The Collapse of Commercial Real Estate

Are you waiting for the next shoe to fall and are sure it's going to be Commercial and Corporate Real Estate? If so, you are in the majority. If so, I think you are dead wrong. You have missed the bottom of the commercial real estate market which I suggest occurred about the end of the second quarter of 2009. There have been a number of signs, not the least of which is a four percent average price increase of commercial real estate prices in the third quarter.

Banks who hold debt have been renegotiating loans like crazy. Everyone has a story about a commercial real estate borrower who got a "kick the can" response from their bank. Where this has happened the terms of a final principal and interest write down is postponed for a few quarters. But they have done two things when they have. First, they have relaxed repayment terms significantly. Second they have provisioned for losses often exceeding that of a future renegotiation.

In a number of past recessions the commercial real estate sector suffered from significant overbuilding which took years to absorb. This recession did not see so much overbuilding as over financing. Unlike residential real estate, commercial real estate has not suffered from a jaw dropping high Loss Given Default (LGD) rate or as severe of an asset impairment. Users of commercial real estate, x-housing and hospitality, went into the downturn less leveraged than in past recessions. They are unlikely to be shedding as much excess space as many observers expect. The commercial real estate debt hangover will take a long time to recover from. Securities invented or simply abused in the last fifteen years will need to be unwound, often painfully. Real demand will turn the tide on valuations long before the financing excesses wash out. In my view this will lengthen the financial unwind well beyond the beginning of the next building cycle. It will also soften the shock as properties perform their way out of crisis.

The PricewaterhouseCoopers' Korpacz Real Estate Investor Survey for the second quarter predicted a market turn around in 2011. Their third quarter edition now predicts a turn around in mid 2010. In the first quarter they were predicting three more years of price declines. This survey while interesting and exhaustive in its market coverage is the ultimate rear view mirror picture of the market. If you like to look at contra indicators, this may be a good one.

People have been raising lots of money to buy distressed commercial real estate assets. Their problem is there are few properties for sale at the current distressed prices. Look for prices to move quickly when these funds run out of patience.

The administration has issued REMIC rule changes which were announced by the IRS and the FDIC to make workouts easier across CMBS barriers. Full story here. It's hard to say if this will lead to a new wave of loan modifications but it will at least prevent distress pressures from building. Security prices have already collapsed. Security holders are well prepared to ultimately accept lower payouts. Tranche class warfare will erupt but this will hardly impact commercial real estate asset valuations.

There are many other signs out there. Have a favorite of your own? Please email them to me at richardlellisjr at gmail.com and I will include your insights.