Commercial Real Estate Crash Coming
A commercial real estate crash is set to descend on us in 2010. I don't mean to use the word "crash" as a kind emotional manipulation here. I'm not trying to scare anyone. It's simply the correct, accurate term to use under the circumstances.
Commerical real estate, strictly speaking, consists of buildings that house businesses. The crash will come because commercial real estate developers and owners will not be able to meet their scheduled debt payments. For one thing, rents are coming down, so owners are collecting less. Some owners won't be able to meet their mortgage payments. Even though the rents (their source of revenue) are dropping, the mortgage payments are not. As rents drop, cash flow decreases. Since many commercial developments are financed with mortgages that are fixed, the mortgage must be paid out of a decreasing cash flow. At some point, the owner makes no profit. All the cash flow from rents must meet expenses of managing the property. Many of those expenses are fixed as well. Then, at some point, cash flow is negative. There's not enough revenue coming in to pay the expenses. Game over.
The situation is similar to an unemployed person not being able to pay their mortgage. They no longer have income and so can't meet their obligations - their mortgage payment, insurance and other home expenses (gas and electric, heat, taxes, etc.).
But there's more to the story. In addition to decreasing cash flow from rents that are dropping, the debt owed on many commercial buildings is far in excess of the value of many properties. Many owners, especially since the early part of the last decade (hard to believe it's already 2010, isn't it?), borrowed as much money as they could get when they bought commercial properties. After all, money was cheap - which just means interest rates were low. So why not borrow more money while it was "on sale."
Some commercial developers not only borrowed heavily to purchase real estate, they bought at the top of the market. And, of course, commercial real estate values, just like the values of home, have been heading down since 2006 or so.
Now payments are due on those loans. On top of all that, many of the loans taken to purchase these properties have to be re-negotiated. If the original loan was for a period of, let's say, five years, then the owner needs to either renegotiate with the lender to extend the loan. And maybe the lender doesn't want to renegotiate at the old low rate. They want a higher rate of interest on the loan. It's a bit like the home owner with an adjustable mortgage whose rates are going up. If they can't afford the higher mortgage payment, there's a problem. It's not different for the commercial real estate owner.
Add in the fact that (just like with the home owner) a lot of the real estate has dropped in value and the mortgage may be worth more than the property. Of course, they could always find another lender. But good luck with that. First of all, banks aren't lending much these days. Second of all, if the value of the property has declined (and it most assuredly has), the new lender isn't going to loan the owner as much as the original lender.
Will these owners just walk away, in the same way that homeowners walk away from their homes when the mortgage is worth more than the equity in their home?
I'm going to use the example of Stuyvesant Town here in New York City. It's basically a large apartment complex that includes some commercial establishments to serve the needs of the residents. It's illustrative of how it's not just amateur dabblers, but experienced real estate professionals who made big mistakes during the recent real estate boom.
The new owners bought Stuyvestant Town at the top of the market and financed their purchase with what was then "cheap" money. Banks jumped at the chance to finance that deal. It was a perfect example of the lunacy that prevailed until just a couple of years ago.
Pieces of that original financing need to paid off or re-financed. In fact, the owners have already defaulted on part of their loans. The current owners have watched this complex lose over 20% of its value and - even though these were professionals buying from other professionals - their property is now underwater (loans are greater than the value of the property). What will happen now that they've defaulted? We'll find out this year.
It kind of shocked me when I realized that even seasoned professionals "drank the kool-aid": 1) they bought at the top of the market under the premise that real estate can never go down (at least not significantly for any period of time); 2) they financed the bulk of the purchase because money was "cheap." (Why tie up your capital when you can borrow all that cheap money that banks were just dying to throw at you? I'm sure they thought of it like this. And how is this any smarter than the homeowner who bought his home with a 100% mortgage? It's not.)
This, of course brings up the issue of all that cheap money that was available. I'll talk more about that in my next blog.
For now, let's finish up with what this coming crash will mean to all or us. Let's look on the positive side. It's not necessarily something that should make you run for the hills. If you're flush with cash and know your way around the real estate market in your area, you may find some bargains, some real investment opportunities. Money is being raised right now on Wall Street to create funds that will swoop in and buy up these bargains as they come on the market. But that doesn't mean you can't too - again if you know what you're doing. So in the midst of the crash will come some opportunity.
Someone wins when someone loses. You've really got to see things like "crashes" in this way. It's not a one-way ticket to disaster. While commercial real estate begins crashing this year, unless you're one of those waiting in the wings to buy up some bargains, just stand back and watch the show.
Commerical real estate, strictly speaking, consists of buildings that house businesses. The crash will come because commercial real estate developers and owners will not be able to meet their scheduled debt payments. For one thing, rents are coming down, so owners are collecting less. Some owners won't be able to meet their mortgage payments. Even though the rents (their source of revenue) are dropping, the mortgage payments are not. As rents drop, cash flow decreases. Since many commercial developments are financed with mortgages that are fixed, the mortgage must be paid out of a decreasing cash flow. At some point, the owner makes no profit. All the cash flow from rents must meet expenses of managing the property. Many of those expenses are fixed as well. Then, at some point, cash flow is negative. There's not enough revenue coming in to pay the expenses. Game over.
The situation is similar to an unemployed person not being able to pay their mortgage. They no longer have income and so can't meet their obligations - their mortgage payment, insurance and other home expenses (gas and electric, heat, taxes, etc.).
But there's more to the story. In addition to decreasing cash flow from rents that are dropping, the debt owed on many commercial buildings is far in excess of the value of many properties. Many owners, especially since the early part of the last decade (hard to believe it's already 2010, isn't it?), borrowed as much money as they could get when they bought commercial properties. After all, money was cheap - which just means interest rates were low. So why not borrow more money while it was "on sale."
Some commercial developers not only borrowed heavily to purchase real estate, they bought at the top of the market. And, of course, commercial real estate values, just like the values of home, have been heading down since 2006 or so.
Now payments are due on those loans. On top of all that, many of the loans taken to purchase these properties have to be re-negotiated. If the original loan was for a period of, let's say, five years, then the owner needs to either renegotiate with the lender to extend the loan. And maybe the lender doesn't want to renegotiate at the old low rate. They want a higher rate of interest on the loan. It's a bit like the home owner with an adjustable mortgage whose rates are going up. If they can't afford the higher mortgage payment, there's a problem. It's not different for the commercial real estate owner.
Add in the fact that (just like with the home owner) a lot of the real estate has dropped in value and the mortgage may be worth more than the property. Of course, they could always find another lender. But good luck with that. First of all, banks aren't lending much these days. Second of all, if the value of the property has declined (and it most assuredly has), the new lender isn't going to loan the owner as much as the original lender.
Will these owners just walk away, in the same way that homeowners walk away from their homes when the mortgage is worth more than the equity in their home?
I'm going to use the example of Stuyvesant Town here in New York City. It's basically a large apartment complex that includes some commercial establishments to serve the needs of the residents. It's illustrative of how it's not just amateur dabblers, but experienced real estate professionals who made big mistakes during the recent real estate boom.
The new owners bought Stuyvestant Town at the top of the market and financed their purchase with what was then "cheap" money. Banks jumped at the chance to finance that deal. It was a perfect example of the lunacy that prevailed until just a couple of years ago.
Pieces of that original financing need to paid off or re-financed. In fact, the owners have already defaulted on part of their loans. The current owners have watched this complex lose over 20% of its value and - even though these were professionals buying from other professionals - their property is now underwater (loans are greater than the value of the property). What will happen now that they've defaulted? We'll find out this year.
It kind of shocked me when I realized that even seasoned professionals "drank the kool-aid": 1) they bought at the top of the market under the premise that real estate can never go down (at least not significantly for any period of time); 2) they financed the bulk of the purchase because money was "cheap." (Why tie up your capital when you can borrow all that cheap money that banks were just dying to throw at you? I'm sure they thought of it like this. And how is this any smarter than the homeowner who bought his home with a 100% mortgage? It's not.)
This, of course brings up the issue of all that cheap money that was available. I'll talk more about that in my next blog.
For now, let's finish up with what this coming crash will mean to all or us. Let's look on the positive side. It's not necessarily something that should make you run for the hills. If you're flush with cash and know your way around the real estate market in your area, you may find some bargains, some real investment opportunities. Money is being raised right now on Wall Street to create funds that will swoop in and buy up these bargains as they come on the market. But that doesn't mean you can't too - again if you know what you're doing. So in the midst of the crash will come some opportunity.
Someone wins when someone loses. You've really got to see things like "crashes" in this way. It's not a one-way ticket to disaster. While commercial real estate begins crashing this year, unless you're one of those waiting in the wings to buy up some bargains, just stand back and watch the show.
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