Commercial Real-Estate Disaster

This afternoon I was reading my favorite daily financial websites and blogs and found a good piece that explains in considerable depth why there is a disaster pending in the Commercial real-estate market.  This has been brewing sense the bubble burst in ’08 , it’s just a matter of time when this all compounds together.

Not only is the commercial real-estate market in big trouble, so are the Balloon option ARM mortgages that reset very soon . This is not only a nightmare scenario for those without jobs now who are having trouble meeting obligations on mortgage payments.  This is also a nightmare for our government and it’s buddy the “independent” Federal reserve who have attempted to do anything from falling prices.

It’s pretty hard to keep prices where they are when they were created in a fraudulent and artificial environment.  In fact it is an impossible task.  Instead, like every other action taken by politicians, we will just try and kick the can down the road and hope future generations / elected officials  somehow magically figure out how to get out of this mess.

This from the Daily Reckoning

“Attention REIT investors! The commercial real estate is a disaster-in-the-making – both for property investors and for the thousands of American banks that are carrying outsized exposure to commercial borrowers.

Commercial real estate borrowers and their lenders face a mountain of debt maturities over the next few years. And re-financing this debt will be next to impossible, thanks to soaring vacancy rates and plummeting property values. “Zombie buildings” are popping up all over the place, according to Crain’s New York Business.

“Virtually all the assets bought between ’05 and ’07 cannot be refinanced today without a significant capital infusion,” says Shawn Mobley, executive vice-president at real estate firm Grubb & Ellis Co. “These buildings need to be recapitalized to get back in the business of being active real estate.”

Unfortunately, these “zombie buildings” can’t compete for new tenants because they lack the money to cover brokers’ commissions and interior office reconstruction. The number of zombie buildings in the Chicago area is likely to grow in 2010, according to a forecast by Grubb & Ellis. For landlords, the trend means even top-quality office properties are likely to divide themselves into “haves” and “have-nots,” with the latter seeing their vacancy rates worsen because of the lack of financing.

We’ll see many more zombie buildings emerge in 2010.

Many REIT investors seem to have grown complacent about the risks in the commercial real estate market. These investors seem to believe that banks will simply roll over underwater loans once they reach maturity, in the hopes that a future rebound in property values will catapult these loans back into solvency. This phenomenon is known as “extend and pretend.”

The “extend and pretend” strategy did not work for Japan’s banking system, and it won’t work for the US either. It won’t work because it will lead to a two-tiered commercial property market. In one tier, we’ll see property owners with affordable mortgages cut rents to fill their vacancies. In the other tier, we’ll see property owners and lenders hoping for a return to bubble values, and maintaining a high-mortgage, high-rent strategy.

Property owners in the high-rent tier may be making payments on their underwater mortgage for now. But once the low-rent tier starts winning all of the scarce leasing activity, vacancies in the high-rent, high-mortgage tier will accelerate and property-level cash flow will fall dramatically.

In other words, just because a mortgage happens to be performing now does not mean it will be viable in the long run. As commercial landlords with negative mark-to-market equity watch their tenants flee, they will stop making mortgage payments and surrender their properties to the lenders. Thus, sooner or later, commercial real estate will find its way down to the prices that would attract new investors and speculators. This process is known as “price discovery.”

By rolling over the maturing bubble-vintage loans made to underwater, but cash-flowing properties, the banking system (if allowed to do so by its regulators) would establish an artificially high price floor. Such industry-wide collusion would slow – but not prevent – the slide toward real-world pricing – the kind that would attract new investment.

But even if the process of price discovery in real estate is delayed by “extend and pretend” at banks, some measure of price discovery will come from the liquidation of properties that collateralize commercial mortgage-backed securities (CMBS). In these securities, when the underlying properties default on mortgages, the holders of the senior CMBS tranches usually push for liquidation. This means that junior tranche holders get wiped out, but losses to the senior tranches are minimized. The senior tranche holders have neither the patience nor the risk tolerance to hope for a rebound in property values. They just want their principal back as soon as possible.

One way or another, commercial real estate prices will fall toward their real-world prices…which are clearly below the “pretend” prices that most banks are using today.

Dan Amoss
for The Daily Reckoning”

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3 Comments

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3 responses to “Commercial Real-Estate Disaster

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