Will Commercial Real Estate Be Next?

There's been a lot of talk in the media these days that the next shoe to drop in the credit crisis/financial meltdown will be commercial real estate. Two weeks ago there were a couple of moderately-sized defaults on mortgage loans (hotel and retail projects) that were packaged in commercial mortgage backed securities (CMBS). The media seized on this and started worrying out loud about commercial real estate.

Let me cut through the silliness and give you "the skinny":

A bad economy will cause increased defaults in commercial real estate, but nothing even approaching what happened in the residential world. Here is why:

1. Commercial real estate investors do not buy on emotion. It is all numbers. If a deal does not pencil out, it is not purchased. This does not mean that investors never make mistakes. We do (I have made many). But, it is because our assumptions are wrong or events cause changes in the projected numbers. To be contrasted are buyers of homes who fall in love with a home and then buy at whatever price it takes. An emotionally-charged purchase causes people to buy beyond reasonable values and, their means.

2. Commercial real estate lenders have not engaged in the nutty lending behavior that residential lenders did. Although there were some aggressive loans made, the magnitude of the lending mania was nothing like what happened in residential. During the last decade the world clamored for residential mortgage securities because everyone was quite convinced that U.S. housing prices never fall, and that homeowners never walk from their homes. Oops!

3. Unique to most of the world, in the United States homeowners can generally walk from their mortgage debt without consequence. Whether you agree with this or not, it is fact. Such is not the case in the commercial world. Whenever there is personal recourse or some other kind of guarantee, a U.S. commercial mortgage lender is going to come after the commercial real estate owner should he or she up and walk from a losing deal. That tends to keep people focused and much less likely to default.

4. Most commercial real estate investors have reserves for difficult times. Even assuming that an investor could get a loan of 90%+ of value (which is much less likely than in the residential world), it would be the rare investor who had no savings or back-up for the down time. Large numbers of homeowners, on the other hand, operating under the premise that housing prices always go up, were "all in," that is they put every dime they had into buying a home.

For these and other reasons, I do not believe we will see levels of defaults in commercial real estate approaching U.S. homeowner levels (now exceeding 10%). And I wish the media would stop writing about commercial real estate defaults because it spooks lenders and investors. I will whine about this next time I am on TV.

Follow Jim Randel on Twitter: www.twitter.com/jimrandel

Comments

[brooklyncitizen]

06:06 PM on 12/03/2008

Well we should also include the rampant development that has led to cities filled with half-constructed buildings and abandonned foundation pits for future buildings .The subprime market certainly will impact those high end condo buildings .

One particularly prominent pit is Ground 0. Given the current market can't see any construction there now.

[cylindar]

04:15 PM on 12/03/2008

You are dead wrong. Comercial real estate is affected very heavily in an economy or lack thereof). Fewer shoppers and clients leads to bankruptcy and vacancy. Not only that you state that commercial loans are more intelligently made. This is balony. The penciling of the figures don't mean diddly because most business people did not see this downturn coming and thus all the sober calculating you talk about did not make any difference. How many ways can you spell screwed? You are right that commercial property will not take as big of a hit but it will be a lot more massive than most people think. A lot o9f vacant space will be created and thus owners wil not be able to pay their notes when due and thus poof! There is going to be more talk about the problems coming to commercial property and investment and bankruptcies, etc. etc. . Get used to it cause it ain't goin away babe.

[ElTiante]

07:56 PM on 12/02/2008

I won't return the insult and call you "silly," but you might have a little too much faith in this phantom investor class that is all brains and no emotions. Isn't that what we were led to believe about "the smartest guys in the room" over at Goldman Sachs, which leveraged itself to about 35-1? Greed is also an emotion. Remember those stoical smarties with monikers like Merrill Lynch, Lehman Brothers, Bear Stearns?

And as for point #4 in your article... Reserves? Those went out of fashion among the financial genius class about a decade ago.

Also, one of the largest bankruptcies in Australia last year was a commercial real estate firm that had large holdings in the US (mostly shopping malls). So it is possible for the biggest and the best investors in commercial real estate to make ALL of the mistakes you mention.

You could be right about the scope being smaller than the US housing crash, but it would be hard to find something bigger than that.

[TheIG]

01:12 PM on 12/02/2008

Jim,

I hope you are right, but I am pretty certain you are not. I am not sure there is a big difference in letting emotion drive a purchase or an Excel spreadsheet that has flawed assumptions...I might be inclined to take the emotional buy over a deal that never loses in Excel. Commercial RE lenders have not engaged in "nutty" lending practices?...that is funny. I am not sure that the people at Wells Fargo would agree with you...they are probably the only lender that almost stuck to their guns and traditional commercial real estate underwriting rules. A crappy buy is a crappy buy...most of the deals that have been purchased in the last 3 to 5 years could turn out to be some crappy buys (IMHO). I am not sure when 5-6% CAP deals (on real numbers) became a good play, but that has been all the rage for a while now. With that said, I hope you are right.

[Petrovas]

12:39 AM on 12/02/2008

Hey Jim, I hate to break it to you but BILLIONS of commercial real estate is coming due next year and the cost to refinance are either nosebleed or the cap markets are CLOSED.

People who once worked in the real estate department are moving to workout groups.

GENERAL GROWTH PROPERTIES is one to watch.

There is no liquidity. An asset is worth only as much as someone is willing to pay for it.