Flat Tax, Free Tax Proponents Praise Bulgaria, Blast America »More updates
Hear exclusive interview with SEC Chairman Chris Cox
By SCOTT POWELL AND DAVID LOWRY | Posted Thursday, August 20, 2009 4:20 PM PT
The recent uptick in home sales, green shoots of new housing starts and rebounding stock market may suggest that the long-awaited turn in the U.S. economy is here.
But is this daylight at the end of the tunnel or the beam of an oncoming locomotive of commercial real estate insolvency coming down the tracks on a collision course with a shaky economy?
Commercial real estate (CRE), valued at $3.5 trillion in the U.S., has experienced a 39% decline in prices from the peak only two years ago, according to the MIT Center for Real Estate.
This drop is greater than the 27% commercial real estate decline associated with the longer savings and loan crisis of the late '80s and early '90s that precipitated government Resolution Trust Corp. (RTC) seizures and auctions.
Additionally, the 18% price decline in the second quarter was the largest three-month drop in the 25 years since MIT first published the CRE price index.
Real Capital Analytics reports that over $2 trillion in commercial properties bought or refinanced in the past five years are upside down on their loans — having fallen below the finance or purchase price.
It appears owners have lost their entire down payments on $1.3 trillion worth of property. In the first six months of this year, commercial properties in default, foreclosure or bankruptcy doubled. That pace may accelerate because commercial usually lags residential by a year.
The same conditions that caused the residential bubble — including easy credit created by the Fed, lax lending standards and a boom in the underwriting of commercial mortgage-backed securities on Wall Street — also drove the overvaluation of commercial real estate.
According to Deutsche Bank, 65% or more of existing commercial real estate loans will fail to qualify for refinancing due to falling prices and higher capitalization rates, which are interrelated.
From 2004-07, cap rates were on average no higher than 6% and lenders typically provided 75%-80% financing. At a 6% cap rate, a property that generated $1 million of net income was valued at $16.6 million and would likely have $13.3 million of debt financing.
In this economy, that same property, now subject to cap rates heading toward 9%, is worth 40% less.
Today, with lenders providing 60%-65% financing, the property owner must come up with millions in new equity to refinance and hold on to the property.
During the past year, lenders hoping for stabilization were quietly extending performing loans on previous terms. But facts and accounting rules that tie appraisal values to cap rates are stubborn things, and conditions are likely to deteriorate.
With five-year terms quite common in commercial real estate, the U.S. is at the beginning of a refinance cycle that increases each year through 2012.
Already high vacancy rates will continue upward with more bankruptcies and higher unemployment. The only meaningful lease activity in commercial real estate will stay in the sublease market at rents 50% to 85% of existing scheduled lease rates.
These lower sublease rates will become the effective and real market rates and put further downward pressure on commercial real estate property values.
The economic impact of the impending commercial real estate meltdown is staggering, with massive defaults and losses in the hundreds of billions of dollars for lenders and property owners.
According to Crosswind Capital, $1.4 trillion of commercial real estate mortgage loans are coming due within the next five years, with nearly $800 billion needing refinancing over the next three years.
With constraints on traditional lending and no help from Wall Street's shuttered commercial mortgage-backed securities departments, there simply will not be enough capital capacity and valuation flexibility for banks and commercial real estate borrowers to refinance their way out of this problem.
The sidelined real estate investment capital of private equity, hedge funds and REITs — estimated at $75 billion to $100 billion — provide only enough capital to absorb $250 billion worth of property. Ultimately, prices will have to fall to levels necessary to draw in other sources of capital to clear the markets. While bankruptcies and foreclosures are painful, the stage is being set for new buyers with cash.
The great American story of easy money, boom, bust and redistribution — which marks a cycle of new wealth creation out of the destruction of old wealth — would not be complete without government involvement.
The FDIC will seize dozens more banks and assume an enlarged role as the new RTC auction agent. And with the U.S. tax code treating relief of debt as receipt of income, many former wealthy stakeholders will lose most of their net worth in foreclosure and property forfeiture. They will also owe enormous sums in taxes resulting from recapture of previously taken depreciation and 1031 tax-deferred exchanges.
So it will not just be the boom and bust of the recession that takes its toll. The IRS will have the last say in taking its cut, in some cases all the way to the grave and beyond.
Powell is the founder of AlphaQuest, a hedge fund consulting firm and visiting fellow at the Hoover Institution.
Lowry is an owner of numerous Southern California retail properties and a former elected official in San Diego County.
Print | View All Editorials | Search
Back To Top
© Copyright 2009 Investor's Business Daily. All Rights Reserved.
Hear Bill O'Neil on the Michael Medved Show June 24 at 4:00pm ET
Hear IBD founder Bill O'Neil discuss his new book, the current market, and more. Check Your Local Times --> var strTrack_UserID = "unknown"; var strPageSectionIXE = "IBD Editorials"; var strPageNameIXE = "IBDeditorials.com: Editorials, Political Cartoons, and Polls from Investor's Business Daily -- Second Wave Of The Credit Crisis: Collapsing Commercial Real Estate"; var strListTypeIXE = ""; var strIssueIXE = ""; var strActionIXE = ""; var strProductsIXE = ""; var strTickerIXE = ""; var strCountryIXE = ""; var strLinkedThroughIXE = ""; var strSourceCodeIXE = ""; var strPageIXE = "/IBDArticles.aspx?id=335660380569943"; var strXtransStatus = ""; var strXtransName = ""; var strXtransCategory = ""; var strXtransItem = ""; var strXtransValue = ""; strIssueIXE = "335660380569943"; var tcdacmd="dt"; _uacct = "UA-1008819-3"; urchinTracker(); Read Full Article »
