Commercial Real Estate Is Plunging

By Dirk van Dijk

On Wednesday, Moody’s released its commercial real estate index and reported that nationwide prices for all types of commercial real estate (CRE) plunged by 8.6% in April from March and now stand 25.3% below a year ago, and are off 29.5% from their October 2007 peak.

The Moody’s/REAL CPPI is a repeat sales index constructed very much along the same lines as the Case-Schiller index of residential real estate prices. In the graph below, Calculated Risk has overlaid the Case-Schiller index on the graph from the Moody’s report. It clearly appears that CRE prices follow housing prices with about an 18-month lag.

This is consistent with other findings that investment in CRE (i.e. new building of offices and stores) follows residential investment by about the same period. While the CRE price decline started later than that for houses, it is happening at a much faster rate.

While the all-property index shows a monthly change, the sub-indexes by property type are only available on a quarterly change basis. Relative to three months ago, office building prices have been particularly hard hit, plunging 18.6%. Prices of retail buildings have fallen by 12.9%.

By comparison prices for Apartments and Industrial space have held up well, dropping by just 0.4% each. However, on a year-over-year basis they are both down sharply, Industrial space by 12.3% and Apartments by 16.1%. On a year-over-year basis, retail space has lost 18.5% of its value while office space has plunged by 28.9%.

The reason why the value of CRE is falling is not a mystery. If stores are closing, then they will not be paying rent, and landlords will not be in a position to get rent increases from the remaining stores. If a company is laying off lots of people it will have lots of empty cubicles and offices, and will be looking to sublet its existing space, competing directly with the landlords trying to rent out existing space.

In addition, as recently as the second half of last year, construction of new commercial real estate was still very robust, meaning that there is lots of new space that has recently come on line. Still, a 8.6% decline in a single month is startling and is very bad news for REITs like Mack-Cali (CLI), Liberty Properties (LRY), Post Properties (PPS) and Cousins Properties (CUZ).

We have already seen commercial delinquencies and foreclosures start to rise, and this will be a major headache for the banks going forward. Many small- and mid-sized banks ($1-10 billion in assets) are very heavily exposed to CRE. This could cause them to be the guest of honor at one of the Friday night pizza parties put on by the FDIC. However, individually these banks do not threaten the financial system the way the stress-tested 19 would if they failed.

Comments

[Economic Lens:]

Commercial real estate is in a slow motion death spiral. As the recession grinds on, more and more businesses will begin to fail with subsequent empty strip malls etc. A friend of mine tried to get their funds out of three of the largest commercial REITS in America. Guess what. They were told that the one company was not redeeming any investments at all, one other not until next year and the last not until the first of the year. That does not sound like three companies that have alot of cash to spare right now. GGP will not be the first major REIT to go into bankruptcy in the next couple of years. BTW, all 3 have drastically slashed their dividends. Who would have guessed.

Jun 26 07:27 AM

[AndrewBaker:]

I have in the recent past commented elsewhere on the site about commercial property being in a serious downturn, and related this to banks in respect of losses due to non-performing loans used to buy commercial buildings. The Hancock Tower in Boston sold at auction this year for half the price it previously sold at, and there are numerous other examples including a new build situation in California sold for substantially less than the building cost to put up.

This is one big financial problem that no-one yet seems to have costed into the banks' profitability going forward: add to that personal credit card debts not being paid, along with mortgage and other personal loans, and it's easy to see that a commercial property price crash is not going to do anyone any favours, especially the banks and other commercial lending financial companies. Got bank shares? Then sell 'em.

Jun 26 09:45 AM

[20dollar:]

I am getting excited just thinking about the good deals to come in commercial real estate!

The cycle has begun and it will soon be time to buy. (if you have cash and/or a good banking relationship because attractive financing will be difficult to obtain)

Not only will vacant buildings be cheap, but long term "A credit tenant" buildings will also be cheap as the owners will be unable to refinance their debt at today's conservative terms. This will usher in a tsunami of forclosures, putting even more downward pressure on prices.

I see cap rates (on long term A credit tenant buildings) coming up to the double digits in the very near future.

Jun 26 10:10 AM

[Mad Hedge F...:]

Death Spriral is more like it. The Dana Point, California St. Regis Monarch Beach Hotel has defaulted on a $70 million loan, while lenders have repossessed the “W” Hotel in San Diego. Thus, the spotlight is again refocused on the next phase of the financial crisis, where an army of shoes are falling. A torrent of tenant bankruptcies is creating “see through” buildings in cities throughout the country, which are becoming as abundant as Priuses at an Obama rally. Some players see a further three year bleed that could take property prices down another 40% from here. Large, publically traded REITS have used the three month stock market rally to raise $11.5 billion in new equity that will enable to reduce debt and leverage, as well as buy up of weak competitors and distressed property. Look at Simon Properties Group (SPG), up 128% from the March lows. The saving grace here is that the recent bubble was nowhere as inflated as the S&L crisis in the early nineties. But cap rates may have to climb to the double digit levels we saw then before this period of punishment ends. Cash rich hedge funds are circling.

Jun 26 10:24 AM

[axelrod608:]

One needs to bear in mind that insurance companies are very large investors in CRE. They, as well as the small and mid sized banks, are facing a serious threat of losses and reduced revenues.

One wonders what the Fed and Treasury will do for this sector. Will the big banks will be the only ones put on federal life support.

It's probably not a swell time to be buying annuities from the insurance companies. What's a retiree to do ? There's no port open to weather this storm.

Jun 26 10:35 AM

[ebworthen:]

Unemployment = lost income + reduced spending = lost income for retailers + laying off more workers = more unemployment = less spending = REIT failures and lower prices.

It takes a while for the REIT to fail and the prices to go down, but it will continue. Remember that what caused all this was betting on valuations to go continually up. The housing market turned in 2006 or so? It took several years for the bubble to pop.

Just as the green shoots are appearing and people jump into the market and things are ginned up - this shoe will drop and a second wave of fear and selling will occur and the March lows will be exceeded.

Honestly, go look at the DOW charts from Summer of 1929 to Summer of 1930. There are other indicators that mirror that crash. The Summer of 1930 was the inflection point where market watchers and investors thought "happy days were here again" before unemployment and bankruptcies and bank failures caught up with the speculators and hookah smokers.

Jun 26 11:26 AM

[joes:]

There are several pressures on Commercial Real Estate, most have been mentioned in other comments concerning the ripple effects of any downturn, less shoppers, less stores, less rent paying tenants, no money to the REITS.

The aspect that is new of course is the Internet, which combined with the shift to computer based service jobs makes working in an office very expensive as opposed to the price of a PC and a high speed connection.

There are six siblings in my family, three of us have been working from home for almost 10 years now, and I don't miss the office scene at all.

Jun 26 11:36 AM

[jksisco:]

The beauty of a Capital economic system is in it's cyclical nature that rewards the prudent, the risk-takers, and those that can see the forest through the trees. Enormous fortunes will be made for those that keep reality in perspective.

Jun 26 12:19 PM

[Fred Voetsch:]

On Jun 26 11:36 AM joes wrote:

> There are six siblings in my family, three of us have been working
> from home for almost 10 years now, and I don't miss the office scene
> at all.


Many of these small businesses, such as mine, can easily move out of their small offices back to home without great pain but the pain to the CRE market is going to be great, and then these same people are less likely to eat out at all those trendy restaurants that have sprung up all over the place in past decades, fuelling the CRE boom.

All signs point to this as being a long-term trend - just a part of the overall deleveraging process.

Jun 26 01:44 PM

[CBTeas:]

The question was asked, "what is a retiree to do?"

First, don't believe financial statements from any institution. Earnings on these income statements and assets on these balance sheets are garbage. Second, stay liquid and get more liquid. The stock market will NOT be the answer. Third, get some money in gold and non-traditional (non-correlated) assets. No yield but there is very little you can trust these days and gold won't lie to you.

Jun 26 01:54 PM

[WS1835:]

Unfortunately, the USA (and western world in general) left capitalism behind in wake of World War II. We all moved to the wonderful utopia of "mixed" economic models, which over the course of time have become less mixed (more socialism, less capitalism). Hence, we now get the same downward cycles but get minimal econimic gain from the "creative destruction" due to government meddling. The bail-outs/nationalization of the large financials and car companies are good examples. The government keeping economic zombies alive that would have otherwise died brutal (but quick) deaths at the hands of naked capitalism. Hard to see any reward for the prudent or intelligent risk-taking when the government is actively bailing out the imprudent and the profiteers.


On Jun 26 12:19 PM jksisco wrote:

> The beauty of a Capital economic system is in it's cyclical nature
> that rewards the prudent, the risk-takers, and those that can see
> the forest through the trees. Enormous fortunes will be made for
> those that keep reality in perspective.

Jun 26 02:14 PM

[WS1835:]

Your point is spot on. Just take a look at what is happening to the sales volume and margin at Crispy Creme and Starbuck's.....


On Jun 26 01:44 PM Fred Voetsch wrote:

Many of these small businesses, such as mine, can easily move out of their small offices back to home without great pain but the pain to the CRE market is going to be great, and then these same people are less likely to eat out at all those trendy restaurants that have sprung up all over the place in past decades, fuelling the CRE boom.

All signs point to this as being a long-term trend - just a part of the overall deleveraging process.

Jun 26 02:16 PM

[Michael Clark:]

A recession is a supply/demand imbalance. It takes a few months usually to re-establish this balance.

A depression is a debt imbalance. It takes a generation to re-establish this balance. How long is a 'generation'? 18 years. (2001-2019)

Jun 26 02:43 PM

[MichaelJ007:]

most life companies didn't get nearly as overexposed and overleveraged on CRE whole loans and CRE equity as the REITs and funds did. Their main losses came via CMBS which has already blown out. Additionally, due to the structure of their whole loans they will be much easier to workout than CMBS or REIT structures. There will be some losses, but there will also be some gains as life companies can now make very lucrative loans on very strong properties as well as purchase notes at a discount- that is if they didn't prematurely blow their $ load.


On Jun 26 10:35 AM axelrod608 wrote:

> One needs to bear in mind that insurance companies are very large
> investors in CRE. They, as well as the small and mid sized banks,
> are facing a serious threat of losses and reduced revenues.
>
> One wonders what the Fed and Treasury will do for this sector. Will
> the big banks will be the only ones put on federal life support.
>
>
> It's probably not a swell time to be buying annuities from the insurance
> companies. What's a retiree to do ? There's no port open to weather
> this storm.

Jun 26 03:07 PM

[Mark54:]

GGP biggest sin wasn't CRE but leverage. Only a handful of their properties are performing poorly. Simply too many loans maturing at once. This is going to be a great opportunity for liquid real estate firms (Simon) to add some good assets.

Their next biggest sin is their attempt to muck up the bankruptcy remote entity.

Jun 26 04:35 PM

[Old Trader:]

WS1835,

I take your point, but Krispy Kreme isn't really a good comparison to Starbucks. KKD was having major financial problems LONG before the economy tanked, and already underwent some pretty serious overhauls to top management, franchisees, etc.

Starbucks, on the other hand, can more justifiably claim to be hurt by the downturn (although more than a fair bit of overbuilding certainly didn't help their cause).


On Jun 26 02:16 PM WS1835 wrote:

> Your point is spot on. Just take a look at what is happening to the
> sales volume and margin at Crispy Creme and Starbuck's.....
>
> Many of these small businesses, such as mine, can easily move out
> of their small offices back to home without great pain but the pain
> to the CRE market is going to be great, and then these same people
> are less likely to eat out at all those trendy restaurants that have
> sprung up all over the place in past decades, fuelling the CRE boom.
>
>
> All signs point to this as being a long-term trend - just a part
> of the overall deleveraging process.

Jun 26 06:06 PM

[geewow:]

This is no surprise. Many of us writing about the economic meltdown have been saying that after the home mortgage collapse will be commercial real estate. We predicted that it was in June of 2009 that this would be seriously beginning. So, now, here it is.

Jun 26 06:08 PM

[Steve Owen:]

Nice call. I've been watching the increasing vacancy rates with some concern. And, I started having that concern between about nine months ago and a year ago... it takes awhile to build up critical mass.


On Jun 26 06:08 PM geewow wrote:

> This is no surprise. Many of us writing about the economic meltdown
> have been saying that after the home mortgage collapse will be commercial
> real estate. We predicted that it was in June of 2009 that this would
> be seriously beginning. So, now, here it is.

Jun 26 11:30 PM

[MadScientist:]

The company I work for has recently reduced its workforce to the point that they no longer need a secondary office building they had been renting for years. There has also been a move to "cube farms" for entry level employees that have also reduced the need for extra office space.

Result? Vacant spaces for CRE that are not likely to be filled until this recession/depression turns around (maybe in two years?) Hope they can hold on through the acceleration of such vacancies, but I am concerned that most CRE is too leveraged to survive.

Jun 27 10:28 AM

[ur2smrt4me:]

Zymogenetics (ZGEN) here in Seattle expanded into a second building two or three years ago. They've been through two rounds of layoffs since then, the latest cut amounting to 1/3 of the workforce. They are now trying to get everyone back into one building.


On Jun 27 10:28 AM MadScientist wrote:

> The company I work for has recently reduced its workforce to the
> point that they no longer need a secondary office building they had
> been renting for years. There has also been a move to "cube farms"
> for entry level employees that have also reduced the need for extra
> office space.
>
> Result? Vacant spaces for CRE that are not likely to be filled until
> this recession/depression turns around (maybe in two years?) Hope
> they can hold on through the acceleration of such vacancies, but
> I am concerned that most CRE is too leveraged to survive.

Jun 28 07:45 AM

[cashflowtrader:]

Talk about trifecta of real estate plunge;
1) increasing cap rates 5-6% to 8.5% and posibly to 10%
2) Highest unemployment in 28 years leading to further vacancies and drop in NOI
3) Worsening tenant credit quality

I have not seen many A properties going for cheap in my local market just yet. I would surmise it is going to take at least another year for things to soften up more the ultimate buying opportunity. The current CRE buyers are playing a dangerous game.

Jul 15 11:46 AM

[Broxburnboy:]

The government has in fact been taken over by corporate monopolies and cartels from Wall Street to military contractors. They pay the Congressmen and Senators to cut their taxes and pass laws to suppress competition. The problem is lack of enforcement of existing regulation to ensure a level playing field for free enterprise. It doesn't help when the sheeple vote for more government spending with borrowed money.


On Jun 26 02:14 PM WS1835 wrote:

>
> Unfortunately, the USA (and western world in general) left capitalism
> behind in wake of World War II. We all moved to the wonderful utopia
> of "mixed" economic models, which over the course of time have become
> less mixed (more socialism, less capitalism). Hence, we now get
> the same downward cycles but get minimal econimic gain from the "creative
> destruction" due to government meddling. The bail-outs/nationalization
> of the large financials and car companies are good examples. The
> government keeping economic zombies alive that would have otherwise
> died brutal (but quick) deaths at the hands of naked capitalism.
> Hard to see any reward for the prudent or intelligent risk-taking
> when the government is actively bailing out the imprudent and the
> profiteers.

Aug 02 11:20 AM