…wait until you see what’s in the cards
for commercial real estate.
That’s right, the
next train wreck will be in commercial real estate. Couldn’t be worse
than last year’s residential market crash? That remains to be seen. But
it’s coming soon, probably as early as the second quarter of next year,
and there’s nothing that can prevent it. The government will intervene,
trying desperately to delay the day of reckoning, and may even succeed. For a
while. But make no mistake about it, that train is
going off the tracks no matter what.
Every part of the sector – from multifamily apartment
buildings to retail shopping centers, suburban office buildings, industrial
facilities, and hotels – has accumulated a huge amount of defaulted or
nonperforming paper. It’s an impossible, swaying structure that cannot
long stand.
Just ask Andy Miller.
Andy is one of the most knowledgeable people around
when it comes to commercial real estate. Co-founder of the Miller Fishman
Group of Denver, he has spent twenty years buying and developing apartment
communities, shopping centers, office buildings, and warehouses throughout
the country. He’s also worked extensively – especially lately –
with asset managers and special servicers (those who handle commercial
mortgage-backed securities, or CMBS) from insurance companies, conduits, and
the biggest banks in the U.S., advising them on default scenarios, helping
them develop realistic pricing structures, and making hold or sell
recommendations.
It isn’t easy. Commercial real estate sales
are off a staggering 82% in 2009, compared with 2008, and last year was worse
than ’07. No one is selling at depressed
prices, but it hardly matters as there are no buyers, either because
they’re afraid of the market or can’t meet more stringent loan
requirements. Two years ago, the value of all commercial real estate in the
U.S. was about $6.5 trillion. Against that was laid $3-3.5 trillion in loans.
The latter figure hasn’t changed much. But the former has sunk like a
bar of lead in the lake, so that now between half and two-thirds of those
loans will have to be written down, Andy estimates.
“If the banks had to take that hit all at once,
there wouldn’t be any banks,” he says.
And it’s actually worse than that. As even
average citizens became aware during the subprime meltdown, loans in recent
years were bundled into exotic financial vehicles that could be sold and
resold, a class generically known as conduits.
These commercial mortgage-backed securities, while less well known than their
cousins built upon home loans, are nonetheless ubiquitous.
Three guesses who were among the significant buyers
of CMBS. If you said banks, banks, and more banks, you got it. Thus these
folks are sitting not only on their own malperforming
loans, but on a whole lot of everyone else’s toxic junk, too.
This is how bad conduits are: A 3% default rate last
year jumped to 6% in 2009 and is expected to double again, to 12%, in 2010. An
entity that takes a 12% hit to its portfolio – and this includes countless
banks, pension and annuity funds, international institutional investors, and
others – is in deep, deep trouble.
The real tsunami is coming,
probably in the second quarter of 2010, Andy estimates. Because that’s
when banks will have to start preparing for the wave of mortgages that were written
near the market top and are maturing in 2011-12. Unlike home loans, commercial loans
tend to be relatively short-term in nature (average 5-7 years), because –
outside of apartment building loans backed by Fannie or Freddie – there
are no government programs to subsidize longer-term ones. These guys mature
in bunches.
According to a
recent Deutsche Bank presentation, the delinquency rate on commercial loans
as of the end of 2Q09 was greater than 4%. Of these, they expect that north
of 70% will not qualify for refinancing. Imagine what will happen to the
estimated $2 trillion in commercial mortgages that mature between now and
2013.
And even that is not the end of it. There’s a
second huge wave on the way in 2015-16.
Problem is, instead of trying to meet this
inevitable challenge head on, asset managers have decided to believe in such
phantoms as the tooth fairy, honesty at the Fed, and an economic turnaround
powerful enough to bail them all out. De Nile is not just a river in Egypt.
To be fair, it’s difficult to envision what an
intelligent, aggressive response would look like, given the breadth and depth
of the crisis, and the lack of resources available
to deal with it. Miller recently met with a group of asset managers from a
number of different, prominent banks. They reported that they’re completely
overwhelmed and can’t even begin to cope with the sheer volume of
problem loans on their calendar. It’s so bad that they’re now dealing with some borrowers who
haven’t paid a cent in a year and a half.
What do you do if, as Andy thinks is the case, 85-90%
of the entire commercial real estate market is under water relative to its
financing? What happens to a property when its value drops way below the
loan, a seller can’t get enough money to get out, a buyer can’t raise
enough money to get in, and the bank can’t afford to foreclose? Simple.
It just sits there, carried along on the bank’s books at some inflated
“mark to fantasy” price that makes the institution’s
balance sheet look passable. The industry even has a catchphrase for the
situation: “A rolling loan gathers no moss.”
In the case of a retail store, a bankrupt tenant
walks away. Andy looked at just the part of Phoenix where his firm does
business and found 90 vacant big box stores, with an aggregate floor space of
8 million square feet. If Christmas season is as lackluster as cash-strapped
consumers are likely to make it, there will be many others to follow.
The hotel business is terrible. Overbuilding based
upon travelers who went into debt to finance lavish vacations is taking its
toll on tourist destinations. At the same time, business travel has seriously
contracted. Flights into Las Vegas, which caters to both, have been slashed
so much that even if every seat on every remaining flight were
filled and visitors stayed for an average number of days, the hotels still couldn’t
break even. In industry parlance, banks are now engaged in “extend and
pretend,” i.e., giving hotels three- to six-month loan extensions in
the hope that things will somehow improve in the near future.
Office space is doing okay in central business
districts, but not faring well elsewhere. Some estimates tab the national office
vacancy rate at over 16.5%, compared with 12.6% in January 2008. It exceeds
20% in parts of Atlanta and San Diego, and in many places in between.
Multifamily apartment
buildings – and the very creaky Fannie and Freddie are carrying a load of
them – may be the next to topple. As values deteriorate and landlords
are faced with loans coming due, there is no incentive to fix whatever goes
wrong. If, for example, you have a $10 million loan maturing in two years,
and the property value has declined to $6 million, why would you spend half a
million to fix leaky roofs? The question answers itself. Yet, as capital
spending needs are not attended to, the apartments deteriorate. Which leads to working-class tenants replaced by meth labs.
Which leads to even lower property values. And so
on. In the end,
when the banks are forced to take possession, they will be left with either
expensive repair jobs, or the cost of demolition and a total write-off.
As the overall commercial real estate crisis
escalates, the banks will do the same thing they did last year: run to the government,
palms outstretched.
How will Washington respond? Good question. On the
one hand, further bailouts will further infuriate the public. But on the
other, the political sentiment will be that allowing the banks to fail will
have even more dire consequences.
The Fed has already tried to let some of the relentlessly
building pressure out of the balloon through TALF (Term Asset-Backed Securities Loan Facility). But that hasn’t
worked, because TALF only backs the most senior, creditworthy bonds in a CMBS
pool. Those aren’t the problem. The problem is the junior notes no one
wants.
In order to increase
market liquidity and get conduits moving again, the government will likely be
forced to create a guarantee program similar to the FHA, Miller thinks,
whereby short-term money (on the order of 5-7 years) is made available. Will
that just push our problems five to seven years down the road? Quite
possibly. But what is being purchased is time,
the only thing left to buy. The hope, of course, is that it’s enough time – for the real
estate market to stabilize, prices to return to more “normal”
levels, and the world to turn all hunky dory.
Rock, meet hard place. Let
all the troubled banks fail, and the consequences will range from some
excruciating but short-term pain, to a plunge into full-bore depression. Prop
them up with yet more newly printed fiat money, and anything from high to
hyperinflation will inevitably result, along with the possibility of
extending the problem well into the next decade.
Both are frightening
prospects. We don’t want either, but realistically, we’re going
to get one or the other. Let’s be clear, it won’t be the end of
the world. However, it will be the end of the world as we know it. That makes
it imperative to prepare for the new one that’s coming.
The editors of The Casey Report, supported by real estate pro Andy
Miller, have been warning of the coming commercial real estate debacle since
September 2008. This one’s rather easy to time – because they
know when the loans will come due. And as subscribers can testify, accurately
predicting big trends is the forte of Doug Casey and his expert team. To
learn how you can profit from making the trend your friend, click here.
Doug Hornig
Senior Editor,
Casey Research
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by Doug Hornig
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