Commercial Real Estate: The Reality Is Not as Bad as It Looks

Thursday's Wall Street Journal reports significant increases in commercial real estate loan defaults and delinquencies. Here's data through the fourth quarter on bank loans:

It paints a useful picture, but keep in mind that many commercial real estate loans are not from banks, and thus not reported here.

Two items for perspective. First, we did not overbuild non-residential properties as we did residential. This chart shows the share of GDP devoted to the two types of construction, with long-run averages in thin lines:

Not having overbuilt is not the same thing as being healthy. The recession has been hard on vacancy rates and rental rates, so the sector is hurting. However, note the difference from residential real estate: it was overbuilt even before the recession.

The second issue to get perspective on is the role of "maturity defaults" in commercial real estate loan problems. Here's what that means. A typical real estate mortgage has a 5-year term. The loan may amortize over 30 years, or may be interest-only (common a few years ago, but rare now). Five years after the commercial mortgage was originated, the loan must be repaid and a new loan found. (I'm describing typical terms, but there's variation from these.)

Suppose you bought an office building five years ago with 20% down, for an 80% loan-to-value ratio. You have not missed a payment, the building's value has been stable, your amortization has paid down the loan balance by four percent of the building's original value. A new loan will have a 76% loan-to-value ratio.

Here's the problem: nobody will make a commercial mortgage loan with a 76% loan-to-value ratio today. You haven't missed a mortgage payment, your building is fully leased, you've been working down your principal, but the lenders are all scared. Bank regulators are scared. Secondary markets are scared. So you have to pony up additional cash to bring the loan-to-value ratio down to at least 70%, and maybe even 65 or 60%.

What if you don't have the cash sitting around to do that? You have a maturity default. Your problem is that credit standards tightened faster than you were paying off your loan.

What does this mean for the larger economy? It reflects a financial problem, not a real problem. A real problem is real estate that isn't wanted. A financial problem is useful real estate that doesn't fit lenders' risk profiles. The lender will face the facts and let the loan ride. The lender may be unhappy, and a regulator may be unhappy, but nothing bad is going to happen to the property. Even if the lender forecloses, the building is still occupied. There's no big impact on the economy. In other words, the real situation is not as bad as it may appear.

How much of the total commercial real estate loan problem is due to maturity defaults? A Deutsche Bank analysis suggest a whole boatload of loans won't qualify for refinancing in the coming years. As I read their estimates, some 66% of loan values coming due in 2009-2012 won't qualify for refinancing. The biggest problem areas are multi-family and office.

Comments

[Steven Hansen:]

Actually, you left off the issue of valuation in refinancing. commercial real estate is valued based on revenue. when your anchor tenant goes bankrupt, you have no revenue. your property value drops.

now you have a funding shortfall even if you can find the credit.

Mar 27 04:44 AM

[2houndz:]

The comment above (the hand) is correct in that you seem to assume that nothing has changed regarding the value of commercial RE and that the entire problem is in lending. CAP rates have gone from sub-6 in some cases back to 10 and 11 which is maybe where they belong. Add to that a huge amount of renegotiating of rents, and you see that NOI has been pummelled.

My economic analysis always leads me back to the idea that people vote with their feet and their wallets. If shoppers are not patronizing a store or an entire shopping center due to any number of reasons, then retailer income suffers and the developer's NOI suffers in turn. This, along with the financial viability of the income stream (the tenant's balance sheets) is the only objective source of determining the value of income producing property. Property owners are being sliced and diced with both edges of this sword.

Sure, I know of examples where there is nothing fundamentally wrong with a project except a lack of financing, but to suggest that, in general, there's not a "real" problem is not accurate. In many categories of real estate our country has been demonstrably overbuilt. There are old, defunct regional malls in places that simply can't support them. There are lifestyle centers built for "aspirational" retailers in towns where the income levels just can't support them. There are small retail centers all over the country with horrible visibility, ingress/egress and parking issues that should have never been built. It is true that money flowed easily back when these projects were built, but we can't now say that because it was easy then it should be easy now and that's the problem. The problem now is that we have been shaken to our senses and now realize that much of this stuff should never have been funded (or recently re-funded) in the first place.

I limit my examples to retail because that's my field of expertise. I understand that you are talking about a bigger picture and I must give you some benefit of doubt, but knowing the personality of both developers and lenders, it's hard for me to imagine that other areas of RE are much different.

Mar 27 08:22 AM

[Rhino Realty:]

Also, you did not consider the "co-tenancy" requirements in most retail center leases. When Circuit City goes BK, all ofther tenants go either 50% rent or leave the center....RETAIL will see significant issues over the next year or two. Lenders will be choking on deals with "con-tenancy" and bankrupt retailers.

Mar 27 08:38 AM

[Allan Frain:]

Adding to that--Restaurants, Jewelry Stores and the like will be hit hardest by loss of discretionary spending as unemployment manifests itself.


On Mar 27 08:38 AM Rhino Realty wrote:

> Also, you did not consider the "co-tenancy" requirements in most
> retail center leases. When Circuit City goes BK, all ofther tenants
> go either 50% rent or leave the center....RETAIL will see significant
> issues over the next year or two. Lenders will be choking on deals
> with "con-tenancy" and bankrupt retailers.

Mar 27 09:47 AM

[Mad Hedge F...:]

Yes it is. George Soros says that it is “inevitable” that commercial real estate falls another 30%. Rents are falling, tenant bankruptcies are rising, there is tons of debt to be refinanced for which there is no market, so cap rates are rocketing and “ghost mall” has joined the recessionary lexicon. This all adds up to lower prices. Some credit default swaps are trading at levels suggesting that a major REIT bankruptcy is imminent. I know George is sometimes prone to extreme statements, but this time he may be on to something. If you want a short play, or if you have an existing long position in commercial real estate which you can’t get out of and want to hedge, try a short position in the (IYR), although it has already dropped from $85 to $21. You can also play one of the sicker REIT names like Brookfield Properties (BPO).

Mar 27 11:34 AM

[MLKlein:]

We recently did our own analysis of where we think real estate values are today relative to the 2007 peak. We believe values are off at least 35%. Below are three major points in our assessment:
1. With lenders pulling back there overall participation in the capital stack from 80% to 60% or so, the weighted average cost of capital has increased approximately 32% without changing the actual cost of capital. This will eventually be seen in cap rates.
2. Vacancy has increased in almost every market, so even without changes in rents, NOI is down.
3. Given greater vacancy and a weak economic outlook, rent rates will be under pressure to fall. If numerous buildings in a sub-market go into default and are sold at distressed prices the new entrants to the market will have lower basis than the other buildings and will be able to offer lower rental rates to attract tenants. This begins a cycle that adjusts all rents down until basis is adjusted through foreclosure or sale.

Unfortunately, there are many deals that were done in 05-07 where the going in margin of cash flow safety (DSCR) was predicated on increasing rents, interest only for the first 2 or 3 years and historically low margins for error.

So as usual, a business weakness t will be exacerbated by a leveraged capital structure that leaves no room for cyclical change.

Mar 27 12:07 PM

[REITBull:]

Soros will make money riding CRE down. 6 months from now he will be telling everyone about the great bargains in CRE, after he has sold off his shorts and put on his long positions. Yes I am biased due to my long position in REITs, but this seems to be the MO of hedge fund managers.

Mar 27 01:43 PM

[Jugheadjack:]

Now's the time. Let's get rid of all deductions for interest paid on real estate. Real estate speculators don't outright own their home and I'm subsidizing them. Outright homeowners should lobby aggresively to eliminate the mortagage deduction to lower our taxes to our fair share.

Mar 27 09:43 PM

[Kunst:]

"First, we did not overbuild non-residential properties as we did residential."

That's not true in the Sacramento area. Lots of new centers with barely any tenants, some still coming online.

Mar 28 01:32 AM

[donzelion:]

"The lender will face the facts and let the loan ride. The lender may be unhappy, and a regulator may be unhappy, but nothing bad is going to happen to the property."

Similar arguments could be made about family farms in 1929. Lender would be unhappy letting loans ride, regulators (such as they were) would be unhappy, but the farm itself would be fine...UNLESS a major disturbance arose that coincided with the precarious situation of all concerned.

The point? In the real world, it's difficult to distinguish a "merely financial problem" from a "real problem." Perhaps AIG experts could tell you the distinction (just read through the algorithm that apportioned risk...), along with their counterparts at Bear Stearns, Lehman, Countrywide, etc. - but the rest of us non-experts have a tough time figuring it all out.

For me, as a non-expert, I'd want to see who is buying up bankrupt big box stores - Circuit City, Linens, etc. - and what they're paying for leases. It's much easier for me to understand "big empty store" than to distinguish among types of problems.

Mar 28 09:31 AM

[Liberty:]

I think the author makes a good point, which is commercial real estate is not as bad as it seems. I think its understood by all that CRE is doing poorly. 'Maturity defaults' appears to be the best answer for most lenders facing a loan expiration that cannot be refinanced at today's more onerous loan terms. (The banks and borrowers actually have little choice on this). Commercial real estate values are probably fairly close to their values in 2003-2005 in my experience. Hence, the author's example is a fairly good one - reflective of typical properties today. Give the economy about 24 to 36 months, and rents will be growing again and vacancy fundamentals will be more sound. Borrowers will generally be much more able to refinance at market oriented terms in 2 to 3 years from now, not really a long timeframe for most RE investors.

Mar 29 01:20 AM

[mrbill:]

You leave out one important detail, a great deal of building was shopping centers vs industrial. And what is industrial is mainly business parks with lots of office and warehouse space and little production. Consumerism is dieing, slowly but surely. CRE is dead in the water. The only question is, will they go belly up, or will they be bailed out with money printing via C.R.A.P. (Commercial Realestate Asset Protection).

Mar 30 05:30 AM