Some journalists have been suggesting that values in commercial real estate will be the next to
crash - following housing and dragging the U.S. economy even further into a serious funk.
Prior to giving you my opinion, I'd like to give you my resume: before I turned to journalism (writing, teaching and speaking), I spent 30 years as a real estate investor. During that period I bought and sold single-family houses, small multi-unit properties (duplexes and triplexes), apartment buildings, office and retail properties, factories, warehouses and land. In addition, I built condominiums during the stagflation of Jimmy Carter's Presidency (prime rate of about 20%) and struggled through the real estate crash (both banks and S&L's) in the late eighties and early nineties. So, I feel that I should know what is coming next.
Actually, however, I don't. But, I can give you the factors that will affect what happens:
1. Financing: if lenders get overcautious - which of course is already happening - problems in commercial real estate will become self-fulfilling. In other words, if enough lenders considering a refinance or new loan say to themselves "I am worried about commercial real estate prices, therefore I will pass on this loan or, impose some serious restrictions," well that statement will be a self-fulfilling prophecy. As everyone knows, the grease of the real estate world - be it housing or commercial real estate - is debt. If the free-flow of debt starts to clog up, prices will fall (correct that: since they are already falling, they will fall further).
As an aside, I think real estate lenders have got to act as if real estate investors are the goose that has laid them a golden egg for many years. I am OK with caution but when lenders start going overboard (as they always do), they can kill their fine goose (and themselves in the process).
2. The Economy: needless to say, the fundamentals of commercial real estate require that businesses rent space. The retail world is already in trouble and owners of retail properties are feeling it. Some commentators have suggested that commercial real estate is buffered from economic problems because of lease agreements, i.e. five and ten-year contracts committing to a space. Unfortunately, that is only the case when the tenant is a significant credit. When retail sales soften, the 80% or so of non-national tenants (sometimes called "mom and pop" stores) start calling their landlords seeking immediate rent reductions "to keep afloat." I have already gotten these calls from retail tenants.
As to the health of office properties, that too depends upon how quickly the economy pulls out of the nose dive it is in. While retail tenants may bear the brunt of consumer cutbacks sooner than office tenants, obviously an economic tsunami that is 2/3 dependent upon consumer spending brings down all sorts of boats. There will be some office-user defaults but probably more problematic is office users putting sublease space on the market (as the result of lay-off's) which spikes vacancy rates and drives down rentals.
3. The Pricing Model: one topic that I have spoken about for many years is the subjectivity of the housing pricing model. In other words, a house is only worth what people think it is worth. Only in rare cases (such as investors buying foreclosed houses) do people buy a house based on a net income analysis. 99% of home buying decisions are emotional and because of that, in a free fall like we have now, there is no real floor. Prices will only recover when home buyers across the board (not just investors) think that prices have stopped falling. In other words, it is all about buyer psychology.
To be distinguished is commercial real estate. There is little psychology involved when an investor buys an investment property. It is all about the rent and expenses. Every investor asks himself: what is the net present value of the income stream I can expect from this property over the next five years or so? That is really all that matters. For that reason, commercial real estate investors are not subject to extreme swings in the psychology of the market. If rents hold up, then they will react rationally and work their properties. Few will panic because the media starts speaking about deflation or depression.
4. Owner Behavior: one cause of the housing crisis is that homeowners who are walking from their properties are making rational decisions when they are "under water," i.e. they have more debt than value. Since residential lenders almost never chase a home owner for his or her deficiency (the shortfall on the face amount of the debt when a house is sold by foreclosure), homeowners have little economic incentive (other than maintaining credit scores) to stay with a house whose values have dropped.
The situation with commercial real estate owners is different for several reasons:
a) As already mentioned, the commercial real estate owner is a pure numbers guy or gal. If rents are holding, he or she will fight the fight to hold ownership as long as possible. Back in the days of the "S & L" crisis, the mantra of me and my buddies in the early nineties was "just stay alive 'til '95." In other words, most of us believed that the real estate world would eventually right itself and most of us were psychologically prepared to hold on until that happened.
b) Commercial real estate lenders, unlike residential lenders, have every intention of chasing defaulting borrowers when the lender has recourse protection, i.e. personal signatures or guarantees on a loan. No commercial real estate owner with recourse debt just up and walks.
c) Commercial real estate owners, in general, have a greater margin for error than do many homeowners. When nutty lenders put U.S. homeowners into 95%+ loan-to-value mortgages in the first seven years of this decade, they created a situation with no room for error. Although some commercial owners do have too much debt, most owners have significant equity in their property as well as reserves against downturns. The fact is that any real estate investor whose ability to pay his debt depends on a couple of months of cash flow from his property is probably a newbie to the business. Those who have lived through real estate cycles before - most real estate investors - realize that real estate ownership can be a roller coaster ride. And they prepare for the ride by skipping lunch at times (is this metaphor making you sick to your stomach?).
In conclusion, anything can happen of course but I do not see large-scale defaults in the commercial real estate world approximating anything even close to the housing world - unless, of course, the economy continues to struggle for the next few years. If that happens, then all bets are off!!
Jim Randel is the author of Confessions of a Real Estate Entrepreneur (McGraw Hill, 2006) and the just-released The Skinny on the Housing Crisis (Clover Leaf, 2008).