Residential and commercial are two very different markets although (obviously) problems in the residential market tend to leak into the commercial market eventually (lower residential prices lead to fewer jobs, particularly here in SoCal).
But the big difference between the two markets, and the reason why commercial tends not to get as totally crazy as residential, is the financing. Residential loans are based on appraisals which follow prices set purely by the forces of supply and demand. We’ve witnessed first-hand over the last several years how crazy such a process can get.
Commercial real estate values are also based on appraisals, BUT such appraisals are based on estimated cashflows (or Net Operating Income, which is rent less non-interest expenses, in simple terms) AND a discount rate (or “cap rate”). Currently cap rates are at historical lows – some properties sport cap rates of 4%-5% – which is crazy in my mind. BUT, even with a low cap rate (which increases the value of the property) the property must have enough NOI to service its debt in order to get a loan. So, even if a commercial building has very low cap rate, there will have to be enough equity in the deal such that the interest coverage ratio is at least 1.1x for just about any bank to finance it. So, put simply, “fundamentals” (that is, cashflow) play a much larger role in how CRE is valued than residential real estate. Now, banks and other lenders can still get hurt on these loans if cashflows decline AND cap rates increase at the same time. But, at least there’s something “real” – in the form of NOI – that supports CRE. With residential real estate there’s just “air and prayer” (although at levels considerably lower than we see today, residential properties are supported by NOI, in the form of rents, as well).
So, what’s happened over the last five years here in CA is that residential real estate has gone berserk due to speculators, easy financing, fraud, etc. while the CRE market has just continued to chug along aided by low vacancies, relativley little new construction (relative to demand, that is), rent increases and declining cap rates.
I think what you’ll see over the next five years is the following: Residential real estate will continue to decline (how low, who knows?). This will increase vacancies a bit on the commercial side, but not to dangerous levels. Cap rates will climb, but slowly. You’ll see some banks take hits on CRE but nothing like the early-90s. For the most part, CRE is going chug along, but the really good times are over – it’ll be much more challenging going forward. We could easily see a bloodbath in residential real estate and a simultaneous stabilization or modest decline in the CRE market. Most California markets are simply not overbuilt on the CRE front, even projecting increased vacancies from the residential fallout.
