Something To Keep An Eye On: Commercial Real Estate

by: John M. Mason

Summary

There is some more bad news out about how the commercial property area performed in February.

Ever since the end of the Great Recession, the commercial real estate sector has received strong financial support from the Federal Reserve and bank regulators.

As a consequence, investors need to watch out what is going on in this area because it could, potentially, be one of the weaker areas of the economy.

I have had a concern about the commercial real estate area for about four years now. I have written about my concerns on a regular basis.

The reason for my concern has been the commitment of the commercial banking sector to commercial real estate lending, especially commercial banks smaller than the largest 25 domestically chartered banks in the country.

My concern grew out of the fact that a lot of expansion in commercial real estate loans that came out of the Great Recession were refinances of deals that were in fairly desperate states as the economy started to pick up again.

And the problem, as I saw it, was located in regional or local banks that were very closely attached to their geographic region.

These commercial real estate loans were to be paid off as they matured. As a consequence, many of these commercial banks were carrying loans on their books that were not in very good shape, but since the loans did not fall due until the loan matured, the banks did not have to treat them as troubled or bad loans. They were in no way delinquent.

Two things saved the banks.

First, the Great Recession ended and the economy began to recover.

Second, the Federal Reserve, hoping to get the economy moving faster, but also hoping to allow these banks to work themselves out of their hidden loan problems, entered into a round of quantitative easing… which eventually continued on until the Fed had gone through two additional rounds, making a total of three rounds, of quantitative easing.

Even with the Fed's quantitative easing, the number of commercial banks in the industry has been declining at a pace of more than 200 banks leaving the system every year since the current recovery began. The Fed apparently achieved its goal of seeing these banks leaving the system without disrupting the commercial banking system, itself.

These two factors gave the banks the time to refinance the loans that were potentially a problem and provide some added-on funds to carry the developers through to complete their projects. Federal Reserve statistics showed that commercial real estate loan growth at commercial banks was the strongest area of performance in these institutions, especially in commercial banks that were not included in the largest 25 domestically chartered banks in the United States.

Things have gone pretty well in the commercial property space during the current economic recovery, although perhaps not as robustly as might have been desired.

The economic recovery was not that strong. The compound annual rate of growth of the US economy in the first six-and-a-half years since the recovery began has only been 2.1 percent. This is far below every other economic recovery since the end of World War II.

And, commercial banks had a lot of other things to clean up after the Great Recession and looked primarily to clean up deals that had not been completed when the financial crisis arose and not go so much into new deals. The financial industry, itself, went into a mode to use the very cheap debt that was available during the recovery to make money on troubled or foreclosed properties.

However, some concerns about the commercial real estate market began to arise. I wrote about these problems in the middle of February. In the post, I made reference to some problems noticed in secured loans and to some things that were happening in the hotel industry.

Now, it seems as if we are going into a second month with bad news about this sector.

Peter Grant writes in the Wall Street Journal "U. S. commercial real estate sales plummeted in February, sending the clearest signal yet that a six-year bull market might be coming to an end."

Not only have sales of office buildings, stores, apartment complexes and other commercial properties dropped from $47.3 billion last February to $25.1 billion this year, but prices of these properties "are beginning to plateau and have started falling in certain sectors and geographies…"

Mr. Grant adds that hotel values were 10 percent lower in February than a year earlier."

Furthermore, "The most striking sign has been the sharp decline in bonds backed by commercial mortgages. In 2015, about $100 billion of commercial mortgage-backed securities were issued. This year experts believe volume will fall to $60 billion or $75 billion."

Additionally, Mr. Grant reports that loan terms have also become more tighter.

Jim Costello, Senior Vice President at Real Capital Analytics is quoted: "Buyers have been hearing 'no' from lenders for the first time in a while."

The point is, investors need to pay attention to what is going on in this sector of the economy and how this sector of the economy is impacting commercial banks.

As I have mentioned, I have believed that the commercial real estate sector is a potential weak area of the economy, and, in my mind, has been floating on the Federal Reserve's efforts to pump up asset values without a solid foundation to keep it up.

Along with the stock market, no other asset class has done as well over the past six-and-a-half years as commercial real estate. But, the question is, how much longer can this floating continue. Keep your eyes open.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.