The Commercial Real Estate Market A Common Sense Outlook

Based upon recent market data and looking at the macro economic landscape in the United States the following is my outlook for the commercial real estate market. It is not a pretty view and there is no bias in this opinion other than using common sense from extrapolating the social and economic events shaping the economy. Please note that commercial real estate does not perform in a vacuum as many transaction based commercial practitioners would have you believe.

There is no spin needed unlike the data providers use when releasing much of their data headlines. Remember who pays the fees and monthly subscription costs to these very same data providers who continue to state they are unbiased and neutral in their assessment of the market.

There are similarities with the rating agencies that were highly culpable for the economic meltdown which kicked off  this prolonged economic swoon we continue to deal with 4 years later. The rating agencies were “supposed” to be neutral third party arbiters of the credit worthiness of the securitized mortgage instruments (RMBS & CMBS). Eventually we had come to learn this premise was totally false. They were paid by the very same institutions that were selling these toxic debt packages and putting Triple A ratings “stamps” of approval on them.

They admitted they were in over their heads with the complexity and so forth of those investments, and I know they did not vet the underlying collateral.

Admittedly the commercial real estate data providers are not even in the same league as far as the rating agencies as they are not putting their ratings on instruments that are being sold but they do serve an industry whereby the very health of their bottom lines are directly connected to their subscriber’s economic health. So a little overly stated headline can go a long way, and as most of us know, that is the sound bite the mass media picks up on.

If the commercial real estate firms themselves want to put their overtly positive spin on things fine I guess, as self promotion is the American way, but I would contend they have responsibilities to their clients to be honest and forthright about the reality of any situation.

So here is my take on the near term future, and if anyone believes those that can forecast or predict beyond 6-12 months just needs to look at the wild swings on Wall St to know the real answer to that question. This is why no one should buy a commercial real estate investment based upon a “Pro-Forma” as it is a totally subjective prediction favoring the seller.

One can surmise what can happen in the future beyond 12months using what is happening in the macro economy since that has a ripple effect in the amount of time it takes for the impact to be felt. Much like a Tsunami the waves can take hours to reach its final destination.

So here is my forward looking insight…

The market will remain bumping along the bottom for quite a while and for the following reasons which have not changed all that much over the last several months sorry to say.

  1. Unemployment: The number of unemployed has remained relatively the same. There has been some minor improvement but it’s barely moved the needle. The government still isn’t reporting the folks that have given up looking. The “Official” number of unemployed is approximately 13 million. The “unofficial” count is still somewhere around 17+ million. Now millions of the chronic unemployed are running out of their 99 weeks benefits. So they will most likely be dropped from the statistics and in a back handed way that will reflect in lower unemployment numbers. In addition it has been reported there are 2 million fewer jobs available then a couple of years ago.

Until this picture brightens substantially the macro economic health of the United States cannot possibly improve. The unemployment rate directly impacts mostly office vacancy rates. It also negatively affects retail real estate as retail sales slump. So when retailers can’t create revenue, what happens…yes they close stores. Adding to this misery index it was reported last week that service sector jobs have decreased, which is no surprise, knowing how the United States has become a “Service Economy”. And keep in mind, retail jobs are grouped with the service sector. Just look at how many finance/mortgage companies have closed their doors. Banking and Financial Institutions have also cut jobs.

  1. The Housing Market: The same can be said of this situation. There are infinitesimal signs of improvement. That being said just today it was reported…” Trepp: Slow Decline in Delinquencies Suggests Prolonged Recovery…Recording a slight decrease in delinquencies in its preliminary third quarter estimate, Trepp predicts full market recovery will not occur for years.” The housing market and the chronic unemployment problem are joined at the hip.
  1. 3. Manufacturing: Again this ties back to the unemployment numbers. Manufacturing has been in decline for decades in this Country. However, until the United States can resurrect this sector we will continue to find ourselves sinking further economically speaking. The service sector is shrinking. But the big question becomes, how can our labor force compete with the labor force of 1 Billion Chinese who are working at wages 1/100th of our workers? The obvious answer is we can’t. Even Countries such as Japan and Taiwan have outsourced their manufacturing to less developed Asian Countries such as Thailand and now Vietnam. Why…because their labor rates have become substantially lower than their own. So unless the American and Western Consumer is willing to pay $2000 for that Flat Screen TV which you can buy now for $400 this trend will continue. If you think I am kidding, Toyota is closing 4 United States Auto Plants due to severe flooding in Thailand which has created a “Parts Shortage”. This was reported last week.
  1. Political Climate: In a word TOXIC and getting worse as the Nation heads into an election year. This also ties in with business since recent spending sprees under both Obama (at an incredible rate never before seen) and Bush has put the United States on a path of fiscal ruin. If you want a predictive look at our future if the Government does not get a handle or better said if the Citizens of the United States don’t wake up to understand the Government cannot support their every need and that they will need to become much more self sufficient there will be no hope of a recovery. We will be following in the paths of the European Economic Socialist Countries such as Greece, Italy, Portugal, Spain, France, and Ireland. Politicians only know one way of solving things and that is to spend and tax. Lastly during an election year most investors want to keep their powder dry until they are certain what direction the political climate will be heading and the same for employers.
  1. Unfunded Entitlement Liabilities: Most people don’t realize how dramatic and systemic a problem this issue is. The estimated amount of this Unfunded Entitlement Liability is about $65 Trillion according to many government and private organizations that track this. This encompasses all the Social Security, Government and Private Sector Pension Funds/Retirement Funds. The Social Security Trust Fund is bankrupt as are many Corporations’ pension funds. What happened is the Congress raided Social Security it to cover other expenses. So there are a bunch of IOU’s instead of cold hard cash sitting there. The Non-Government pension funds were allowed to go unfunded or underfunded. The Pension Guarantee Trust which the Federal Government controls takes over those pension funds for companies that have gone under or can no longer maintain. Can the government cover this…the only way is to print more money.

Keep in mind the currency today is not backed by any Gold Standard, all currency is backed by the Good Faith and Economic stability of the Country issuing the money. That means the net worth of the United States. Well folks, S&P for all their arrogance fired the first shot. Look at Greece, anyone want to buy Greek Bonds or own Greek money or

how about Italy which is the next shoe about to fall? Take an economics class 1.01 so you all can begin to understand the synergy between all these economic issues. Printing more money will lead to inflation which then leads to higher interest rates. Governments cannot spend their way out of hardcore structural economic issues.

  1. 6. Banking Sector: Despite all the bad things one can say about the Too Big To Fail Banks, such as B of A etc, they are the result of flawed banking policies perpetuated by the Federal Reserve. Currently the Large Banks are hanging on by threads. All the TARP and other measures were to prop up the banking system so there wouldn’t be a 1930’s type of banking failure crisis. And since the trigger point for their problems was and still is real estate both residential and commercial the Federal Reserve has allowed many measures such as “Pretend and Extend” to keep the bank’s balance sheets looking much better than they should if they were made to realize the real losses on their mortgage debt holdings. The artificially induced low interest rates are more for the benefit of the banking system than for the citizenry. Banks could not afford to pay high yields on deposits or bonds or whatever because they don’t have the funds to cover it, and they cannot invest in anything that can produce a sufficient yield spread. The banking balance sheets are abysmal if they were forced to deal with reality. There are high stakes law suits going on at various levels against the banks and Wall St Investment firms over the sale of the CMBS & RMBS securities. The crisis in confidence is still a major factor hammering the CMBS marketplace. There is NO trust and quite honestly why should there be.  The delinquency rate for CMBS bonds is still increasing, what does that tell you? There are 100’s of $Billions of CMBS mortgages that are soon to be maturing. This will create another round of major loan defaults. Property owners will either have to put up more cash due to the lower values which have occurred and the lower LTV’s lenders now require, and higher Debt Service Coverage Ratios (DSCR) than what they used previously. The property owners facing lower rental rates, higher vacancy rates, money needed to entice tenants with TI (tenant improvements at landlord’s expense) etc. will have no appetite to hang on to their properties especially if their loans are non-recourse, meaning no personal liability or guarantees on the loan. So the properties will go back to those very same lenders that currently have to deal with the same issues which haven’t been resolved. Therefore there will be a compounding effect on the banking/financial system.

There was an article released the other day which stated  Bank of America actually admitted it in a lawsuit involving Freddie Mac. Whereby B of A were securitizing the SAME mortgages MULTIPLE TIMES.
It was in their response to Freddie’s suit.
The excerpt is from the actual response. http://4closurefraud.org/2010/06/21/freddie-mac-bank-of-america-taylor-bean-whitaker-important-info-amp-statement-for-you-all-regarding-assignments-transfers-note-ownership/.  B of A admitted to double and triple selling the same residential securitized notes. And if anyone is naïve enough to believe it was just B of A doing this, then you need to start reading and listening more.

The banks and lenders also got stuck with holding onto unsold CMBS securities which were teed up to be sold when the market collapsed.  They are still sitting on them and are now trying to “repackage” them. Add to this all the publicity going on now with the anti Wall St and Banking situation and you will not have a window for better results going forward. Small Business lending has picked up a little bit but just ask a small business owner about getting loans and they will either say it is a nightmare to get one, or they don’t want a loan because they are NOT looking to expand due to the slow economy and the uncertain political climate regarding taxes.

  1. Commercial Real Estate:. The Prognosis is not good and will remain this way until the two main factors unemployment and housing, begin to change to the upside,. I  believe there will not be any substantial forward progress. Increases in employment results in lower vacancy rates, and as stated above  the long term prospect of that being corrected is miles away. The second issue is the housing market which appears to be stagnating at the bottom. Have there been some positive signs, yes but ever so slight. Not enough to make any real substantive difference. Housing involves so many industries within the United States which begin with construction jobs, which have all but vanished. The banks are continuing to be propped up by the Federal Reserve, make no mistake about that.. Retail sales are expected to slow and the Christmas selling season is so far not  predicted to be looking good.  What happens if the economy’s growth stays below 5%, it’s called treading water. Nothing will get better to the extent needed to help the commercial real estate market. As a matter of fact if retail sales slide over the coming Holiday Season, it will have a ripple effect that will carry forward this bad economy for many months to come. Don’t lose sight of the fact the United States economy has become 75% beholden to the consumer. The last I heard people not working usually don’t spend other than for living necessities.

In addition, the increases you have read about in the main stream media regarding consumer spending is an illusion. Why…because if anyone has gone to buy groceries and fill up their cars lately, understand all too well that inflation in those sectors have increased quite a bit. Why do you think the Government always makes a point to say “Excluding the Volatile Energy and Food sectors….”

Including these two Volatile sectors within the overall consumer spending figures gives the impression of more goods sold. Nope just higher prices for the same goods you always buy.

Based upon the above, does this mean there are no commercial real estate deals getting done? On the contrary, there are, but at a much slower pace and for less rent or sale prices.

The exception is and has been for the last 12-18 months high-end Class A properties 90% leased or better with high credit worth tenants in Top Tier Markets.

The buyers have mostly been large institutional investors paying all cash. They are looking for “stabilized” income properties which will provide a higher return than what they can achieve with conventional investments. Be sure to note that many of the media headlines concerning commercial real estate are about the ‘Big Deals”. However the meat of the commercial real estate market is driven by small leases and small sales of properties, just as small business had been responsible for 65%-70% of all new employment in the United States for the past 15 years.

The other exception is the Multi-Family Sector for the simple reason of those that have lost their houses still needs a place to live, so they go rent an apartment or house.

The last sectors doing OK are Medical Office Buildings.

Why because the population is growing older or at least the largest segment of the population, the Baby Boomers are getting older and they need more medical services. This sector which was responsible for a majority of the spending for the last several decades is now beginning to retire. This means less spending by a population of 80+ million and more health care and entitlement benefits.

Folks I don’t mean to sound negative…but if we don’t fess up to the realities of what we are currently dealing with and will be dealing with, the economy is not going anywhere. This means the commercial real estate sector will not be going anywhere except as I said above, continuing to bump along the bottom. Will there be opportunities, yes, but limited to say the least.