by Calculated Risk on 12/22/2008 11:43:00 AM

From Bloomberg: Commercial Loan Defaults May Triple as Rental Income Declines

U.S. commercial properties at risk of default could triple if rental income from office, retail and apartment buildings drops by even 5 percent, a likely possibility given the recession, according to research by New York-based real estate analysts at Reis Inc.

Lenders that used optimistic rent estimates to grant mortgages beginning in 2005 stand to lose as much as $23.1 billion, or 7.02 percent, of total unpaid balances if landlords lose 5 percent of net operating income, according to Reis. ...

[O]ffice vacancies are forecast to rise to 15.6 percent next year from an estimated 14.6 percent at the end of 2008. ...

At the end of Q3, REIS reported office vacancy rates hit 13.6% (see WSJ: Office Space Is Emptying Out). Clearly REIS expects a significant increase in the vacancy rate in Q4 2008 (to 14.6%), and then a further increase in 2009 to 15.6%. Although that 2009 projection might be low ...

Click on graph for larger image in new window.

This graph shows the office vacancy rate vs. the quarterly unemployment rate and recessions (hat tip Will)

Changes in the unemployment rate and the office vacancy rate are highly correlated. As the unemployment rate continues to rise over the next year or more, I'd expect the office vacancy rate to rise sharply - possible to 17% or more by the end of 2009 (significantly higher than the REIS forecast).

REIS believes the rise in defaults will primarily because of the overly optimistic projections used when properties were purchased in recent years:

“A large decline in net operating income isn’t necessary to shift a lot of properties underlying CMBS loans into debt- service coverage ratios that would be worrisome,” [Victor Calanog, REIS director of research] said in an interview.
...
Over the last three years, lenders raised income projections for commercial properties by as much as 15 percent more than those properties’ historical performance, he said.

“That optimism might not be warranted,” Calanog said. “There’s a big pool of loans underwritten in 2005 and 2006 coming due in 2010 and 2011 that I believe will experience a rise in delinquencies and defaults.”

Loans from those years assumed strong growth in rents, a scenario that seems unlikely as the recession deepens, Calanog said.

As I've noted several times, many existing properties were recently purchased at prices that were based on overly optimistic pro forma income projections. These loans typically included reserves to pay interest until rents increased (like a negatively amortizing option ARM), and it is likely that many of these deals will blow up when the interest reserve is depleted - probably in the 2009-2010 period.