Joe Franzetti, managing director of debt advisory services at Cohen Financial, Chicago, works with borrowers--commercial real estate owners--and lenders to workout troubled commercial mortgage loans. He discusses distressed assets and future loan defaults in the commercial real estate finance markets.

MBA NEWSLINK: Commercial real estate has been characterized as the next shoe to drop with a "tsunami" of distressed assets and loan defaults on the horizon. Is that your outlook?

JOE FRANZETTI: I think it's unavoidable. Commercial real estate always lags the economy because day-rate type assets always get hit first--hotels and retail where people are showing up everyday is also when they start to feel it. Then, it moves into those longer-leased assets, such as office buildings and warehouses.

We are really starting to see the hotels and the retail sector get hit in the last year, and now it's starting to creep in.

You have two things hitting at the same time, both brought about by the general credit crisis.
 
The first is a general lack of economic activity, which means [landlords] cannot lease space, and they cannot lease it at the rates they should even if they find a tenant. Couple that with the fact that they cannot refinance.

Property values have been impacted by less cash flow and higher cap rates because [property owners] cannot leverage the investment.

NEWSLINK: Is this pattern of falling property values, tight credit and upcoming maturities similar to what we have seen in residential real estate with more foreclosures, or do you foresee a different outcome?

FRANZETTI: That's a great question. I'm not a single-family expert, but on the commercial property side, it is a situation where the lender may, in fact, be better off trying to work with borrowers--assuming it's a good borrower. They can keep borrowers running the property and working toward some common resolution rather than just viewing the asset as a commodity, displacing the borrower and selling it to someone else.

In fact, there may not be somebody else to sell it to because that person cannot get a [commercial real estate] loan.

On the residential side, it might be a little more cut-and-dry in terms of the house as more of a commodity, taking the house over and selling it someone else at a reduced price. At least they can sell it. Commercial assets are not necessarily in that same position.

I believe we are going to find [commercial] lenders more likely to find a resolution with the borrower. There will be a wide range of pain to be experienced by both the borrower and the lender, but they may want to find an amicable solution. People use the term 'kicking the can down the road' rather than foreclosing now and selling [the asset] in this bear market. 

NEWSLINK: Banks with portfolios can do that, but based on pooling and servicing agreements, and assuming special servicers are going to continue their fiduciary duties to bondholders, when can we expect commercial mortgage-backed securities defaults to peak and foreclosures to become an issue?

FRANZETTI: The general opinion floating around among servicers [at the CMSA conference last week] was that 80 percent of all the [CMBS] loans that matured were able to get refinanced. That was supposed to be the good news.

But I looked at it and said 20 percent could not, and that is a pretty big number considering where subordination levels are in commercial mortgage-backed securities.

We are starting to see the problems begin to overwhelm some of the special servicers.

[Servicers] really have to go back and look at the years of origination to figure out when we see most maturities coming due. I figure a year or two from where we actually peak because, as I mentioned, there is that lagging effect.

The economy may, in fact, have bottomed, but by the time [a tenant] says they are not renewing their lease anymore even though they paid [the owner] for the past two years, they are not renewing because the lease expired. So [a borrower] is sitting there with an empty building and the economy has not revved up to where [firms] need new space, then they have a cash flow problem on their hands as well as a potential refinance problem if, in fact, the refinance market does not return.

It is hard to see why the refinance market will return until people can get comfortable with [commercial] mortgage-backed securities again. I think we probably have 18 months to two years before this peaks.

NEWSLINK: What impact do the CMBS loans, in particular, have on the large bank balance sheets and, that being said, do you see them more affected than community or regional banks that might be hit with construction lending?

FRANZETTI: Let's take that in pieces. The stable assets that were historically [past 10 years] financed by the insurance companies or the CMBS market are more stable properties that have run into today's economic problems.

Smaller banks generally tend to have development-type loans, maybe assets that were in lease-up--maybe they received some guarantees, maybe they didn't. The assets tend to be a little bit more transitional.

Then, there were some foreign banks that were doing a lot of construction lending. There was also some construction being done in smaller banks--smaller, local projects.

The way I see it now, the insurance companies are really faced with more refinance problems than they are with pure credit problems in terms of their asset mix. The CMBS market is really faced with a similar situation.

Then, there are the local banks that are really going to be the ones that are wrestling with the fact that a construction project just didn't work. There is probably no need to have the asset in the marketplace, and they don't necessarily have the expertise to build it out.

Those smaller banks that have done some of the riskier, more developmental projects are going to be in trouble with those assets. Couple that with the stress tests that the Treasury put out, and it shows that a lot of these smaller banks were in trouble already.

The smaller banks are going to be hit with some real problems with land loans and construction that have a far greater variability from a risk perspective than there is with the insurance companies or the CMBS market.

Read part two of this interview in Monday's MBA NewsLink. The entire Q&A interview will be in next Thursday's MBA Commercial/Multifamily NewsLink.