Wednesday, November 18, 2009

Can Commercial Real Estate Have a “Debtless” Recovery?

Like so many things over the past decade, commercial real estate experienced a boom by way of unprecedented debt financing. This debt was securitized and transformed into CMBS bonds, lending otherwise unsavory debt high credit ratings. Thus, people were allowed to have their cake and eat it too, taking out huge amounts of debt while retaining investment grade status. The loans this debt was culled from are now fast approaching their due dates, with over half predicted to default. Without a new source of debt financing, it is clear the commercial real estate market will be rocked by a gale force crisis.

Currently, our economy is already suffering from many ailments. Unemployment stands above 10%, our government is trillions of dollars in debt and the dollar is weakening. Many say a commercial real estate crisis would crush what little recovery we have experienced and we should go to all lengths to stop it. However, this is a flawed premise. The outstanding debt on commercial real estate is not like some group of foreign barbarians ready to sack our recovery, it is an integrated part of the economy. It is tied to things like unemployment and low consumer spending; there is no feasible way for commercial real estate to recover unless the economy itself is healthy. Conversely, a crisis in commercial real estate would naturally impact the rest of the economy as well; it is a complex ecosystem of interrelations. It would make no sense to throw our gold at it and hope it simply goes away appeased.

According to the MIT Real Estate Center, commercial properties have dropped close to 42% over the past 2 years, leaving 55% of the outstanding $1.4 trillion worth of commercial mortgages underwater. This in turn has caused the delinquency rate to increase to 5%, up from 0.77% a year ago. These are the effects of an economy suffering from the collapse of a bubble fueled by reckless debt. There have been some positive recent developments such a $400 million offering of CMBS bonds (enhanced by TALF financing) but these properties represent the exception rather than the rule as they were conservatively underwritten. In-fact the Wall Street Journal goes as far to say “it will likely provide little solace to owners of tens of billions of dollars of office buildings, shopping centers and other commercial real estate that are now worth less than their mortgages.”

This is not the time for illusions about security, they are what got us here in the first place. The level of debt leveraging that occurred in the past is simply not a feasible business model. Furthermore, those properties and loans which are now under water due to that model should default as their positions are obviously untenable. These are not horrible abnormalities but necessary corrections dictated by the market. The bubble has collapsed. Only through intelligent investments, prudent decisions and a revived economy can commercial real estate rebound.

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