In the last 18 months, the commercial real estate market has seriously deteriorated. Yet many analysts are hopeful that the worst is over and that pressure on property owners will begin to ease. Let's take an in-depth look at whether their optimism is justified.
Early 2007: The Perfect Calm
Charles Dickens began his classic, A Tale of Two Cities with the famous opening "It was the best of times ..." That was the tone of the Mortgage Bankers Association's (MBA) January 2007 assessment of the commercial market which was entitled "The Perfect Calm." Indeed, everything looked calm and promising to the MBA.
Record amounts of investor money were pouring into the market. Delinquency rates had dropped to only 1% of all commercial real estate loans, down from the heart-stopping rate of 12% in 1991 after the S & L collapse of the late 1980s. The author of this MBA review could find little on the horizon that warranted concern except for possible overbuilding by optimistic developers.
Although the residential subprime market collapsed only three months after this report appeared, this had little effect on the commercial real estate market. For the rest of 2007, investors continued to bid on just about anything that hit the market at prices that defied traditional standards. A record $522 billion in sales transactions were closed that year according to Real Capital Analytics. The chart below shows how purchases skyrocketed from 2001 to 2007.
The Blackstone Group, perhaps the nation's leading real estate management and advisory firm, wisely sold off $60 billion of its holdings during the market peak of 2005-2007. Yet even it was subject to excessive exuberance, purchasing the Hilton Hotels empire in October 2007 for a whopping $26 billion. That was 40% more than the stock market valued the common shares at the time.
It Was Quite a Party While the Lending Flowed
The previous commercial real estate boom in the 1980s was characterized by massive overbuilding fed by easy money from the S & Ls and commercial banks. Total office market space actually doubled in the 1980s by the time the boom collapsed. The market was saved from total ruin only by Congress's creation of the Resolution Trust Corporation (RTC) which took over the assets of failed S & Ls and sold them off in bulk often for pennies on the dollar. It cost the taxpayers $157 billion according to the Congressional Oversight Committee's February 2010 report on the state of the commercial real estate market.
The lesson was clear: When threatened with a potential systemic failure, the federal government would bail out surviving financial institutions and all their insured depositors. No need for depositors to exercise any prudence as to where they put their money.
Like its residential counterpart, the commercial real estate bubble of 2004-2007 was a buying binge fed by a seemingly inexhaustible supply of mortgage funds. Most of the lending was provided by two sources - the commercial banks and institutional investors who purchased commercial mortgage-backed securities (CMBS).
Since the late 1990s, small and mid-sized banks have drifted away from their traditional role as short-term lender to commercial developers. Over the last dozen years, these banks gorged themselves on commercial real estate mortgages and became the primary lenders in this market. According to the Federal Deposit Insurance Corporation (FDIC), banks with assets between $100 million and $10 billion held 36% of their total assets in commercial real estate loans at the end of the first quarter 2010. Half of their total loan portfolio was in commercial mortgages.
Between 2000 and 2004, CMBS lending averaged $70 billion annually according to the real estate law firm Robins, Kaplan, Miller & Ciresi. Then it took off in 2005 and peaked at $248 billion in 2007.
Underwriting standards went out the window. According to the Congressional Oversight Committee report cited earlier, during the peak bubble years of 2006-2007, nearly 90% of CMBS loans were either interest-only or partial interest (negative amortization). Many of the deals required little down payment. As prices soared, lenders justified their actions by assuming that rising rents would continue indefinitely.
The Office Market in 2009
In the largest commercial sector -- the office market -- the statistics didn't seem right to the CoStar Group in April 2009. Millions of jobs had been shed since the recession began, but the vacancy rate had not gone above 12.5%. Then Mark Heschmeyer, their chief analyst, published an article entitled "Has the Office Vacancy Rate Become Irrelevant?" In it, he quoted the firm's CEO, Andrew Florance, who put it bluntly: "Never has a vacancy rate chart been more useless in commercial real estate than right now."
Florance went on to elaborate: "Based upon the job losses we've seen to date, we should be seeing something on the order of 450 million square feet of negative absorption compared to the negative 20 [million] we've actually experienced."
The firm's conclusion was that there was an enormous "hidden supply" of available space which had not been listed on the market. Some of the key reasons for this were:
Established tenants were still hopeful about being able to rehire laid off staff.
Major tenants such as those in the financial services industry were fighting bigger fires and were not focusing on a few million dollars in underutilized space.
Smaller and mid-sized tenants were worried that putting their unused space up for sublease might send an impression that they were not financially stable.
Lenders were not forcing the issue of recognizing unoccupied space as long as owners were still collecting rents and making loan payments.
Their conclusion was that a 1,100 basis point spread existed between the official vacancy rate and the actual percentage of available space. In other words, the percentage of total available space was not 12.5% but 23.5% of all office space. An incredible and frightening number!
CoStar found that in the 15 largest office markets, leasing activity had plunged by an average of 46% from a year earlier. With fewer deals being done, the average time between a space being listed on the market and a signed lease had soared from 270 days at the start of 2006 to 415 days in the first quarter of 2009.
Furthermore, office building prices had collapsed in early 2009. Class A space was down 21% from the previous quarter and by an average of 51% from the peak in early 2008. Class B space had fared even worse - down 40% in the first quarter and 55% from the third quarter 2008 peak.
A good example of the unreality that CoStar had found so frustrating was an announcement by Morgan Stanley in December 2009. Bloomberg reported that Morgan Stanley's real estate division, which had spent $8 billion to purchase properties at the peak in 2007, planned to "relinquish" five San Francisco office buildings to its two lenders after having purchased them two years earlier from the Blackstone Group. One analyst estimated that the properties had lost half their value since having been bought as a result of a 37% plunge in prime office rents in the third quarter from a year earlier.
The Bloomberg author explained that Morgan Stanley had been negotiating an "orderly transfer" since early 2009. A Morgan Stanley spokeswoman took pains to explain that "This isn't a default or foreclosure situation." Really? What was it, then? A deed-in-lieu of foreclosure?
The Commercial Banks - A Policy of Extend and Pretend
As their commercial mortgage loan portfolio deteriorated, the banks have been extremely reluctant to foreclose on delinquent borrowers. Instead, they have chosen the route of extending loans as they matured with the hope that the market would improve. This policy was derisively called "extend and pretend." The banks were taking their cue from the FDIC which had adopted a policy in October 2009 that supported what it called "prudent commercial real estate loan workouts." The FDIC certainly did not want to take on the added burden of massive commercial loan defaults which so many mid-sized banks were facing.
By the end of 2009, all commercial banks and thrifts combined had charged off a mere $11 billion of commercial mortgages in the preceding two years according to FDIC figures. However, a growing number of community banks were failing in 2010 due largely to their commercial real estate loan portfolio. The FDIC has already closed 86 banks as of June 25. The five banks shut down in Florida, Nevada and California on June 18 had eighty per cent of their non-performing loans in commercial real estate.
A few months later, an August 2009 Wall Street Journal headline warned that "Commercial Real Estate Lurks as Next Potential Mortgage Crisis." The authors pointed out that banks held a total of $1.7 trillion in commercial real estate loans. By way of comparison, at the height of the last commercial crisis in 1992, banks held roughly $400 billion of these loans.
The Current Commercial Real Estate Market
Although the Obama Administration has continued to assert that the economic recovery is on track, the most recent statistics for the commercial real estate market cast serious doubts on that premise.
In early May 2010, the real estate data firm Trepp reported that the 60 day delinquency rate in April for CMBS hit a record 7% up from only 1.8% in April 2009. Topping the delinquency list were the lodging sector with 17.1% of loans at least 30 days delinquent and multi-family residences with a 30-day delinquency of 13.1%.
That same month, the research firm Realpoint issued its latest report for April which showed that the total outstanding CMBS delinquent loan figure had more than tripled in the last 12 months to $54.6 billion. The chart below shows how this amount has steadily skyrocketed.
It was not surprising to learn that 80% of these delinquent loans were securitized between 2005 and 2007. Loans that were liquidated in April were resolved at an average loss to the lender of 52%.
In the first quarter of this year, office vacancy rates climbed to 17.2% according to real estate data provider Reis Inc. As CoStar pointed out in the April 2009 article cited earlier, the available space was considerably higher. Effective rents were down an average of 7.4% from a year earlier.
Real Capital Analytics tracks distressed commercial real estate figures which are broader than simply delinquent loans. It calls this universe "Troubled Assets." In addition to delinquent or defaulted loans, it also includes loans in the process of foreclosure, loans where the owner is under financial pressure, loans where the owner has declared bankruptcy, and loans where a key tenant has declared bankruptcy which could affect the ability of the owner to service its debt.
Their latest figure for total Troubled Assets is $150.2 billion. Adding in the $31.9 billion in loans where the lender has foreclosed and taken back the property, the total figure for distressed loans is $182.1 billion.
No One Wants to Catch a Falling Knife
In mid-June, CoStar's Mark Heschmeyer published a comprehensive review of the nation's commercial real estate market. He emphasized that the damage to major metro markets varied widely.
Hardest hit were Las Vegas, Orlando, Tampa and Atlanta where distressed property sales accounted for 27-44% of all transactions. Nationwide, nearly 19% of all office transactions from early 2009 through March 2010 were distressed sales which were heavily concentrated in the suburbs.
Heschmeyer then turned to reports on specific markets from professionals in the field. The managing director of brokerage firm NAI Global reported that various sectors of Manhattan commercial property had plunged 40-60% from the peak years and sales activity had also plummeted. A commercial land buyer in Dallas lamented that investment funds which had been created to pick up distressed property - primarily REITs and hedge funds - were all over the place, bidding up prices and "not letting assets hit bottom."
The Florida situation was so grim that the president of one troubled asset firm believed the general consensus to be that distressed properties would account for a majority of transactions for the next 3-5 years. A Philadelphia professional lamented that "properties are distressed because there are no tenants to lease up vacant space." In San Diego, the number of defaults filed this year was running at a pace more than ten times greater than a year earlier.
One sarcastic pro from Arizona quipped that "It looks like we have reached the bottom, unless we find a new bottom."
Another seasoned veteran of real estate cycles in Tempe, Arizona perhaps summed up best the attitude of market participants: "No one wants to catch a falling knife."
Commercial Mortgage Loans Coming Due - A Ticking Time Bomb
William Hoffman is the CEO of Trigild, a non-performing loan specialist firm. In a telephone conversation with this REAL ESTATE CHANNEL author, he pointed out that although lenders do not want to foreclose, there is no other way to work out underwater loans that are coming due in the next two or three years. His view was that lenders will not want to refinance properties that have dropped 30-40% in value. The chart below aptly illustrates the ticking time bomb that awaits both underwater owners and lenders.
If there is a bottom on the horizon for commercial real estate, it is very difficult to see from this chart. Perhaps it is time to batten down the hatches.