What's Down with Commercial Real Estate?

Home prices are way down, but an uptick may be underway. However, commercial real estate — office buildings, malls, warehouses, hotels, theaters — is still heading south.

Let’s start with home prices. This chart shows the decline in home prices as shown by the S&P / Case-Shiller home price data versus the owners’ equivalent rent line (OER), tracked by the Federal government.

Owners’ equivalent rent attempts to measure the market value of homes in terms of rental income. Without going into the details, I believe OER constitutes a good benchmark for evaluating whether or not homes are overvalued, undervalued or fairly-priced.

As you can see, we are getting back to a reasonable valuation level for homes. However, markets typically overshoot on the downside of fair valuation just as they often overshoot on the upside. If that’s the case, more trouble is ahead.

Source: Calculated Risk

According to this data, home prices peaked in early 2006 and have slid ever since, except for a modest uptick in prices recently. We do not know whether or not the bottom has been reached, but we believe we are quite close. However, even if a bottom has been reached, real estate activity - sales of existing homes, new construction, remodeling - will remain at low levels for some time to come.

Commercial Real Estate: Commercial real estate has also fallen hard although the downturn started later than that of residential. Unfortunately, the decline and fall of commercial property has been very quick indeed. This chart compares the decline in residential with that of commercial. The blue-gray bars denote periods of recession. The blue is residential and the red line is commercial.

Source: Calculated Risk

As you can see, commercial real estate took longer to begin falling, but the downturn has been steeper. Now, both real estate markets are off considerably from the highs.

With falling prices for homes, those who provided residential mortgages have been the big losers. And, unfortunately, the government is the ultimate deep pocket when it comes to home mortgages through takeovers of Fannie Mae, Freddie Mac and the possible takeover of FHA.

With falling prices for commercial real estate, those mortgages are under extreme pressure also. But, commercial mortgages are typically held by regional and local banks. Those institutions are now struggling and we have seen a rash of bank failures as a result. In a way though, the Federal government is the ultimate guarantor for banks too through FDIC guarantees.

For more on bank loans, see Bank Problem Loans Keep Growing.

Comments

[enigmaman:]

Commercial faces a big problem because refi is not based on the property / debt loan to value but on the rental cash flow of property. Without sufficient rental income lenders will be hard pressed to accomodate even good quality owners refi requests, since most CRE equity has been wiped out, its estimated that 65% of CRE loans will not qualify, I guess the FED will have to come up with a CRE bail out program, otherwise it will be a big problem for economy.

Sep 24 07:11 AM

[Value Added:]

Thanks for the data. Another thought: the elephant in the middle of the room is the mountain of worthless assets on the banks' balance sheets that have not been written down yet. If these assets were valued realistically, panic might set in.

Sep 24 07:14 AM

[Mad Hedge F...:]

rdc The vultures are circling the embattled commercial real estateindustry, ready to swoop down and devour the carrion before it’s dead.A trio of REIT IPO’s have hit the market this week looking to buy realestate for pennies on the dollar, as well as the bargain basement debtof other troubled REIT’s. JP Morgan, Citibank and Barclay’s launchedtheir Apollo vehicle (ARI). Bank of America and Morgan Stanley came outwith a new security called Foursquare (FSQU). Not to be outdone, Bankof America, Merrill Lynch, Goldman Sachs, and UBS followed up withtheir Colony (CLNY) instrument. This is a classic example of new equitycoming in and taking ownership of assets where the previous owners havegone to money Heaven. Commercial real estate lending exploded from $1trillion in 1988 to $3.5 trillion in 2007, and some $2 trillion of thathas to be refinanced this year. Takers are few, with banks reeling inleverage ratios, insurance companies gun shy, and the collaterized debtmarkets in intensive care. The TALF is expiring at year end. Did I hearsomeone shout “Bail Out?” Many listed REIT’s will only survive becausetheir rules limited them to mere 2:1 leverage, and were able to raise$16 billion in new equity since March. That has helped propel the DowJones REIT Index ($DJR) up 84% from the lows. More highly leveragedprivate investors and regional and community banks not so constrainedare choking on their holdings, and many are limping on by letting markto market rules fall by the wayside. This is why I am not recommendingbank stocks or REIT’s at these levels. The new vulture issues may beanother story. I was involved in a strategy at Morgan Stanley to Hooverup Houston office buildings on the cheap in the wake of the earlyeighties oil bust. The lucky investors got a tenfold return on theircapital.

Sep 24 08:24 AM

[JAMES CARLINI:]

Commercial Real Estate is going through a silent transformation.

Broadband connectivity is something that corporate site selection committees are looking for and 90% of the market does not have it.

Not DSL or T1 services but broadband connectivity at gigabit speeds.

The three most important words in real estate have gone from location, location, location to location, location, connectivity.

Values are going down because many properties don't have the right amenities.

Read one of my white papers:
dntp.com/news/pdfs/int...

Sep 24 09:38 AM

[31October:]

Mad Hedghog Spammer,
How many times do you need to post the same comment before you find... actually, what is it that 2,990 repeated comments gives you?


On Sep 24 08:24 AM Mad Hedge Fund Trader wrote:

> rdc The vultures are circling the embattled commercial real estateindustry....

Sep 24 01:28 PM