Thursday, March 26, 2009

Commercial Real Estate

Commercial Real Estate is not looking so hot right now. Like any other asset, commercial real estate is valued on cash flows. Many leases are structured such that tenants have a minimum payment with additional payment for a total outlay of 6-8% of total sales. The problem lies in how many stores have had drops in sales and outright closures. There are several shopping centers that have been vacated in the absence of risk taking in my area. A 10% drop in rents could result in a value drop of at least 10% and sometimes more depending on the market capitalization rate. Unfortunately this is what we're seeing. Massive oversupply and falling demand for retail is causing prices to fall fairly dramatically.

If this were residential real estate, this probably wouldn't be a problem. Loans on residential real estate are typically long term fixed rate mortgages with no short term balloon. Commercial real estate loans are typically on shorter amortizations (10-20 years) with 5-7 year balloons. The problem is the balloons. Commercial developments can take several years to complete. So the time between start and completion represents a huge credit risk to banks. If 5 years have passed and the real estate is underperforming, a bank may not be able to get an appraised value to support the loan value. If this is the case, the borrower will have to ante up and increase the equity investment or face foreclosure by the bank. We will likely see more foreclosures as many new real estate investors were not prepared for the drop in values and had little equity on the side to invest.

Commercial Real Estate is going to get ugly if things don't turn around over the next year or two. There were a lot of projects that were initiated in the 2004-2006 time frame that will be facing big balloon payments that may not be affordable. For investors with cash this will be a good time to pick up RE at 20-30 cents on the dollar. Commercial MBSs are going to be really ugly.

Disclosure: I work in commercial banking with a focus on commercial real estate.

1 comment:

Investment Services UK said...

Nice Post ! I agree with you. Since real estate is stabilized by a balance of demand and supply, the rate and strength of the recovery will be determined by economic factors and their effect on demand in the near future.