Commercial Real Estate May Be the Next Asset Bubble to Burst

While the Obama administration and the politically powerful oligarchs of finance focus on so-called public/private partnerships as a solution to the financial toxicity created by securitized subprime mortgages, another sizeable component of real estate securitization on bank balance sheets is on the verge of being the next domino to fall. While residential real estate's impact on the global financial and economic crisis still retains the spotlight, indications are growing that a global commercial real estate implosion is on the verge of becoming the next asset bubble to pop, with devastating consequences. Perhaps it is only because so many fires are already burning amid the rotting timbers of our flawed financial architecture that the impending disaster about to afflict commercial real estate has yet to compel urgent attention. Some, however, are astute enough to see the train wreck that is coming down the track at breakneck speed. Take, for example, billionaire financier and investor George Soros.

Speaking at a conference held in Washington, Soros said, "Commercial real estate has not yet fallen in value. It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent."

What are the transactions that George Soros is referring to? Some major commercial real estate markets are already pointing towards a catastrophic collapse. The brokerage firm C.B. Richard Ellis Inc. has issued a report on the prime Manhattan commercial real estate market that presents a truly apocalyptic image. The past year saw the value of Manhattan office building transactions decline by a staggering 69%. A high proportion of such sales were of a distressed character, the bulk involving buildings that had been owned and managed by Harry Macklowe. The real estate entrepreneur was forced to deleverage due to his inability to secure financing and meet loan obligations to his creditors, in particular Deutsche Bank. This process of forced deleveraging has had its inevitable impact on the Manhattan commercial property marketplace. Buildings that Macklowe purchased on credit for $1,100 a square foot are now obtaining as low as $778 a square foot, in the diminishing number of cases where buyers can actually be found who still have access to credit.

The contraction of the commercial real estate market in New York is only a harbinger of what is beginning to occur with increasing rapidity in large cities and medium sized towns, not only across the United States but also throughout the world. Two forces are at work in this disaster in the making; frozen credit flows and rising unemployment. Both forces feed on each other in a perpetual negative feedback loop. Restricted access to credit means property owners cannot meet their loan payments or refinance, forcing deleveraging, which in turn further distresses commercial property prices. The increasing levels of unemployment arising from the Global Economic Crisis has unleashed a wave of demand destruction, the likes of which have not been seen since the Great Depression of the 1930s. In major cities and shopping complexes across the globe, retail outlets are bereft of customers, in the process liquidating essential cash flow for these enterprises. This means even where credit might be available, such as through government funded injections of capital into the banking system, enterprises lack the capacity to service loans that otherwise might be accessible. The result is a self-perpetuating meltdown in which commercial real estate increasingly becomes vacant, with few potential buyers or tenants available, further distressing their economic value.

Just as with securitized subprime mortgages, many commercial banks, investment houses as well as the vast shadow banking system invested heavily in paper backed by commercial real estate. For those retaining hope that commercial property mortgages were consummated with more due diligence than was the case with residential borrowing, their optimism will soon be proven to have been unwarranted. Until about 2007, a commercial real estate boom existed in parallel with the residential housing bubble that was being fed in large part by the Federal Reserve and its low interest rate policy. Very often substantial properties were purchased, at the peak of the market, with 90% of the purchase price financed through credit. As these loans become increasingly non-performing, in synchronicity with the diminution in value of the collateral that backed up those loans, another transformation of bank balance sheets into toxic acid will be unleashed, with a vengeance.

How significant is the exposure to the coming implosion in the commercial real estate market? Estimates range in the trillions of dollars. Commercial properties encompass a vast array of buildings in developed and developing economies, from small, medium and large sized office buildings to shopping malls of all dimensions. Strip malls and mega-shopping complexes are losing tenants, with no one lining up to replace them as the Global Economic Crisis curtails demand by consumers. With fewer tenants and constricted income, property owners unable to service their outstanding loans are deleveraging, as mentioned above. Keep in mind that this is not just a New York City phenomenon; London and Budapest, Los Angeles and Berlin, Seattle and Tokyo are already seeing this torrent of economic destruction at work. As the implosion in commercial real estate accelerates, the already fragile global banking and credit system will be hammered yet again. In a worst case scenario, the blow about to be delivered by this next bursting asset bubble may prove to be mortal for the global economy.

Comments

[TheMadHedgeFundTrader]

Walking around San Francisco’s financial district the other day, I couldn’t help but notice the colorful, but huge “for lease” and “space available” signs wrapped around whole buildings. The San Francisco Chronicle produced some current market figures for the wasteland that is now the commercial real estate market. Rents have crashed 24% in a year, with Class “A” office space plunging from $50.92 to $38.80, the biggest drop since the dot com bust in 2001. Tenants are downsizing, consolidating, or disappearing altogether. Macy’s and Charles Schwab together are vacating 500,000 square feet this year, with more than half of all Bay Area companies expected to shed staff in the next six months. Purchases of office building have ground to a complete halt because of the absence of financing. Not helping are the city’s notoriously high operating costs, labor rules that would make Bolsheviks blush, and a tax rate that is about to jump from 8.75% to 9.75% to help bail out the state. It’s a lot to pay for a great view. Will the last one leaving please turn out the lights? www.madhedgefundtrader.com.

[larry278]

We have another step into the mother of all depressions when the bubble for commercial real estate breaks.

[scottsdalebubbe]

Here in Maricopa County (Phoenix, Scottsdale, Glendale, Mesa, etc.), Arizona, "may happen" is already happening. Low interest rates are irrelevant to current owners because the vacancy rates in office and retail are already so high. New commercial construction is stalled out because financing dried up mid-construction. Projects are in bankruptcy. Commercial tenants are asking for and getting better terms mid-lease. "A" multifamily properties were purchased with very little down payment and at inflated prices -- buy at a 3.5 or 4 cap and 1.1 debt service ratio (what were the lenders' underwriters smoking???), counting on a 5 year hold to make up the difference in sale price to the next greater fool?

Remember, when you are investing in a commercial property -- office, retail, industrial or multifamily 5 units or greater, you are buying cash flow. Any other reason to build or buy is not investing, it is speculating or gambling. If you want to speculate or gamble, there are plenty of opportunities in the stock market. Don't try it with commercial property.

[WorkingClass]

Shhhhhh. Mr. Filger Mr. Filger. How am I supposed to feel confident?

[olephart]

In 2007 in a response to an article by Bonddad I postulated the eminent decline of the American consumer. This was strictly based on the knowledge that cash out refinancings and the real estate boom had busted. At that time it was estimated that 0.5% of GDP was based on this source of “income” with an equal or greater amount based on “flipping” houses. I then reasoned that many thousands of retail establishments would go bust creating both unemployment and vacant commercial retail real estate.

This occurrence was a natural outgrowth of the flawed economic model that has evolved over the past 30 years. This model is based on corporations being the all important driver of the economy. During Reagan’s tenure the assault on labor and government began. Clinton continued this with “free trade” policies and later by embracing the Republicans’ deregulation philosophy. Bush Jr. brought this witches brew to a boil by completely ignoring any semblance of lawful business practices and allowing those who would game the system a free and unfettered reign of terror on Wall Street.

Now Obama has partaken of the Wall Street kool aid and has thrown in his lot with those who have committed trillions in inexcusable frauds. He has mortgaged this Nation’s future to prop up the criminals that caused this debacle.

Commercial real estate may fall but the government has shown that it will sacrifice anything to protect the guilty.

[jerrypl]

We have been waiting for this commercial real estate collapse for months, but has not yet happened. It will has the economy continues to shrink, consumers don't go the mall as much, stores close, malls fold, tenants walk, etc.

It is inevitable.

http://eye-on-washington.blogspot.com

[Henry]

"Speaking at a conference held in Washington, Soros said, "Commercial real estate has not yet fallen in value. It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent"

The things to ponder with commercial real estate are vacancy rates and interest rates. So...while vacancy rates are creeping up, interest rates are at a real rate negative level. It's rental revenue that pays the mortgage note and it is really no more complicated than that.. Keep your eyes on vacancy they happen before foreclosure.