate threatens the survival of hundreds of the nation’s small and medium-sized banks.

Financial reports this month from federal regulators and industry analysts detail a new cycle of uncertainty that they fear could cripple the economic recovery. Billions of dollars in commercial debt will have to be paid back or refinanced at a time when property values have plummeted. About $500 billion will come due in 2010 alone and an equal amount every year through at least 2012, according to the Federal Reserve.

Many banks that cater to regional and community developments were largely unscathed by the residential mortgage meltdown. But now they are facing huge numbers of possible defaults by builders who erected thousands of office towers, condominiums and shopping centers with the easy credit available five years ago. With few tenants, those developments are turning into what industry insiders call zombie buildings.

Commercial real estate loans generally have terms of five to seven years. Many of the loans issued at the height of the credit bubble are coming due. By mid-November, $150 billion worth of commercial properties, about 7,500 in total, were in distress, according to Real Capital Analytics Research Inc.

Next year “looks like an unavoidable bloodbath for a multitude of ‘zombie’ borrowers, investors and lenders” and the shakeout could continue for “several years,” says a recent report by PriceWaterhouseCoopers and the Urban Land Institute drawn from confidential interviews with industry experts.

Stephen Blank, a principal researcher for the report, said that regional and smaller banks that made the loans are bracing for big losses that could overwhelm their resources.

“The number on the street – what we hear – is that as many as 400 banks might fail before this is over,” Blank said in an interview.

As of mid-November, 123 banks had failed this year, largely split open by commercial debt. More than 400 banks now are on a problem list maintained by the Federal Deposit Insurance Corp.

Industry analysts, such as the Real Estate Roundtable trade group, point out that a sick commercial market hurts any hope for recovery. Local government revenues suffer. Construction jobs — and all sorts of ancillary jobs — disappear. Retirement funds are vulnerable.

In recent Capitol Hill testimony, Roundtable President Jeffrey D. DeBoer pointed out that “a growing number of Americans have a stake in commercial property” because of their investments in pension plans, 401(k) plans and direct investments in real estate investment trusts. He estimated that $160 billion of retirement savings are invested in commercial real estate.

In October, federal regulators issued a statement encouraging banks to work with borrowers to extend loans, rather than call them in. The federal government is also trying to entice investors to buy back bonds based on commercial mortgages through a government-run emergency fund aimed at salvaging the credit market.

Despite those efforts, the banks’ problems are continuing to grow, said Michael Stevens, senior vice president for regulatory policy at the Conference of State Bank Supervisors.

“It’s not the next big thing. It is the big thing,” Stevens said. “We’re dealing with it right now. We wouldn’t be at 120 bank failures if we weren’t seeing it now.”