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News reports in the last few days indicate that small Lackawanna County banks are increasing reserves for potential failed commercial loans. This should come as no surprise as banks around the country have already, or will in the near future experience increased default on commercial loans.

The reasons are complex but understandable. Commercial real estate is frequently purchased using a fifteen or twenty year payback plan (amortization schedule.) However, built into that is usually a reset of the interest rate and review of the performance of the real estate pledged for the loan, typically every five years.

With the general level of business down, commercial businesses have been hurt. Locally, retail is the hardest hit, with manufacturing second, office rental third and apartment rental the least.

In a typical downtown office building, we might find shops on the first floor and offices above. Most landlords are experiencing higher vacancy retail and reduced office rental. Firms may be reducing the size of rented offices, or moving to lower priced space or lower priced properties. The result is less income for the landlord. At the same time, the landlords may be experiencing increased costs. The PPL electric rate increase is a good example. Rates will increase by about 30% on January 1. Total electric buildings will be hit particularly hard. At the same time, tenants will be reluctant to accept rent increases, even those that are clearly justifiable.

When the bank does its five year review, income may be down and expenses may be up. Commercial real estate is valued on the amount of money left after all the bills are paid, called net income. A reduced net income means the property is worth less than before. National figures are as high as 50% less. Local values are probably not as dramatic.

However, whatever the change, a bank may be wary to renew the loan on the same terms when the asset securing the loan has diminished in value. Problems are particularly acute when the owner has borrowed a substantial amount of the value of the property (called highly leveraged or aggressively leveraged in real estate terminology).

Assume we have a property originally appraised at $1,000,000. The owner aggressively leveraged the building and borrowed $900,000, putting $100,000 down. At the five year review, the principal has been reduced by $50,000 leaving a balance of $850,000. The landlord’s net income declined by 10% and as a result, the building is only worth $900,000. In additional to the decrease in value, the bank is currently taking a more conservative approach to lending and will only loan 60% of value rather than the 90%. In this case, the bank might renew the loan at $540,000 forcing the landlord to put up an additional $310,000 of cash or collateral If he has the cash or collateral, he can survive but if not, foreclosure is around the corner. In extreme cases, owners have simply given the keys to the bank.

As a renter, you may find this scenario academically interesting but unrelated to your situation. So what if the landlord defaults? First, all leases are null and void in a foreclosure. So let us assume you just made substantial improvements to your office and the current landlord, who was happy to have a tenant at all, gave you a break on the rent for the next five years in exchange for your investment. The bank or new owner arrives after the foreclosure, sees your beautiful office and low rent and gives you a whopping rent increase.

The lesson is to “choose carefully.” Select a landlord who has a record of success and one whom you know to be a conservative, substantial owner. Avoid doing business with those who are “on the edge.”

downtown

Justin Bullaro was one of the subjects of an article in the October issue of Happenings Magazine. Like many members of the MEI maintenance staff, Justin is a graduate of the Lackawanna County Vocational Technical School. The article discusses his decision to follow his career path in Northeastern Pennsylvania rather than seek employment elsewhere.

An unsolicited letter from a MEI tenant appeared in the November edition of Happenings and is reproduced below.

Dear Happenings:
I can’t tell you how happy we were to see Justin Bullaro featured in your “Meet the Keepers” (October 2009) copy story and article. Justin is not only worth his weight in gold here at the Scranton Professional Arts Building but he is genuinely a great guy. Thank you for the great article… we love Happenings!.
Kathy Colombo Lackawanna Valley Dermatology Associates

Louis Danzico, president of Management Enterprises, has written a recently available whitepaper called “Housing the New Elderly: renovating Geneva House, an apartment building for the aged,” published in the Journal of Property Management and now available from Amazon.com.

This digital document is an article from Journal of Property Management, published by Institute of Real Estate Management on July 1, 1992. The length of the article is 2,069 words. The page length shown above is based on a typical 300-word page. The article is delivered in HTML format and is available in your Amazon.com Digital Locker immediately after purchase. You can view it with any web browser.

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