(Ed.: This article originally appeared in the July 31 "Weekly Insight" column of EWI's intensive Currency and Interest Rates Specialty Services.)

"The worst thing about real estate is its lack of liquidity during a bear market." Robert Prechter, Conquer the Crash, Chapter 16.

Large commercial buildings are illiquid. This is especially true during an economic contraction and credit crunch. The commercial real estate market is twice the size of the total U.S. stock market, so its problems are too large to ignore. They include:

1.Lower Prices. The commercial real estate market didn’t top until late 2007, about a year and a half AFTER the top in residential real estate prices. But, since the top, prices are now down close to the same percentage, as the chart shows. During May and June commercial real estate prices have fallen 16%!

2.Financing Trouble. Almost 40% of the financing for retail, industrial and office space flowed through the securitization market. The securitization market has largely been shut down, effectively turning off liquidity for purchases and refinancing. As a result, in the first quarter of 2009 the delinquency rate on commercial properties rose 43%, and sales volume in the US fell 83% year-over-year in the second quarter of 2009.

3.Rising Supply. General Growth Properties, the second-largest shopping mall owner in the country, became the first large-scale bankruptcy in April. Vacancy rates are at a 20-year high, which is putting additional downward pressure on prices and rents.

Is it any wonder that commercial real estate lenders want to delay recognizing bad commercial real estate loans considering their paper-thin capital levels? The leverage on banks’ balance sheets remains astonishingly high. For perspective, in the first half of last century, banks were required to hold 18 cents for every dollar of loans, or only 5.5 times leverage. Today big banks, on average, have only 4.2 cents of equity for every dollar of exposure. These capital levels are still so thin that a new wave of commercial defaults could require further capital-raising or larger government bailouts.

Many loans that lenders hold on commercial property are classified as “whole loans,” so it behooves the banks to keep them out of foreclosure. A “whole loan” is carried on the banks’ books at par until it actually enters the foreclosure process. But, because the prices of properties have fallen so far, the underlying collateral is now likely to be less than the banks’ exposure should the loans sour. As a result, banks are attempting to delay foreclosures by modifying commercial real estate loans through interest rate reductions. Unlike the residential market, commercial properties have multiple tenants, so there’s at least some cash flow coming in. This cash flow is one reason banks are willing to modify troubled commercial loans. This stalling suggests that there are significant unrecognized commercial real estate losses currently hidden on banks’ balance sheets.

The new consumer frugality is wreaking havoc on real estate and therefore on banks. Real estate investment trust (REIT) investors would do well to recall Bob Prechter's comment regarding REITs from At the Crest of the Tidal Wave: “In 1974, some REITs that had topped out two years earlier could be bought for 40 cents on the dollar.”

Now is the time to prepare for the devastating impact on commercial real estate and financial institutions by saving your bullets to shoot when prices are much lower than they are now. Don't get impatient. Fortunes will be made before this deflationary cycle is finished.