Causes and effects: a downturn may be looming for L.A.'s commercial real estate market.

WITH the collapse of the subprime mortgage market, lack of liquidity in the mortgage-backed securities market and lenders continuing to crack down on what they see as risky lending practices in commercial real estate, the pendulum has clearly swung to the conservative side.

Low interest rates and an abundance of money have led to great times for buyers and sellers of office buildings, hotels and other income-producing property. Buildings have traded at record prices and loan terms have become increasingly generous with many buyers putting little or no money into the deals.

'TWO VIEWS

These two commentaries were written for the Business Journal on the outlook for L.A.'s residential and commercial real estate markets.

Like residential loans, commercial mortgages are pooled and packaged into bonds that are sliced into portions carrying different degrees of risk. According to rating agencies, there were nearly $770 billion in commercial mortgage-backed securities at the end of last year, representing approximately 28 percent of all outstanding commercial mortgages with the remainder being held by banks or institutions on their balance sheets.

Unlike the residential real estate market, I don't expect as dramatic of a turndown in commercial real estate values. Nevertheless, there is reason for concern.

As concerns are looming about the state of the economy, many reports are now suggesting that commercial rents will begin to drop as demand for commercial real estate diminishes because of problems in the housing market and the overall economy.

Neither the possibility of a slowdown nor the warnings about lax underwriting standards have led anyone to predict an imminent catastrophe in commercial real estate. The default rate for commercial mortgage-backed securities remains quite low and is not expected to increase appreciably in the near future. In fact, the delinquency rate for commercial mortgage bonds is still at the lowest levels since its delinquency index was created in 1999.

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However, as was the case in the overheated residential mortgage market, many loans for commercial transactions have interestonly payments with very little reserves set aside by borrowers for reserves to cover taxes, insurance, improvements and other costs if things go wrong, and are based on projections for rent growth that is now clearly too optimistic.

While many borrowers took advantage of the aggressive lending practices with short-term investment objectives, the more sophisticated long-term investors were much more conservative in the loans they took on. Those who took the more aggressive financing options will face severe problems if the econ omy continues to slow. They will not be able to refinance their mortgages because they borrowed more than what their property can currently service with today's more conservative lending guidelines.

In fact, many may be faced with foreclosure due to their inability to refinance since they can't generate sufficient income to service their existing loans and property expenses.

Spreading crisis

Two years ago, I began advising clients that if things continued at an aggressive pace, the commercial mortgage market would suffer significantly as common-sense underwriting was ignored. Now we are seeing the liquidity crisis spread across all areas of the marketplace. There is still an abundance of liquidity in the market for commercial loans that are underwritten properly and make sense.

Overall, the economic signs clearly suggest a mild recession has already begun and I expect a minimum of 24 months before we see a recovery.

While lending practices have become more prudent, the availability of commercial financing is still available in the market through banks, insurance companies and institutional investors who are using a more conservative approach to lending.

Pricing adjustments will certainly continue to take place as the same property will now qualify for a smaller loan than just six months ago. Lower loan amounts will force buyers to make larger down payments. At the same time, we may see sellers reducing their prices.

The number of sellers will increase as many speculative buyers that purchased for a quick sale realize that they cannot continue to carry the property and the gains they were expecting would not be materializing for some time to come. Furthermore, as inventory of property for sale grows, sellers will begin to reduce their prices to entice buyers. Prudent financing and planning are critical in protecting your assets to ensure long-term prosperity and just like the all you can eat buffet, self-control and discipline are tantamount to a good experience.

Jacob Yadegar is chief executive of Empyrean Funding, a Los Angeles company that specializes in commercial real estate financing.