The Commercial Real Estate Death Spiral

The Wall Street Journal recently did an article on a shopping mall in Connecticut that had been valued at $153M in 2012. After losing the majority of its tenants it went into bankruptcy and was recently sold for $9.5M.

The article went on to talk about how malls across our country have decreased in value anywhere from 50% to 70%. The former owner of our own Water Tower Place gave this premier property back to the bank in August last year for the same reason.

The question becomes, what does all of this mean to us? Please understand that commercial real estate is in the middle of a perfect storm.

1 – Interest rate increases have put significant downward pressure on prices. Buyers can only afford what the rents will support.

2 – Tenants are impossibly difficult to find. When they are found, the rents they’re willing to pay are paltry at best.

3 – Financing has almost completely dried up. Banks in response to the current banking crisis are holding onto their deposits like the lifelines they truly are.

4 – Construction costs, property taxes, and utility costs have all skyrocketed with inflation leaving even less money available to pay a mortgage.

All of these factors erode commercial real estate values, and I’m not just talking about shopping malls. These factors affect the values of everything from single family rentals and apartment buildings to industrial properties.

And the real problems are yet to begin.

The majority of these properties are financed with 5 year balloon instruments. This is a loan, normally with a variable interest rate, where the entire principal balance comes due every five years.

Under normal circumstances, a landlord will simply renew the financing, but these aren’t normal times because these loans are done based on a loan-to-value percentage. To illustrate the problem, let’s use an example.

Johnny Landlord purchases a property for $1M, puts down $200K, and finances $800K on a five year balloon. Mr. Landlord pays his mortgage timely and is operating the property without any major issues.

Four and a half years go by and it’s time to refi. The problem he faces is that the building now only appraises at $700K and the bank is only willing to do an 80% loan-to-value refi.

In the past five years of paying the mortgage, he’s only paid down $50K of his principal which leaves $750K to refi. The bank is only willing to lend 80% of that value or $560K. In order to do the deal he has to make up the difference which is $190K. This is what lenders commonly term a “Cash Call”.

If he doesn’t have $190K laying around, the bank will foreclose. What happens if he owns five properties that were all personally guaranteed? They’ll all end up in foreclosure.

Moody’s rating service is telling us that $14B of these loans are coming due in the next twelve months. Tens of thousands of these loans will probably go bad in the next few years.

After a year or two of lawyers making arguments in bankruptcy court, the bank will take these properties and need to get these bad deals off of their balance sheets. And how will they do that?

They’ll reduce the prices even further. This will further erode commercial real estate prices.

The true Death Spiral in Commercial Real Estate prices won’t begin until these foreclosures hit the market.

Let me leave you with this.

I’ve been writing about this problem for a long time. Sadly, it’s now beginning.

Please allow me to restate the question. What does all of this mean to you?

If you find yourself in a position where you’re facing a Cash Call, then you need to make your preparations now. As we go further into this Real Estate Recession, things will get worse. Handle your issues while you still can.

If you plan on purchasing real estate, be patient. It’s easier to make money on any investment if you purchase it when the prices are low. We aren’t even close to the bottom.

It’s certainly true that interest rates are probably going to go down rather quickly. The Fed will need to do this in order to try to stick a soft landing, but that won’t solve the entire problem by itself. The other issues I mentioned will still affect prices.

Hang in there. It’s going to get worse before it gets better.

We’re all going to get through this. Let’s get through it together.

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