Commercial Real Estate Hyperpocalypse: Where is Elizabeth Warren Getting Her Numbers?

Some deliciously diabolical news went mostly unremarked this week. "Commercial Real Estate Eyed as Looming Trouble Spot?," CBS News reported. "[TARPCOP board member Elizabeth] Warren Says to Expect Commercial Real Estate Trouble," said The New York Times, while Minyanville noted, "Commercial Real Estate at the Center of Credit Crunch."

What these laid-back headlines indicated was that Warren told CNBC Monday that half of all commercial real estate loans would be underwater by the end of this year. (The term "commercial real estate" encompasses most investment property, including retail and residential rental. "Underwater" describes mortgages in which the remaining principal is larger than the current appraised value of the property.)

Why wouldn't a showstopper like that get more attention? Maybe because it's really unclear how Warren is arriving at her estimate.

Warren refers to $1.4 trillion in CRE debt that will roll over in the next three years. She has also said a fifth of all CRE debt is already underwater, and at least rhetorically she seems to associate these two figures. So is that a fifth of $1.4 trillion, $280 billion? Or is it a fifth of the total CRE debt market of about $3.5 trillion, $700 billion? (This is the figure that COP says is currently underwater.) If it's the former, Warren is saying that $420 billion in commercial property will sink below outstanding principal in the next nine months. If it's the latter she's saying $1.05 trillion will do so.

Note that while being underwater is by far the most likely indicator that you will default on your mortgage, it is not the same as being in default. Commercial real estate distress is not a national phenomenon. It is concentrated among such usually suspect areas as Los Angeles, New York and Chicago. Actual CRE defaults are concentrated in those areas, plus such hall of famers as South Florida.

While the Washington, D.C. area has only the fifth-largest concentration of underwater commercial real estate loans, the capital leads the nation in CRE loans that have actually gone bad. So you can expect to keep hearing about the need for a national response to the CRE crisis.

But this is not a crisis in need of a national response, because the crisis (if you call a drop in the price of an overvalued asset a crisis) was only partly national in origin. State, county and municipal governments zoned and midwifed all those ghost malls and multi-unit residential behemoths of the dead.

No-one dast blame the smart growthers for cursing us with these vast and trackless deserts of investment property. But that doubly means Uncle Sam should not be involved in solving this problem.

The sentiment value of CRE for Warren -- who suffers from the truly grand delusion that she is a defender of common folk against monied interests -- is that the CRE decline will hurt mom and pop banks. That may screw President Obama's plan to encourage local banks to use more lax standards in business lending. But it is not something that should concern you, me, or anybody else except the people who made these bad deals in the first place.

Interventionists like Warren would counter that the feds need to act because FDIC will not be able to bear the liquidation of the unwisest local banks. I say we've been down this road before. The amount the government will actually have to pay to liquidate banks that fail because of bad CRE loans will be well shy of the figures mentioned above. And if in this case the market decline really does stretch the FDIC's capabilities as badly as alarmists claim it will, the most efficient solution to the problem problem will still be simply to give more money to the FDIC, not to pour more money into failing banks.

Warren may well be right that hundreds of billions or more than a trillion in CRE value will vanish by the end of this year. But she needs to give a little more detail when she makes these broad claims -- which in Warren's universe are always preparatory to demanding a larger percentage of your hard-earned dollar.

Comments

[Beamer]

"Underwater" describes mortgages in which the remaining principal is larger than the current appraised value of the property.

I thought "underwater" described Guam with 8,000 new sailors flipping it over.

[Episiarch]

"maxillary fistectomy"

LOL

[Shirt]

If the alt text refers to the photo, it should be a mandibular fistectomy.

[Titanic]

"Underwater" - bouyancy-ist!!

[Joshua Corning]

Another common term used to describe owing more money on a piece of real estate then it is worth is "upside down".

[MikeP]

Where is she getting her numbers? If history is any guide, she's making them up.

Remember that this is the same person who, after finding that 29% of people suffering personal bankruptcy surveyed believe it was health related, divined the evidence to claim that "62.1% of all bankruptcies in 2007 were medical".

[Joshua Corning]

But this is not a crisis in need of a national response, because the crisis (if you call a drop in the price of an overvalued asset a crisis) was only partly national in origin. State, county and municipal governments zoned and midwifed all those ghost malls and multi-unit residential behemoths of the dead.

No-one dast blame the smart growthers for cursing us with these vast and trackless deserts of investment property. But that doubly means Uncle Sam should not be involved in solving this problem.

Good work Tim i am proud of you.

[Tim Cavanaugh]

I'm referring to CRE only, not residential.

[Tim Cavanaugh]

But I am always looking to find common ground, so we can all come together and be the change we've all been looking for, for the sake of the children, because they are the future.

[Titanic]

Bouyancy-ist!!!!

[shakes fist]

[Kant feel Pietzsche]

Good job! Keep them safe, and keep them warm!

[Mr. Randy Watson]

"I believe the childrens are the future....teach dem well. Then let them lead the way...."

SEXUAL CHOCOLATE!

[DWCarkuff]

Brought a tear to my eye.

[Joshua Corning]

I'm referring to CRE only, not residential.

Yeah cuz it makes sense that urban growth areas and zoning would be efficient in residential uses but not commercial uses.

[Tim Cavanaugh]

It makes sense because the kind of projects that carbon-phobic municipalities like my own fair city support with public funds and tax breaks are massive mixed-use monstrosities. They do not by and large put a lot of support into development of single-family homes. So when those mixed-use developments hit the skids, the municipalities are more to blame than they are when single-family homes lose value. (And of course, they're actually to blame for creating the bubble, not for popping it.)

[Joshua Corning]

It makes sense because the kind of projects that carbon-phobic municipalities like my own fair city support with public funds and tax breaks are massive mixed-use monstrosities.

Ah I see. So your particular taste in architecture is the perfect proxy for the market behavior of commercial and residential real estate.

And of course it is inconceivable that in the not so fungible single family home market when prices are inflated by local regulatory hurdles (not just the lack of subsidies) there would be a price point beyond which people simply stop buying and move to cheaper markets.

And even if such an inconceivable possibility occurred it is absolutely totally impossible that such a market phenomena would resemble a bubble.

Cuz as we all know bubbles are only caused by the animal spirits hidden in our brains waiting for us to go bankrupt.

Plus we have to assume that manipulation of the currency markets (ie loans) quite possibly the most fungible commodities market in the multi-verse including earth 3063 would cause bubbles in housing in cities with stagnant demand yet growth managment policies and not in cities with high demand and no growth management policies.

It makes perfect sense. The local fungible price of money determines the national price of the unfungible price of homes.

If you believe all that i got a house in Seattle that i would like to sell for the same price of 4 homes in Huston.

[zeroentitlement]

If you've ever seen this daft cow on TV, she hardly stops short of claiming that credit card issuers sneak in to people's houses in the middle of the night, pull them out of bed and start beating the crap out of them until the poor slobs agree to sign up for cards with high APRs and then skip their payments.

[Almanian]

*Sigh*

It's when they shoot their dogs that the poor slobs sign up for cards w/high APR's.

"Waking up in the middle of the night and beating the shit out of them" is the province of teh evul mortgage corporashuns.

[Almanian]

At least that's what Elizabeth Warren says

[KTWO]

And when the poor slobs woke up the next morning their kidneys had been stolen.

Hence the origin of the phrase "its even worse than ......

Seriously. It is.

The numbers for CRE are dismal. The numbers for residential are dismal.

My SWAG is that the stock market told us something important this week. Prices shot up and they were already good YTD. And at least one gold mining ETF made a big jump Thursday.

And Friday the buying has continued in Asian and European markets.

What about government bonds? Eh, not so good here or around the world.

I interpret stocks as paper property, you pay a price and buy them just as you pay a price to buy a hammer.

And what does inflation do to prices?

The long dreaded Hyper Inflation may have arrived. Its companions, Huge Deficit and Huge Debt are present.
With High Unemployment present we will get Stagflation too.

[robc]

if you call a drop in the price of an overvalued asset a crisis

I dont. I call that the market making an appropriate adjustment.

[alan]

Five star take down, Cavanaugh. I haven't seen someone play the public crusader shtick to this obnoxious degree like she does since Nader was merely middle aged.

[Ken Shultz]

From a commercial real estate guy...Excellent piece of work!

There was a while there where you couldn't buy much in the way of small buildings for better than a 6.5% cap.

Much of that was because investors had to compete for space with businesses themselves. And the smaller users were using the equity in their homes to buy their place of business. It's hard to compete on price with a business that figures its loan payments into the rest of its business. All the owner gets is rent.

Of course, all that activity disappeared with the home mortgage business starting around July of '07, and ever since then, it's been lease activity in those smaller spaces.

Cap rates will come back up again.

One of the important things to remember is that investment real estate was always tied to the return on investment. ...and that wasn't the case with home mortgages. Most home owners don't pay themselves rent...

So prices got a lot more out of whack in pure residential. There were some distortions on the smaller side of the commercial real estate markets too, but they were more tied to rent/NOI.

I doubt there are many banks that aren't lending because of what they lost on their commercial loan portfolio. I think even the problem loans in commercial are really tied, mostly, to the value of the equity in those homes the small business owners were using to up their commercial loan.

[Tim Cavanaugh]

So how vicious can the spiral get when investment property also have to revise down their rental incomes? (In my neighborhood at any rate, rents have been falling for more than a year and are, I believe, still heading south.)

I think even the problem loans in commercial are really tied, mostly, to the value of the equity in those homes the small business owners were using to up their commercial loan.

Just to bring it all back home, this was the situation of that folk hero home bulldozer who showed up on H&R a while back.

[Hazel Meade]

Also, it's worth pointing out that we don't have a bunch of large government sponsered enterprises encouraging people to build and purchase commercial real estate. Or a commercial mortgage deduction.

[Corduroy Rocks]

You are correct there, but we do have a large number of municipally sponsored development projects where public bonds were taken out to underwrite sewer, roads, utility development, etc... associated with a large commercial project.

When these developments go bust, the local taxpayer is going to be footing the bill for these bonds instead of the tenants.

The general consensus I get from general contractors, architects and developers is that CRE is dead. The activity going on right now is what I refer to as zombie projects. Stuff that was in the pipeline years ago and is just now coming to completion. Construction backlogs are at a low point right now.

In short, another major stock market dip and further pain in the residential market will cause more consumers to tighten spending. This will push a lot of retail that was already on the edge over the cliff. Developers simply cannot afford to negotiate rents down further and continue to make bank payments. Banks will start calling in loans when this occurs.

The interesting part will be what happens to these relatively new properties afterwards.

[Hazel Meade]

Considering how much business is going online it makes sense that commercial real estate would be in a decline. Which may continue for decades.

[West Texas Boy]

I get nauseous every time I see this petty shrew on television these days. It's like she thinks every dollar earned by anyone in the financial sector is dirty and that it's her business to point it out.

My guess is that she'll be gone once the Dems lose Congress in November, since she's a congressional appointee, but then apparently she's in real tight with Obama and will probably just land in the executive branch and still be visible until 2012. Ugh.

[beowulf]

the encouraging thing is that CRE exposure is concentrated in mid-size banks - the ones that can be closed down by the FDIC without causing a systemic meltdown.

Something to think about when discussing the Volcker Rule

[Hazel Meade]

I'm curious as to the degree of securitization in the commercial real-estate industry. And hence the potential spillover effects.

We know that commecial real estate isn't backed by federal guarentees the way home mortgages are, so I suspect it's much less, but I could be wrong.

[Ken Shultz]

The CMBS market virtually disappeared for almost two years...

There wasn't a single CMBS deal anywhere for almost two years!

The first one was about six months ago, and it was way over-subscribed.

Since then, there's been plenty of interest. There are some issues with getting anything like that restarted again, but it isn't a dead deal anymore.

That dog is hunting.

[Ken Shultz]

"We know that commecial real estate isn't backed by federal guarentees the way home mortgages are, so I suspect it's much less, but I could be wrong."

I don't think the implicit guarantees were the issue. It was the willingness of our politicians to throw our good money after bad regardless of whether there were guarantees, wasn't it?

There were some chain reaction sorts of things happening in the loan originators like New Century? They had a money back guarantee on their offerings, that if so many defaulted in the first few years, you could get your money back, but syndication doesn't make banks weaker.

My government squandering my future earnings on some bank's bad investments makes me weaker, but selling CMBS doesn't make BofA weaker.

I will say this. I almost never want to propose new laws, but I'd be willing to consider supporting the most obvious law you'd think our politicians would want to pass, if only for the sake of appearances...

Why doesn't somebody propose a law prohibiting the government from giving any bank taxpayer money unless it's for FDIC?

Come on Republicans! There's your Tea Party vote right there--draw a line in the sand. Who's voting against that in an election year? Go ahead and veto it, Obama. I dare you.

'cause BofA selling CMBS really shouldn't be anybody's business but BofA's, their investors and the people who buy their loans.

I mean, when BofA did that first CMBS deal in a long time, that didn't make BofA riskier. It just doesn't.

[Paul]

Underwater? Pff, the mortgage payments aren't even being made, let alone property that's underwater.

The owner of the Northwest's tallest building, the 76-story Columbia Center, missed a mortgage payment this month, providing fresh evidence of the troubles facing downtown Seattle office landlords.

Boston-based Beacon Capital Partners failed to make a scheduled payment of $1.65 million on a $380 million loan it took out when it bought the tower three years ago, according to a recent report by Wells Fargo Bank, which administers the debt.
[...]
At the Columbia Center, however, almost 600,000 square feet ? nearly 40 percent of the building ? is listed as "available" on online commercial real-estate database Officespace.com.

Oh, this is a building that they paid over $600 million for, that's now assessed at $380 million. Underwater doesn't begin to describe it.

[Paul]

effing spam filter... trying again:

Underwater barely describes the problem:

The owner of the Northwest's tallest building, the 76-story Columbia Center, missed a mortgage payment this month, providing fresh evidence of the troubles facing downtown Seattle office landlords.

Boston-based Beacon Capital Partners failed to make a scheduled payment of $1.65 million on a $380 million loan it took out when it bought the tower three years ago, according to a recent report by Wells Fargo Bank, which administers the debt.

This on a building for which they paid over $600 million, that's now assessed at $380 million.

[Paul]

And slightly off point, my property taxes went up considerably in 2009...

[Protest them]

I save nearly $1000.

[Groovus Maximus]

Really? A the risk of sounding like an ignoramus (too late), I didn't know that tax increases can be appealed.

[Protest them]

Read the fine print on the back of your tax bill. The appeals process is generally explained. Information can also found on city government websites. The appeal is time sensitive and requires a hearing. If you are unavailable, you can hire a tax appeal company.

[Episiarch]

Paul, email me and I'll detail how you can appeal them. You're in King County, right?

[Ken Shultz]

"So how vicious can the spiral get when investment property also have to revise down their rental incomes?"

It's really hard to give a short answer to that. Well it's hard for me to give a short answer to anything, but I'll give it the ol' college try.

It's very market specific--I understand the fire department in Detroit doesn't bother putting fires out in abandoned factories anymore; they just let 'em burn themselves out. No sense in some firemen getting hurt over nothing. Real estate really can be worth less than zero.

That having been said, you know the old Wall Street adage about how you should never try to catch a falling knife? Obviously vacancy will be a key factor here, but when we see rents starting to rise, then we know the knife's hit the floor and its probably safe to pick it up again.

One of the other things we look for is replacement cost. Materials costs drop with the economy, but generally speaking, even a vacant building won't drop to much less than two-thirds of its replacement cost. That's how much it would cost to rebuild the same building again today.

Another important consideration is where cap rates are relative to bonds. Real estate is typically valued as a cap rate for just that reason. How much am I paying for future rents vs. how much yield could I get from a treasury?

When cap rates (NOI/Acquisition Price) drop to somewhere closer to treasury yields, then that typically marks a top. The more rents rise, the higher a cap rate you're getting for your acquisition dollar, but falling acquisition prices have that same effect too--a higher cap rate. Still, it's a hurdle that has to be crossed somewhere in the cycle for whatever reason, so if cap rates haven't gone up relative to treasuries, then you haven't really moved into the most painful part of the correction yet.

So when I see that happening, I cross that off my list of things that have to happen before it starts getting better.

I should say that in the markets I watch, which are some of the worst hit markets in the country, I've seen all of these things happen in various asset classes--with the lone exception of buildings under 5,000 SF, office condos and other asset classes where people were leveraging their homes to buy spaces for their businesses.

What does that problem, sub-5,000 SF buildings, have to do with multi-tenant office buildings for lease? Nothing directly. Warehouse Distribution buildings over 100,000 SF? Nothing directly...

Retail is a little more sensitive because when those guys build, it's all about concentric circles and demographics, and if you built in Lake Elsinore because you thought there were going to be 30,000 more people living there in five years, then you might be SOL.

But don't tell me that your local bank in Southwest Riverside County needs help because they were writing loans on the commercial side in Lake Elsinore (or wherever else). Those banks have already been devoured by the residential loans they did. That's putting a band-aid on a decapitated corpse.

"And if in this case the market decline really does stretch the FDIC's capabilities as badly as alarmists claim it will, the most efficient solution to the problem problem will still be simply to give more money to the FDIC, not to pour more money into failing banks."

Anyway, I'm a big believer in the idea that there is no sector of our economy better prepared to take the brunt of those bad investments than the people who made them.

The idea that the economy would be better if people's future earnings, instead of going to pay for things they want and need, went instead to pay for bad investments others made in the past? That's a silly idea... The future of our economy depends on people having discretionary income. Haven't we eaten enough seed corn already?

People need to stop worrying about who's going to do all the lending in the future and start worrying about who's going to do all the borrowing.

I wish I could get the whole world to read your post, Cavanaugh. That does it! I'm buying another subscription.

Anyway, that's the short answer.

[College of]

Prolixity?

[Ken Shultz]

Gesundheit!

[Can't wait to read the long]

answer.;-)

[Groovus Maximus]

Indeed. Brevity is the soul of wit.

[j.i.am]

I don't think Tim is thinking out of the box here.

Vacant commercial real estate should be turned into lofts. Community gardens should be cultivated on the roof-tops and monorails should be built to provide green transportation from the lofts to the government offices where the loft owners/tenants work. The corporations can be taxed to pay for this.

[Hazel Meade]

Also, the tenants can be employed designing the monrails and lofts.
Also on taxpayer dime.

[j.i.am]

In a democratic manner, of course. We don't want a tenant with any engineering know-how wagging his finger at the aspirations of the majority. Oh, and Hazel, its not taxpayers, its the corporations that will pay for it.

[KTWO]

You will sure have the government workers on your side.

Urban transport, no commutes, roof top gardens, great views.

And everyone else paying for it.

[FreeView Documentaries]

Great SITE for Documentaries check it out

[dennis]

Should we check it out because knowledge is power?

[Random Dude]

Way more information than any normal human being wants to read on CRE exposure in the banking system.

I personally think this article is being a little unfair in dismissing her claims, regardless of their specificity. Just because she's a regulator, doesn't mean she's being ignorant by specifying large ballpark figures regarding losses. Given the incredible counter-party centralization of the financial system, it's really anybody's guess as to how bad the eventual writedowns could be. The point is, it's pretty damn bad anyway you look at it. While her nannyizing grates me, it's a little ridiculous that this article would condescend on her comments as hyperbole, given that it seems if anything she was understating the scope of the problem.

Cavanaugh, you mention that CRE is not a "national problem." It absolutely is a national problem because these securities are on the books of the TBTF banks that taxpayers are unfortunately on the hook for. Furthermore, even small writedowns above expectations can lead to extreme losses because of leverage.

I think we should all let the banks and creditors burn in a fiery pit of their own demise, but given that CRE is a radically larger block of capital on the banks' books than subprime ever was, and the writedowns are looking to be even more extreme, it should not be hastily dismissed.

These crap securities are laced through the entire financial system and will hit the European banks especially hard in 2011, when the resets start really picking up. Whether or not we like it, this mass absorption of private sector junk into public balance sheets across the world has formed a unicredit bond market. Higher rates for a distressed EU might seriously harm the bond markets here in the U.S., despite any perceived flight to safety.

When they have to unwind their leverage to cover "unexpected" shocks, we could see another fire-sale race to the bottom like fall 2008, despite the best efforts of Helicopter Ben and money printers around the world to prop up the market.

[George Finch]

Thanks for the links in the piece, so I can try to figure it myself.

Unfortunately your article loses creditability by the amateur and immature psychological hit about Ms. Warren's "delusion" about protector of the common folk. Didn't realize you had access to her mind and motivations. Deal with her facts and logic, drop the pseudo- psychological stuff. It was a cheap, unnecessary hit that takes away your argument, at least to this reader, and raises questions about your intellect and judgment, which is sad, for some of the questions you raise are valid and worthy of debate.

[dennis]

The great George Finch has spoken!

[Pro Libertate]

Not sure about the actual numbers, but in negotiating commercial real estate leases, it seems like there are a lot of tenantless properties and a major credit crunch in the commercial arena. Certainly, we're seeing huge leverage in this market for lowering rents and other costs. Whether that's just conventional wisdom or a reflection of the facts is anyone's guess, but I think there's a potential shoe dropping with CRE.

[Commercial Notes for Sale]

This is really no surprise. The office and retail sectors will be hit the hardest - you can actually see that right now as some major retailers have been shutting their doors thanks to the Internet retailers such as Amazon.com and others. The Internet will be playing a vital role in the development of the retail business - especially the brick and mortar side of it.

We speak about this on our blog:
http://www.commercialnotebrokers.com/blog

[The Wine Commonsewer (TWC)]

in my little corner of the universe commercial property sits empty and rents/leases are half what they were three years ago. I realize this isn't a scientific survey, but it is indicative of the general trend.

[CREChick]

How is it that all of these people think they know Commercial Real Estate all of a sudden. The biggest difference in lending for Commercial is that good ole word "equity". There are very few 100% loans, below market floating rates, etc.

The worst thing that happened to the market when we went through this in the 80's was the government joke, the RTC. They only made matters worse. Banks fail and life goes on.

[Willem Young]

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