Commercial RE: The Next Bubble?

[contentrenter]

My brother, who rents office space downtown, just read an article in Foreign Policy which argues that money is moving out of residential RE and in to commercial RE. The magazine predicts that commercial RE will be the next bubble.

Does this sound right? And if so, how do we make money off of it?

[Bugs]

The commercial markets did not participate in the outrageous price increases during the first few years of the current upswing. It wasn’t until about 3 years ago that some of these commercial property investors started catching the fever. These properties are still going up, but in my view they’re even more likely to take a beating than the residential markets.

Commercial properties are all about making money, and nothing but making money. There’s no sentimentality or warm & fuzzies involved. The thing is, if a buyer pays 50% more for a property than their competitor did a couple years ago, that purchase has to financially justify itself. That comes either through increased productivity and profits or through further rent/price increases. No matter what, there are limitations to what a business can pay for real property when they compete with other businesses on a national and global scale. Trees don’t grow to the sky, particularly not money trees.

The rates of return on commercial properties are already at or near the interest rates the mortgage lenders charge. That means those rates of return cannot go any lower. Unless the market rents increase the prices can’t go higher without those buyers working on a negative cash flow.

We’ve seen it already with these downtown condo projects being abandoned because the reality didn’t match the forecasts. It’s just a matter of time before a lot of these other property types follow suit. Don’t forget, the weakest link in the business world is the small business owner, so they’re the ones who will feel an economic downturn before anyone else. Whether they have purchased their property or leased space in someone else’s property, if they get starved out during an economic downturn there won’t be a replacement nearby to cover the vacancy.

[VanMorrisonFan]

I’ve worked in the field of commercial real estate for about 20 years and I don’t think that there is a bubble in commercial real estate, although there is cause for concern.

In general, in this cycle, lenders have been more cautious about construction lending (with the exception of condos, which aren’t considered commercial real estate). Supply/demand balance for office, retail, and industrial space is much better than it is in the residential sector. I can’t think of a major market with a huge inventory of vacant office, retail, or industrial space.

The bubble in residential real estate will probably have some effect in commercial real estate as mortgage companies, real estate agents, title companies, etc., downsize, but I don’t think the effect will be large.

In general I think that commercial real estate buying tends to be less emotional than single family buying. There are a lot more people involved in a decision to buy a 50-story high rise office building, and at least a few of these people are usually thinking straight – or they have been in this cycle.

I do see cause for concern. Yields on commercial real estate have been driven down to very low levels, precisely because there are so many people lined-up to buy that 50-story high rise. If interest rates rise a great deal, and the economy slows, there will be a lot of investors “upside down” on their commercial real estate investments.

If you wanted to make money in commercial real estate you may have missed your chance. The major REIT funds have registered impressive gains over the last 3-5 years. Going forward it’s unlikely that they will do as well. Vanguard has a REIT fund, and it’s done pretty well over the recent past.

[hammer]

The commercial real estate market has exploded because the capital markets have appropriated a larger % of dollars away from the stock market and into real estate. The values have exploded from cap rate compression. Properties that have had inflaionary rent increases only have doubled in value due to the decrease in cap rates. If interest rates rise, cap rates will rise. If cap rates move to 8 in the next few years, it will flush out the investors that paid too much for their investments.
It will be an interesting next couple of years, because the prices that some investors have paid will demand a large rent increase when the leases rollover. If the job market has a hiccup, this could steamroll a large commercial real estate bubble.
I believe the markets will remain in tact for the next 24 months, but expect some serious changes thereafter.

[davelj]

CRE is in a mini-bubble, but not nearly the bubble that residential real estate, and more specifically single-family residences, is in. Recall that when appraisers appraise a SFR they basically just use comparable sales to value the property – this is a recipe for bubblicious behavior as there’s no mooring to value based on cashflows. Where most CRE is concerned there is an interest coverage ratio – typically 1.10x to 1.20x – that the lender generally requires that puts a ceiling on the valuation (and, conversely, puts a floor under the cap rate) assigned to the property. REITs are currently assiging cap rates of about 5%-5.5% on big class A properties here in SoCal (too low by about 1.5% in my opinion) and smaller properties that are being funded by banks are being assigned cap rates of about 6%-7% these days (again, probably too low by about 100 – 150 bps). But, despite the fact that these cap rates are probably lower than they should be, they’re cashflowing well and vacancies are very low (here in SoCal that is), so while there’s reason for caution, CRE isn’t in nearly as bad a shape as SFRs.

[Author]

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