Gold News

Commercial Real Estate, 2008

Commercial real estate in Manhattan is only just being kept afloat by billions in foreign bail-outs for the finance sector...

"WE ARE ALL ABOUT to become experts on defaults, delinquencies, foreclosures and write-downs," wails Ross Moore, senior vice-president and director of market & economic research at Colliers International, a worldwide commercial real estate services firm.

   "Retail and consumer spending is tenuous at best," he moans, "job growth is down and this negative trend is almost certain to continue."

   A compelling case, in short...which is not good news for his employer, or for any other participant in the US commercial real estate market.

   Just compare the price trends of the KBW Bank Stock Index (BKX) and the Collier's Midtown Manhattan Office Rent Index.

   These two indices probably share no scientifically valid connection with one another. Indeed, your local MENSA chapter would probably scoff at the comparison.

   But nevertheless, the BKX and the Collier's Index appear to move in sync. Or rather, the BKX appears to lead the Colliers Index. So the squiggly lines on the chart above might offer a valid insight, no matter what MENSA would say about it.

   When the finance industry is flourishing, so is Midtown Manhattan. And when Midtown Manhattan is flourishing, office rents are rising. At present, the US finance industry is not flourishing, it is foundering. And the only reason it has not slipped under the waves is that hundreds of billions of dollars of foreign bailouts have kept it afloat.

   The US finance industry has survived, but it is hardly seaworthy. A crippled finance industry cannot be good for Midtown Manhattan rental rates...or for the rest of the nation's commercial real estate market. The imploding finance sector is a nationwide crisis – one which undermines the viability of almost every capitalistic endeavor, especially endeavors like buying and building commercial real estate.

   For the moment, commercial construction spending remains robust. But this apparent strength owes a larger debt of gratitude to the hopeful expectations of 2005 and 2006, than to the grim realities of 2008.

   Commercial projects operate on a much longer timeline than residential projects, due to the onerous permitting and approval processes. So many of today's commercial construction sites are merely the gestation of ideas conceived two to three years ago as the peak of the bubble drew near.

   That's why we would expect the commercial construction trend to begin mimicking the sickly trend of its residential counterpart...especially because the economy is slowing and the nation's banks already hold too many commercial loans on their books.

   In a slowing economy, commercial real estate loans are dicey assets to hold.

   A developer's hoped-for occupancy projection can vanish faster than morals at a frat party. So the hoped-for cash flows don't flow and, eventually, the banks become the proud owners of empty office buildings.

   Because of this risk, banks tend to curtail their commercial lending at the first sign of recession...or at least at the second or third sign. They are banks, after all.

   During the current economic slowdown, however, banks might pull the plug on commercial lending very abruptly. They've got too many commercial real estate loans already. The ratio of commercial real estate loans to capital has nearly doubled in the past six years, according to US Comptroller of the Currency, John C. Dugan. At the end of a five-course meal – topped off with a cheese plate and a snifter of Armagnac – no one longs for a second five-course meal.

   "Even more significant than this overall industry statistic is the number of individual banks that have especially large concentrations," Mr Dugan adds.

   "Over a third of the nation's community banks have commercial real-estate concentrations exceeding 300% of their capital, and almost 30% have construction and development loans exceeding 100% of capital."

   And like every other kind of loan in this great (indebted) land of ours, commercial loans are starting to go bad as quickly as...well...morals at a frat party. In the area of construction and development (C&D) loans, nonperforming loans in community national banks amounted to 1.96% of the total at the end of the third quarter, double the rate of the year before.

   "The combination of these conditions," Mr Dugan relates, "is putting considerable stress on one particular category of commercial real estate lending: residential construction and development – and other categories of commercial real-estate loans will feel similar stress if general economic activity slows materially."

   Net-net, the commercial real estate market rests on a shaky foundation, which is why Ross Moore at Colliers seems to express more fatalism than confidence.

   "Since the onset of the credit crunch in mid August," Moore explains, "the investment sales market has slowed significantly. What was expected to be a minor blip has turned into a major event.  Following the credit woes in August, the immediate reaction by many was that things would almost certainly get back to normal post Labor Day, as the Federal Reserve and other central banks intervened and provided the required liquidity."

   The Fed indeed intervened, as did other central banks, but things did not "get back to normal." Instead, the credit markets remained abnormally dysfunctional.

   "As writedowns continued," Moore went on, "and debt became more difficult to source – and more expensive once found – markets nationwide began to see deals collapsing or falling out of contract as buyers fully digested the turmoil gripping credit markets around the globe...Deals that had looked highly attractive just a few months ago were now nowhere near meeting required rate-of-return thresholds.

   "The central issue remains debt, both the availability and price," Moore concludes. "Until the credit markets settle down it is highly unlikely the investment sales market will return to anything resembling normal. The following are issues which need addressing:

  • If you can't price money, how can you price real estate?
  • If everybody is sitting on their hands, how can a market function normally?
  • Top tier markets are still attracting multiple bids, but many of the rest are nearing a "no bid" environment;
  • If the consensus view is that prices will be lower a year from now, why not wait? Even well-capitalized investors will be asking that;
  • How will REIT's react? Many are in a position to acquire, but a sinking stock price makes acquisitions more difficult..."

   So where's the good news for the commercial real estate market? One possibility would be that foreign buyers step in to buy, just like they've stepped into the US finance sector – i.e., without paying fastidious attention to the merits of their investments.

   Over in the troubled finance sector, the sovereign wealth funds and other foreign investors have blurred the traditional lines between buyout and bailout by providing tens of billions of dollars of equity financing to operations that excel at destroying shareholder wealth. These dubious investments have created an aura of recovery and newfound stability in the finance sector. Bailing out the entire US commercial real estate market would require a much smaller suspension of investment judgment, but a much larger collective investment.

   Nevertheless, we would not rule out the possibility.

   "This time around," Moore concludes, "the key is the credit markets – and we watch this very closely...Credit is the economy's lifeblood...It looks as though the first quarter [of 2008], and increasingly likely the second quarter, will be very quiet with no privatizations or large portfolios trading and significantly less single asset sales. Sellers will be reluctant to sell and buyers still highly cautious. For the balance of 2008 much will depend on the Federal Reserve, both in terms of setting monetary policy and providing reassurances that the banking system is sound and credit still available. Hopefully the economy will come to the rescue."


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Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

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