Boil and bubble, double the trouble! Commercial RE

[davelj]

A few comments and observations on CRE…

I was at a banking conference last week and there were three CEOs from California banks (“community banks” – $800 million to $6 billion in assets) on a panel discussing Southern California CRE credit trends. Here’s a summary of their thoughts and observations:

– We’re in the third or fourth inning of the downside of the (general) credit cycle; it will get meaningfully worse before it gets better.
– Bottom of the cycle/Recovery will be late-2009/early-2010.
– There’s a notable bifurcation in the CRE market. In general, properties closer to the coast (10 miles) and/or surrounded by “established” neighborhoods are doing pretty well, although problems are expected to crop up. Properties further from the coast – Inland Empire, Murietta, Temecula, East SD County, East Chula Vista, etc. – are struggling and it will get much worse; it will be like the early-90s in these areas.
– CRE in the coastal/established areas will have problems but not as bad as the early-90s due to: (1) A more diversified economy – that is, we won’t have the same proportion of people simply leaving the state as when the defense industry left the state in the early-90s, and (2) Less overbuilding this time around – the early-90s CRE meltdown was exacerbated by dramatic overbuilt conditions throughout SoCal.
– The CRE-oriented REITS with lots of exposure to Class A office towers in Orange County will have big problems as this market is in shambles due to all the high-end mortgage broker-related space available.

These three bankers were all operating their banks during the early-90s and survived without needing to be recapitalized. They are generally thought of as relatively conservative underwriters.

Now, there is a distinction that needs to be made between existing CRE and CRE that’s under construction or recently completed and not leased up. Probably anything that’s under construction or recently completed (and not leased up) is a bad deal for the bank, almost regardless of its location.

The main thing that separates CRE from SFR is that, ultimately, there’s gotta be a debt coverage ratio when the loan is underwritten, generally between 1.1x and 1.2x (now it’s almost exclusively 1.2x because banks are tightening up on underwriting). And the minimum LTV has generally been 85%, even during the boom times, although cap rates have been very (re: too) low. BUT, the debt coverage ratio puts a cap on how much the bank is willing to lend regardless of what value gets generated from the cap rate. So, things got crazy in CRE, but not nearly as crazy as SFR, because there is real income involved (although it will certainly decline for the next few years) and there is real equity involved (again, this too will almost certainly decline in aggregate).

So, my guess is that we’ll see the coastal/established properties, in aggregate, lose some tenants and have to re-lease at lower rates, plus cap rates will inch up and net/net many of these properties will be underwater for a couple of years, but not REALLY underwater. Most will continue to make their interest payments, some loans will need to get restructured (with attendant losses for the banks) and some will get foreclosed, with larger losses for the banks. But – and I could be wrong – while I see impending pain and discomfort, I don’t foresee a total disaster in this property type.

But the stuff in the Inland Empire, East County, etc… that will be a bloodbath largely because the customers (the people who are in foreclosure and/or never moved into their homes) simply aren’t there to support the businesses.

What are your thoughts on some of this Bugs?

[Bugs]

I don’t believe in market bifurcation regardless of location or property type. I believe it’s all connected – some more directly than others. The house in Rancho Santa Fe cannot stabilize at $3+mil if a comparable house in Fairbanks stabilizes at $1.5mil, and the Fairbanks home can’t stabilize at $1.5mil if the Carmel Valley home ends up at $800k. And so on. Eventually, you can connnect the dots between the beater properties in Barrio Logan and the mansions in La Jolla because there are always alternatives. Premiums (and discounts) are based primarily on advantages (or disadvantages), and over time they’re always proportional.

If a Class A office building can’t get $3/SqFt in rents (under Gross terms) then how can it justify a sale price in excess of $400/SqFt? Over the long haul I don’t think it can. Sooner or later the mortgage interest rates will come up, and cap rates will have to come up with them. We’ve seen cap rates that are lower than mortgage interest rates – there’s no way that’s sustainable unless pricing continues to INCREASE (and stabilization isn’t increase). The most agressive investors don’t buy to hold – they buy to flip; and the ones who do buy to hold are not as agressive.

Just like with the housing market, once there’s no short term upside the hyper agressive investors will split and cap rates have to adjust up. As I’m sure you’re aware, between rent concessions, increased vacancy rates and increased cap rates, a commercial building’s income potential, and hence its value can decline pretty quickly.

Over the long term, I think there are some Class A tenants who would be willing to move to Class B space if the rent differential made it worth their while. And likewise as we move down the chain and outward in location. That’s why I think an office or retail or industrial meltdown in the outlying areas will eventually make its presence felt in the more centralized areas.

The only question is whether the trends will hold long enough for that to occur. Reasonable people will disagree on that one, but I think the trend will definitely continue.

[Bugs]

I don’t believe in market bifurcation regardless of location or property type. I believe it’s all connected – some more directly than others. The house in Rancho Santa Fe cannot stabilize at $3+mil if a comparable house in Fairbanks stabilizes at $1.5mil, and the Fairbanks home can’t stabilize at $1.5mil if the Carmel Valley home ends up at $800k. And so on. Eventually, you can connnect the dots between the beater properties in Barrio Logan and the mansions in La Jolla because there are always alternatives. Premiums (and discounts) are based primarily on advantages (or disadvantages), and over time they’re always proportional.

If a Class A office building can’t get $3/SqFt in rents (under Gross terms) then how can it justify a sale price in excess of $400/SqFt? Over the long haul I don’t think it can. Sooner or later the mortgage interest rates will come up, and cap rates will have to come up with them. We’ve seen cap rates that are lower than mortgage interest rates – there’s no way that’s sustainable unless pricing continues to INCREASE (and stabilization isn’t increase). The most agressive investors don’t buy to hold – they buy to flip; and the ones who do buy to hold are not as agressive.

Just like with the housing market, once there’s no short term upside the hyper agressive investors will split and cap rates have to adjust up. As I’m sure you’re aware, between rent concessions, increased vacancy rates and increased cap rates, a commercial building’s income potential, and hence its value can decline pretty quickly.

Over the long term, I think there are some Class A tenants who would be willing to move to Class B space if the rent differential made it worth their while. And likewise as we move down the chain and outward in location. That’s why I think an office or retail or industrial meltdown in the outlying areas will eventually make its presence felt in the more centralized areas.

The only question is whether the trends will hold long enough for that to occur. Reasonable people will disagree on that one, but I think the trend will definitely continue.

[Bugs]

I don’t believe in market bifurcation regardless of location or property type. I believe it’s all connected – some more directly than others. The house in Rancho Santa Fe cannot stabilize at $3+mil if a comparable house in Fairbanks stabilizes at $1.5mil, and the Fairbanks home can’t stabilize at $1.5mil if the Carmel Valley home ends up at $800k. And so on. Eventually, you can connnect the dots between the beater properties in Barrio Logan and the mansions in La Jolla because there are always alternatives. Premiums (and discounts) are based primarily on advantages (or disadvantages), and over time they’re always proportional.

If a Class A office building can’t get $3/SqFt in rents (under Gross terms) then how can it justify a sale price in excess of $400/SqFt? Over the long haul I don’t think it can. Sooner or later the mortgage interest rates will come up, and cap rates will have to come up with them. We’ve seen cap rates that are lower than mortgage interest rates – there’s no way that’s sustainable unless pricing continues to INCREASE (and stabilization isn’t increase). The most agressive investors don’t buy to hold – they buy to flip; and the ones who do buy to hold are not as agressive.

Just like with the housing market, once there’s no short term upside the hyper agressive investors will split and cap rates have to adjust up. As I’m sure you’re aware, between rent concessions, increased vacancy rates and increased cap rates, a commercial building’s income potential, and hence its value can decline pretty quickly.

Over the long term, I think there are some Class A tenants who would be willing to move to Class B space if the rent differential made it worth their while. And likewise as we move down the chain and outward in location. That’s why I think an office or retail or industrial meltdown in the outlying areas will eventually make its presence felt in the more centralized areas.

The only question is whether the trends will hold long enough for that to occur. Reasonable people will disagree on that one, but I think the trend will definitely continue.

[Bugs]

I don’t believe in market bifurcation regardless of location or property type. I believe it’s all connected – some more directly than others. The house in Rancho Santa Fe cannot stabilize at $3+mil if a comparable house in Fairbanks stabilizes at $1.5mil, and the Fairbanks home can’t stabilize at $1.5mil if the Carmel Valley home ends up at $800k. And so on. Eventually, you can connnect the dots between the beater properties in Barrio Logan and the mansions in La Jolla because there are always alternatives. Premiums (and discounts) are based primarily on advantages (or disadvantages), and over time they’re always proportional.

If a Class A office building can’t get $3/SqFt in rents (under Gross terms) then how can it justify a sale price in excess of $400/SqFt? Over the long haul I don’t think it can. Sooner or later the mortgage interest rates will come up, and cap rates will have to come up with them. We’ve seen cap rates that are lower than mortgage interest rates – there’s no way that’s sustainable unless pricing continues to INCREASE (and stabilization isn’t increase). The most agressive investors don’t buy to hold – they buy to flip; and the ones who do buy to hold are not as agressive.

Just like with the housing market, once there’s no short term upside the hyper agressive investors will split and cap rates have to adjust up. As I’m sure you’re aware, between rent concessions, increased vacancy rates and increased cap rates, a commercial building’s income potential, and hence its value can decline pretty quickly.

Over the long term, I think there are some Class A tenants who would be willing to move to Class B space if the rent differential made it worth their while. And likewise as we move down the chain and outward in location. That’s why I think an office or retail or industrial meltdown in the outlying areas will eventually make its presence felt in the more centralized areas.

The only question is whether the trends will hold long enough for that to occur. Reasonable people will disagree on that one, but I think the trend will definitely continue.

[Bugs]

I don’t believe in market bifurcation regardless of location or property type. I believe it’s all connected – some more directly than others. The house in Rancho Santa Fe cannot stabilize at $3+mil if a comparable house in Fairbanks stabilizes at $1.5mil, and the Fairbanks home can’t stabilize at $1.5mil if the Carmel Valley home ends up at $800k. And so on. Eventually, you can connnect the dots between the beater properties in Barrio Logan and the mansions in La Jolla because there are always alternatives. Premiums (and discounts) are based primarily on advantages (or disadvantages), and over time they’re always proportional.

If a Class A office building can’t get $3/SqFt in rents (under Gross terms) then how can it justify a sale price in excess of $400/SqFt? Over the long haul I don’t think it can. Sooner or later the mortgage interest rates will come up, and cap rates will have to come up with them. We’ve seen cap rates that are lower than mortgage interest rates – there’s no way that’s sustainable unless pricing continues to INCREASE (and stabilization isn’t increase). The most agressive investors don’t buy to hold – they buy to flip; and the ones who do buy to hold are not as agressive.

Just like with the housing market, once there’s no short term upside the hyper agressive investors will split and cap rates have to adjust up. As I’m sure you’re aware, between rent concessions, increased vacancy rates and increased cap rates, a commercial building’s income potential, and hence its value can decline pretty quickly.

Over the long term, I think there are some Class A tenants who would be willing to move to Class B space if the rent differential made it worth their while. And likewise as we move down the chain and outward in location. That’s why I think an office or retail or industrial meltdown in the outlying areas will eventually make its presence felt in the more centralized areas.

The only question is whether the trends will hold long enough for that to occur. Reasonable people will disagree on that one, but I think the trend will definitely continue.

[Bugs]

BTW, I’ve been wrong before about future trends, so it’s entirely possible I’m wrong this time, too. So far, I’ve been wrong about the timing, not the direction or the consequence; but my timing sucks really hard so that calls all of my judgment into question.

I called the turn around in the mid-1990s early by 2 years, and more I called the turn around in the residential markets early by 2 years. So I’m an idiot and nobody should listen to me on timing.

[Bugs]

BTW, I’ve been wrong before about future trends, so it’s entirely possible I’m wrong this time, too. So far, I’ve been wrong about the timing, not the direction or the consequence; but my timing sucks really hard so that calls all of my judgment into question.

I called the turn around in the mid-1990s early by 2 years, and more I called the turn around in the residential markets early by 2 years. So I’m an idiot and nobody should listen to me on timing.

[Bugs]

BTW, I’ve been wrong before about future trends, so it’s entirely possible I’m wrong this time, too. So far, I’ve been wrong about the timing, not the direction or the consequence; but my timing sucks really hard so that calls all of my judgment into question.

I called the turn around in the mid-1990s early by 2 years, and more I called the turn around in the residential markets early by 2 years. So I’m an idiot and nobody should listen to me on timing.

[Bugs]

BTW, I’ve been wrong before about future trends, so it’s entirely possible I’m wrong this time, too. So far, I’ve been wrong about the timing, not the direction or the consequence; but my timing sucks really hard so that calls all of my judgment into question.

I called the turn around in the mid-1990s early by 2 years, and more I called the turn around in the residential markets early by 2 years. So I’m an idiot and nobody should listen to me on timing.

[Bugs]

BTW, I’ve been wrong before about future trends, so it’s entirely possible I’m wrong this time, too. So far, I’ve been wrong about the timing, not the direction or the consequence; but my timing sucks really hard so that calls all of my judgment into question.

I called the turn around in the mid-1990s early by 2 years, and more I called the turn around in the residential markets early by 2 years. So I’m an idiot and nobody should listen to me on timing.

[drunkle]

what are the options of converting warehouse space into dual commercial/residential?

what are the prospects for buying a smaller warehouse and moving into it?

[drunkle]

what are the options of converting warehouse space into dual commercial/residential?

what are the prospects for buying a smaller warehouse and moving into it?

[drunkle]

what are the options of converting warehouse space into dual commercial/residential?

what are the prospects for buying a smaller warehouse and moving into it?

[drunkle]

what are the options of converting warehouse space into dual commercial/residential?

what are the prospects for buying a smaller warehouse and moving into it?

[Author]

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