Is commercial real estate a time bomb?

Mall operator General Growth Properties' bankruptcy is worrisome. But even if commercial real estate weakens further, the market probably won't collapse.

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By Paul R. La Monica, CNNMoney.com editor at large

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If you were a venture capitalist, which field would you invest in this year?
  • Green energy
  • Consumer products
  • IT
  • Financial services
  • Medical technology and pharmaceuticals
  • Nothing; I'd hoard my cash until the economy improves

NEW YORK (CNNMoney.com) -- Bankruptcy is coming to the food court. And that's got to make you wonder if the commercial real estate market is a disaster waiting to happen.

General Growth Properties, the nation's second largest operator of shopping malls, filed for Chapter 11 protection Thursday morning. That makes General Growth (GGP) the biggest retail casualty yet of this recession, a downturn that also led to the bankruptcies of Circuit City, Linens 'N Things and Steve & Barry's.

Several U.S. companies could be affected by this development. According to General Growth's bankruptcy filing, one of the company's largest unsecured creditors is Bank of New York Mellon (BK, Fortune 500) -- although it is listed as a trustee for other creditors.

Another bank listed as having unsecured claims, Delaware-based Wilmington Trust (WL), announced later Thursday that it is serving as a trustee for corporate clients with claims and does not have any direct exposure to the bankruptcy. Retailers Sephora and Borders were also listed as creditors.

As this recession continues to drag on, there are legitimate worries that General Growth could be part of a larger trend.

"Losses in commercial real estate will rise across the financial sector throughout the year," said Keith Hembre, chief economist with First American Funds in Minneapolis. Hembre said that banks have an estimated $1 trillion worth of exposure to commercial real estate.

That's about half as large as exposure to consumer residential loans -- but still a very significant risk for already bruised banks.

The Federal Reserve reported Wednesday in its so-called Beige Book report of economic activity around the country that "commercial real estate investment activity weakened further" since the last Beige Book report in March.

What's more, there were reports by the Fed's regional banks of "more stringent requirements for commercial real estate loans due to worries of worsening loan quality in the sector."

None of that is surprising. After all, as unemployment rises, it stands to reason that corporate tenants would require less space in shopping centers and office buildings.

"Historically, commercial real estate is one of the last areas to experience a downturn," Hembre said. "Employment is the driver that determines occupancy."

However, some investors believe that the commercial real estate market won't wind up completely melting down. For one thing, commercial real estate prices didn't get as out of whack with reality as residential real estate did.

"Things are tough in commercial real estate. Values are declining and are likely to continue to do so for awhile," said Kevin Means, managing partner with Alpha Equity Management, a Hartford, Conn.-based money manager.

"But the reason why it won't be as bad as with mortgages is that residential properties are based on many private decisions of personal home owners who are somewhat driven by emotion," Means added. "There are wider swings in value than what you see with the more disciplined activity in the commercial market. So there wasn't as much of a bubble."

In addition, it's worth pointing out that General Growth's bankruptcy does not come out of the blue. The company has been reeling for months and was widely viewed as one of the weaker real estate investment trusts, or REITs.

Other REITs have been doing a better job of managing their balance sheets. In the past few weeks, mall owner Simon Property Group (SPG), shopping center owners Kimco Realty (KIM) and Equity One (EQY) and warehouse developer ProLogis (PLD, Fortune 500) all took advantage of the stock market's recent rally to successfully sell new shares to the public.

Each company intends to use some of the proceeds from these offerings to pay down debt.

"Companies are not going bankrupt en masse," said Michael Cuggino, president of Pacific Heights Asset Management, a San Francisco-based investment firm that owned Kimco and ProLogis as of year-end. "Some REITs are raising capital when they have the chance and are being proactive about their debt instead of waiting until the last minute."

Hembre agreed that there is a shakeout now taking place in the real estate sector and winners and losers are emerging. So even though the General Growth bankruptcy is certainly a bad sign, it may not be the beginning of a massive wave of real estate bankruptcies.

"Stronger companies have access to capital and will gain market share," he said. "Weaker companies just won't be around for much longer."

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