Waiting for the other shoe to drop...

What Mark Grinis, Ernst & Young partner and leader of the firm's Distressed Real Estate team, recently described as the "dog days of real estate distress" may be coming to an end. Two stories in the news today clearly suggest that the perfect storm of a U.S. economy on the skids, an increase in commercial loan delinquencies, the weight of maturing commercial loans and the lack of adequate refinancing options, signals a crisis of 1980s proportions is ready to hit the nation's real estate lenders.

A story currently on the Dow Jones Newswire cites several major banks including SunTrust, KeyCorp and Wells Fargo are all reporting or projecting higher nonperforming loan portfolios in their commercial real estate lending operations. Real estate watchers have been "waiting for the other shoe to drop" on distress for more than six months now and it seems we are close to a crisis.

It's not hard to see why. Last week, Moody's reported that commercial real estate values around the U.S. dropped in May and its Commercial Property Price indexes had fallen by more than a third from their peak in October 2007. No wonder then, that buildings of all stripes are being handed back to lenders, even in markets previously considered recession proof -- like New York City. Delinquencies on commercial real estate loans averaged 6.4 percent last quarter, almost double what it was a year earlier and four times the levels witnessed in 2007, according to the Federal Reserve.

In San Francisco, Hines Interests this week confirmed it would hand back the keys to 333 Bush Street after a large law firm and anchor tenant defaulted on its 250,000 square foot lease and filed for bankruptcy and two high profile hotels, the Four Seasons on Market Street and Nob Hill's Stanford Court are reportedly in default. These are likely just the tip of an iceberg that will shake the foundations of real estate markets throughout the country.

However, the damage to the broader U.S. economy is unlikely to be anywhere near as bad as we've already witnessed from the subprime market fiasco since the housing mortgage market is roughly three times bigger than the commercial real estate loan market. And a lot of commercial real estate owners either sold off major assets near the peak in 2007 and are sitting on cash or maintained some discipline and didn't lever up acquisitions with cheap short term debt. Nevertheless, hold on to your hats, it's going to be a bumpy ride for the balance of this year and probably well into next.