Zell makes some interesting comments on commercial real estate (CRE).
“Well, there’s been a lot of speculation and a lot of journalists have written about the impending demise of commercial real estate,” he said. “First of all, I think that the fact that interest rates are as low as they are means that even if people are under water in commercial real estate, they still can carry it. And if you’re under water and you can carry it, the last thing you’re going to do is sell it, because you don’t get anything.”
“So therefore, that’s why we have no transactions,” he said. “And I think it’s going to take two or three years before we start seeing that happen.”
While I wholly disagree with Zell on residential real estate (RRE), on the CRE side, his comments do make a level of practical sense. While it is true that there will be a few implosions, a housing style bust may not be in the offing. A simple reason may be the string of payments. Unlike a homeowner who loses their job then their home, the owner of CRE has a buffer. First the rents of the tenants pay the loans, and only when they are not enough to cover, do the owner then dip into their own pockets.
In short, the risk/payment responsibility is dispersed among several parties. Again, this is not to say that there will not be defaults, many of them or that REIT’s will not suffer, it is just the widespread and pervasive losses we are seeing in RRE may not be in the cards (losses here are defined foreclosures on CRE).
Disclosure (“none” means no position):
10 replies on “Zell: Commercial Real Estate Demise Overstated”
A few weeks back you had another extremely bearish entry on commercial real estate on which I commented about the likelihood of a RRE bloodbath type outcome. I just don’t see how crap could possibly hit the fan like RRE. Sure, with tighter underwriting standards, much lower leverage, and declines in NOI, property values are going to be down significantly. But if you take a look at the Deutsche Bank report on CRE, which is interpreted as extremely bearish, all of the terrible underwriting that took place in the last 2-3 years was 10 year interest only loans. In the event of a default, the recovery rate will be much worse than normal, but isn’t the likelihood of default pretty low due interest only and multiple tenants making payments? If so, then we don’t have to worry about CRE for another 7-8 years when the balloon principal payment comes due. What am I missing?
your confusing forced sales with refi-
many refi are coming due next 3-5 yrs, not 7. that could cause more GGP style 11’s if credit markets do not get fixed..
as for sales into weak markets, those reit’s that have high occupancy rates, should be forced to do that
make sense?
In truth nobody really knows the answer with any certainty, but I think we can all generally agree that problems in the CRE market will not be quite as explosive as in the residential market. Don’t underestimate the potential problems though. During the credit boom banks were making the same ridiculous, high leverage loans on commercial properties as they were on residential. That is, massive overvaluations and pie in the sky pro formas betting that cap rates would continue to drop before the loan came due. So many properties are over leveraged, there is strong downward pressure on rents, and underwriting standards will remain tight for years to come. (Think DCRs the 125 range.) In the next 3-5 years or so there will be a significant number of CRE loans needing refi where the assets simply won’t qualify.
I’m a broker in the Silicon Valley area of CA. I sell and lease mostly Office/Industrial product but I’m heavily involved in investment deals of all commercial product types around the nation.
The emphasis of this thread is on debt markets and the liquidity of the assets themselves. That really isn’t the trouble anymore. No matter how low (within reason) the interest rates go, we have very little demand for product (space) from tenants. Most buildings don’t carry themselves at all with 50% occupancy and a lot of buildings have that or higher economic vacancy (either actual or tenants not paying). In order to do a lease deal the landlords are being asked to throw the kitchen sink at the tenant in terms of not only rate but TIs. When the rate falls below a certain level (case specific) the DSCR’s don’t work anymore and the bank actually has the right in most cases to call the loan. Additionally, LL’s no longer have the ability to go back to their banks for TI dollars because the values of their buildings have fallen to or below their current debt levels. Without the ability to acquire debt for TI’s they lose the deal that they could have made that would have floated them through the hard times. Once those buildings go into a forced sale situation the values fall further and the next rung of buildings with less debt per foot now find themselves in the same predicament and unable to do needed deals with tenants. Eventually the buildings sell for huge discounts (which we are already seeing infrequently) and the new owners can offer an even lower rate which drives down the lease comps further and starts the cascading effect again. I don’t know where it stops but there are going to be some great deals in the mean time for those with cash. Hit me on twitter (username drawnigh)to chat about it or twobuck@ymail.com.
Along with twobuck's comments, I would simply add that it would be very hard for the Equity portion of the commercial real estate market to be in great shape when the CMBS and REIT debt and markets are in severe pain, like they are now.
Hmmm, I hate to try to contradict someone who’s made as much money from CRE as Sam Zell, but… check out this post on “maturity defaults”.
The gist of it is that CRE borrowers who are current on their payments nevertheless end up in default when it’s time to roll over their debt, because lending standards have tightened faster than they’ve been paying off their loans.
all valid points BUT, in order for that to be true, the CRE lending market would have to be as bad in 3-5 years when most of this comes due as it is today.
we do not know that. if it is marginally better, many defaults will be avoided..
Mr. Zell’s insights are welcomed and valuable. It’s good to hear responsible views that go against conventional wisdom.
The current market scenario has brought everyone on his toes. One should be careful before investing in real estate. Do confirm prices by other builders/other sources.
Idaho Real Estate
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Commercial Real Estate Advice