Is Commercial Real Estate Next

When I saw then HUD Secretary Steve Preston, I had a chance to speak privately with a gentleman involved in commercial real estate law. He told me that his business had suffered much the same as most real estate. He told me that much of the commercial real estate swoon came in relatively small towns that had seen unsustainable growth during the boom. Their commercial business had in fact grown far beyond what the town could sustain.

During the real estate boom, it was not unusual to see towns of 5 and 10 thousand nearly double over that five year period. With it, there came an influx of commercial real estate. After all, someone had to provide food, gas, and retail to all these new folks. When residential real estate crashed, much of the growth crashed with it. Since much of this residential growth was created through non sensical loans, much of this growth eventually wound up turning into foreclosures. Since these towns grew at unsustainable rates, there was no one there to take their places. As such, what were booming suburban towns turned into depressed suburban towns.

Commercial real estate mortgages are very different than residential. They did NOT necessarily go through the same sort of irresponsible revolution that residential did. For the most part, commercial real estate is entirely based on cash flows. In simple layman's terms, a commercial bank wants to see that a property can get at least 120% in terms of income as expenses monthly. There is nothing anywhere near no money down loans. Even appraisals themselves are based almost entirely on the cash flow generated so for the most part, it is much more difficult to create an irresponsible loan.

As such, if commercial real estate falls, it WON'T be because of the loans created. Commercial real estate, if it falls, will fall because the economic downturn will create far more vacancies than is normally accounted for by formulas that create the rates. Remember, a commercial bank wants your monthly income to 120% of your monthly expenses. (this includes everything, taxes, mortgages, and all other expenses) It also gives a accounts for what is known as a vacancy factor. In other words, banks understand that 100% of the units won't always be rented out and so the bank wants to account for a reasonable vacancy factor. So, what happens if the economy is so weak that vacancies exceed far more than anyone expected? All formulas are off and mortgages aren't paid back.

There's more. Remember, the intrinsic value is determined in large part by the income. So, if a building is 50% occupied, it also is currently valued at far less. That means no one else can get a vary large loan on it either. There is one other major problem. A fairly large percentage of commercial loans are done as balloon loans. That means after 3, 5,7, or 10 years, there is a massive payment due unless they are sold or refinanced. Under normal times, this isn't an issue, because doing either isn't that big a problem. Now, both of those things are going to be a problem.

So, we may now be facing the beginning of a long cycle of busting commercial real estate mortgages. With exploding vacancies, properties will be difficult to manage the cash flows on. This will create a problem selling and refinancing. With many commercial real estate loans being balloon loans, this could lead to the next bust.

Think of it this way. Commercial real estate mortgages could be the best indicator of where our economy is at. If there is no bust, then that means that vacancies aren't out of control. It means that things have bottomed out and businesses are managing. If, however, we hear about a commercial real estate mortgage bust, then we all know that our economic crisis is going to be very deep and very long.