Commercial Real Estate Bubble Is Set to Burst

During the work day I usually keep CNBC on to see if the talking heads are doing something entertaining on any given day. Usually I keep the volume low or muted until a story or person of interest pops up.

As the latter hours of the morning were coming to a close the CNBC “Real Estate Task Force” with Re/Max CEO Margaret Kelly and Charles Cohen from Cohen Brothers Realty popped up. I figured on my way out to lunch I would at least give this motley crew a few seconds of my time. I didn’t listen to the whole thing when I started to realize that lending a few seconds of my time was turning into destroying a few points of my IQ. Lucky for us it didn’t take long into the segment before Diana Olick began to spew pure comical economic ignorance out of her mouth.

Olick was quoted as saying, “We thought that commercial [real estate] was going to do far better because the theory was that commercial didn’t overbuild the way that residential real estate did.”

Here’s a link to the full clip.

Maybe we should give her some credit. It takes real fortitude to go on cable television and show the world your inability to process even the most basic notions.

The notion that commercial real estate wasn’t overbuilt in the same sense that residential real estate was is simply wrong. The commercial sector was overbuilt BECAUSE residential was overbuilt. Diana Olick points this out herself later in the clip. I would think it’s pretty hard to contradict yourself in one 5 minute TV clip.

The artificial growth in the housing sector created a pile of excess liquidity in the consumer’s hands. Rising housing prices gave the “something for nothing” crowd the ability to use the growing home equity as a 4 bedroom 2 bathroom credit card. The money was used to make mortgage payments, eat at fancy restaurants, get that new car, and buy everything else you can imagine. As the pile of liquidity grew, the commercial real estate sector followed suit in order to service the fake wealth.

Like all things that were the result of the artificial Keynesian policies that have been running our nation, the party stopped and the hangover is settling in. Except in this case, all the hydration and Tylenol in the world can’t help.

Commercial Real Estate Now

Many regions around the world are already dealing with commercial vacancies of 15-20%. The suburb of Minnesota in which I live was little more than a McDonalds, grocery store and gas station in the late 80’s. A couple of years back, that same suburb surpassed the Mall of America as the largest conglomerate of shopping and eating facilities in the state (not to be confused with the largest mall in MN; MoA still holds that title). After snatching their #1 ranking, the place where I make my home didn’t stop. The kept building with the last of the mini malls being finished in 2008. Now, vacancy rates in the commercial sector have risen significantly with the most recent developments sitting up to 80% empty. Adding to the fire was the closing of Circuit City and Linens-n-Things, both of which had stores in my hometown.

This particular city is a text book example of the boom and bust caused by the housing cycle. The people who live there are rather comical (hopefully not me) as the stay at home moms drove around in their leased Escalades that their husbands never should have been able to afford in the first place. I digress, because there are some good lessons that can be learned here.

As mentioned, the commercial real estate sector was built to service Greenspan’s bubble. On that intuition, the blame for this particular bubble can also be attributed to Easy Al’s policies. Just one of many I guess. Another aspect to note is the effect that corporate bankruptcies have on the market for commercial real estate. In my hometown, when Circuit City and Linens-n-Things went bankrupt, more supply was added to an already bad situation. This will continue to be a reoccurring theme with not just large corporations, but the mom and pops are having a rough go of things as well.

Many are making claims that this is going to be the equivalent of the collapse in residential housing. Although there will be many similarities, the collapse in the commercial real estate bubble will be a beast of different nature.

Commercial vs Residential

Currently there are about $3.7 trillion in outstanding commercial real estate backed loans. Up until now, a very limited number of these loans have reached maturity. The amount of debt reaching maturity will start to pick up at the end of 2009 and greatly accelerate into 2010 and 2011. I imagine that this will create a sort of refinancing crisis in which the timing couldn’t be worse. Liquidity and willing lenders simply won’t exist.

Also, the process in which this plays out will be much simpler than the residential bubble. Store owners are receiving less revenue as a result of the collapse in consumer spending. Soon the owners will be bankrupt and no longer able to pay their leases. The contracts will be broken. After enough broken contracts and the inability to fill empty space takes grip, property owners will no longer be able to pay their mortgages. There’s no predatory lending, and although the asset backed paper behind the commercial sector has been grossly overpriced, it wasn’t chopped up and repackaged nearly to the extent of residential MBSs. The losses will be just as real, but the timing in which it takes to sort the mess out should be less.

Liabilities of the bubble are also slightly different than that seen in the residential sector. The typical candidates were still involved. Leading the way are the insurance companies, hedge funds, and banks. The difference lies in the last culprit. The investment banks definitely partook in the financing of the commercial real estate bubble, but Wall Street financed the highest quality commercial operations. This time it was the regional banks who have taken on the riskiest assets. One of the main reasons the regionals put themselves in this position is because they financed these local projects, many of which were their own customers. Regardless, their balance sheets are going to have a really tough time absorbing the losses. For that reason, several short investment opportunities will present themselves as a result of the commercial real estate bubble.

Disclosures: None

Comments

[Fred Voetsch:]

Ah, I love this type of thinking. Staring with a simple premise and following it through to its logical conclusion without and whitewashing of the facts. A great article!

Excess is pretty much EVERYWHERE in our society right down to the time we waste in front of the boob tube watching inane TV shows or playing video games or sending porn (sexting) back and forth on our glitzy cell phones.

We are coming out of the biggest era of excess in human history and the very nature of excess suggest that we will not react well to its challenges. We are fat and lazy and to those who are not go the prizes.

Feb 08 03:11 PM

[Abasin123:]

I have to agree. The market is overbuilt and vacancy rates are creeping up across the nation. CAP rates are up from 6% to 9% for good reason - resulting in a decline in values.

To compound the problem and further deteriorate values banks started puuling back hard a year ago on commercial real estate.

As a commercial lender I can tell you that the FDIC in its 2008 exams asked virtually all commercial banks to lower their loan exposure to investment commercial real estate (non owner occupied commercial real estate) to a level not exeeding 100% of their Tier 1 capital level. In other words a commercial bank with Tier 1 capital of $1B (about a $13B bank) should have an investment commercial real estate portfolio not exceeding $1B. Most banks have an amount equal to over 200% of Tier 1 capital invested in investment commercial real estate loans. Many smaller banks that specialized in this area have +500% exposure. Believe me - banks listen to FDIC ("don't lend") a lot more intently than they do the Treasury ("please lend")... We have stopped lending in this area. We are turning down 50% LTV deals every day because of our fear of the FDIC and their demand for us to reduce exposure to this segment...

Thousands of Banks have virtually ceased to doing loans in this area. If you don't believe me call a local bank and ask them to refinance your shopping center and listen to their reaction.... Tell them you have a 50% LTV deal with 2X cash flow coverage and you will still get shot down. To make matters worse the conduit market is gone...This is bad news for real estate investors since they will have to pay their ballooning mortgages with cash...

Feb 08 07:02 PM

[mr freddo:]

Thanks for a well written article. I agree that, as a result of the credit and housing bubbles, consumption was boosted with phantom wealth. I'm sure every neighborhood has that couple with the Escalade, who made ends meet by refinancing their house loan.

True wealth is derived from working, saving, investing, repeat. We thought we had created a new paradigm that allowed us a short cut to the joys of wealth. Now we are paying the price.

Feb 09 12:34 AM

[Steven Hansen:]

what you did not mention in the article was that commercial real estate loans are only for periods of 5 to 10 years (although amortized over 30). if banks are reducing their exposure and commercial values falling (because value is a function of revenue - no renters, no value) - then this is a double hit. there will be bankruptcies everywhere.

just wait, the government will open a direct lending window to the commercial real estate market. taxpayers will soon own both banks and the structures which house them. this is vertical integration.

Feb 09 02:12 AM

[TeresaE:]

Think the consumer driven commercial real estate is bad, now add it to the "compete with third world" commercial real estate.

15% vacancies, wow, I WISH we had it so good.

And banks are taking away performing loans from companies that have slashed and burned expenses to keep pace with declining sales and who are still making their payments.

The one truth ALL the experts miss. Every empty building, be it a factory, warehouse or fast food joint, equates to lost JOBS.

And I really wish someone would tell me, HOW this is all going to be ok, when the companies (jobs) are just GONE. Not on hiatus, not downsized, but just GONE.

So, you think the government can tax itself high enough to employ all our children and the millions of foreigners children we keep importing? Sure hope so.

Feb 09 09:40 AM

[bobbobwhite:]

When you wrote your article about commercial real estate, I thought you would include office space in the mix, but you wrote only about retail. That's like writing about residential real estate as if it were only detached single family homes and no condo's.

Feb 09 10:55 AM

[Guero:]

Spot on, although I have seen similar analysis elsewhere, this was the clearest explanation. As for the Escalade Mama Brigade, you could have been describing my 'burb here in TX.

I have an epilogue, though. Many of these empty commercial spaces are helpfully contiguous within their respective strip malls, which facilitates conversion to new scores of new mega-churches, to minister to the busted masses who have found Jesus.

Feb 09 11:01 AM

[applesauce:]

90% LTV loans made with interest only done in 2005 ans 2006 are coming due and will be lucky to get 65% LTV if top notch properties. In Florida cap rates were 5% now going past 8%. Values are plummeting here and I suspect elsewhere. This is like Texas in the mid 80's except country wide.

Feb 09 11:39 AM

[yolosetodo:]

Great article,
Applesauce wrote: "In Florida cap rates were 5% now going past 8%." no one is buying at 8% either. No one is buying period. Smaller Banks in FL are calling commercial loans left & right. I know a bunch of small players with 3 to 5 shopping centers looking for hard money cause their local banks are calling their loans , even if you are at 85% occupancy. Tenants know they have the upper hand and are demanding a ton of concessions in spite of executed leases. Our FL leaders just approved Florida Progress Energy a 25% increase to cover the future cost of a Nuclear plant they are not sure they will build. One of my largest tenants, a triple net national, just requested I replace all my ac units with variable speed compressors & variable speed air handling units $$$$$$$$$$. I know I don't have to, but they are coming up for a new 5 year extension, with bumps & there is plenty of vacant space to choose from. Watch out. I will be thanking Charlie Crist next election for sticking it to us.

Feb 09 02:34 PM

[Urbane Gori...:]

Re: " taxpayers will soon own both banks and the structures which house them. this is vertical integration.".... When we do own the brick and mortar buildings that house the banks, I say we raise their rent!! Then we can jerk them around by changing the terms of the rental agreement monthly. Next move shorten the rental due date to a point where they couldn't possibly get the bill and make the payment on time, thereby triggering not only a late fee, but a higher rental rate... This is good.. I volunteer to handle BofA.. What's grease for the goose, is grease for the gander.... jegan


On Feb 09 02:12 AM The hand wrote:

> what you did not mention in the article was that commercial real
> estate loans are only for periods of 5 to 10 years (although amortized
> over 30). if banks are reducing their exposure and commercial values
> falling (because value is a function of revenue - no renters, no
> value) - then this is a double hit. there will be bankruptcies everywhere.
>
>
> just wait, the government will open a direct lending window to the
> commercial real estate market. taxpayers will soon own both banks
> and the structures which house them. this is vertical integration.
>
>

Feb 09 05:34 PM

[GGriffin:]

Nice. To be considered also is that this time, the market cycles for the various commercial product types have gotten out of sync (as opposed to their normal relationship/timing). They relate to each other; retail following residential, then office and industrial following retail through the ups and downs. New construction creates overlap and helps smooth out the flow. Now we face all product types approaching flatline with virtually no new construction. Also, much of what has been built in the more robust markets was built for the market, not for real people or users (merchant builders versus legacy developers). Thus, a lot of troubled property will be competing with more thoughtful product, particularly as newer, greener developments reflect a new social conscience.

Feb 09 10:34 PM

[Mad Hedge F...:]

With many analysts expecting commercial real estate to be the next shoe to fall in the financial crisis, there is already maneuvering to get a bail out in place before the sushi hits the fan. “Ghost malls” now widespread around Michigan are spreading to the coasts like a highly contagious plague. Simon Properties (SPG) and Westfield have gone to the extremes of shortening hours to save money on staffing costs and electricity. The trigger will be impending failed rollovers of the debt of a couple of big REITs, of which over a $1 trillion are coming due. The Treasury’s TALF program will be expanded from CDO’s backed by student loans, car loans, and credit cards to include commercial real estate loans, giving the industry the safety net, and the breather it needs.

Feb 24 05:24 PM

[cjcbt:]

What in God's name are you talking about? When you say Keynes I assume you're speaking of John Maynard Keynes. If so, what you describe in this article is precisely the opposite of Keynesian economics. The rest is true, but if you want to pin the excess on someone, don't pin it on him. He's the one whose policies are described by right wing ideologues as socialism.

May 03 11:21 PM

[User 447201:]

"Like all things that were the result of the artificial Keynesian policies that have been running our nation"

and

"As mentioned, the commercial real estate sector was built to service Greenspan’s bubble"

Contradict each other - Greenspan was a monetary policy junky from the Friedman camp.... he is decidedly NOT a Keynesian.

In fact, Keynesian policy explains the bubble perfectly - it is the only model that does explain bubbles (or at least with a modified Keynesian approach). The Friedman group believes that self-regulated rational markets could never be over inflated.

If you want to say that loose monetary policy caused the real estate bubble you have a sound argument. However, blaming KEYNESIAN policy makes you look just as foolish as Diana Olick

Jul 14 09:03 AM