February 1, 2010
Despite all the good news that you’ve been hearing about commercial real estate, we haven’t been entirely convinced. We’ve indicated that uncertainty and continued weakness in rents and occupancy are powerful enough forces to keep the commercial real estate sector in check for some time. Now S&P is out with a research paper entitled, “Industry Outlook: The Worst May Still Be Yet To Come for U.S. Commercial Real Estate Loans”.
Pretty icey title. But let’s get to some of the meat:
Supply and demand imbalances are visible in all segments of mortgage lending as well. National vacancy rates in the office, retail, multifamily and hotel sectors are now in the neighborhood of 1991 levels. For example, office vacancies reached 17.3% as of third-quarter 2009, and C.B. Richard Elllis (CBRE) estimates they will go to 19.5% in 2010, higher than the peak of 18.9% in 1991. Likewise, retail vacancies, currently at 12.3%, are headed to 12.9% per CBRE estimates, versus 11.3% in 1991. Multifamily vacancies are at 7.4%, versus 7.0% in 1991. Nationally, rents for offices are down substantially more than in 1991–by 15.7% versus 9.4%. This time around, a particular trouble spot is the hotel sector, especially the casino hotel sector, where overbuilding has been a factor. The occupancy rate for this asset class is a low 60.9%, a level last seen after Sept. 11, 2001. Nationally, rents for offices are down substantially more than in 1991–by 15.7% versus 9.4%. RevPAR (revenue per room) for hotels nationally is down 20%. Real estate cycles generally lag the economic cycle, so vacancies could deteriorate further even as the economy recovers.
Long story short: it’s weak across the board and there are very few hiding spots. Particularly for regional banks. These are the outfits that have heavy CRE exposure, and limited means to deal with them. It’s a recipe for disaster as we’ve seen from so many of the FDIC takeovers that have happened to date.
We very recently wrote a post about the fact that it’s not only early in the game, but the bottom will be something we feel that we will ultimately be able to see, rather than just read about. Here’s some more concrete data:
Problem recognition to date is not very advanced. Even in the homebuilder sector, where nonperforming loans (NPLs) are at 18%, losses for the seven quarters through third-quarter 2009 totaled only 5.5% (median). Commercial construction losses have been 3.9%, with NPLs at 10%. This implies substantial additional losses during the next few years to attain our estimate of 24% cumulative losses for these categories. Cumulative losses in mortgages and multifamily lending have been only 0.80% and 0.92%, respectively, and even NPLs are not yet very high; we expect them to rise sharply in 2010 and eventually achieve the stress loss assumptions, though maybe not until 2012.
…and the conclusion of the report is (in part):
The fallout from CRE exposures for banks has yet to run its course, in our opinion. Although many of the problems are already evident in the homebuilding sector, and are well underway in commercial construction, these are the smaller sectors. We believe the problems in the larger mortgage and multifamily sectors are yet to be felt because for now low interest rates and still-adequate cash flows make debt servicing possible. As rates rise and rent rolls decline further, we believe that delinquencies will rise in this sector as well, and prices will fall further, complicating the refinancing of these portfolios.
Bingo and bingo. Rate uncertainty and resetting rents are the order of the day. Lower rents are a fact, and interest rates going up is a realistic assumption. Here’s a quick example of how a deal we finalized today for a tenant shakes out for the landlord. Tenant is rolling off a lease at $1.30 gross, of which operating expenses are roughly $.40 psf. For simplicity, let’s say that leaves the landlord with a NOI (net operating income) of $.90 psf.
We renewed the tenant at an effective rate of about $.87 on a multi-year deal. With expenses remaining static, the landlord’s NOI from this tenant has just gone from $.90 to $.47, and that doesn’t include the fact that the park is seeing higher vacancy rates – the expenses for which the LL will have to carry. That’s where the market is, and tenants are signing up to lock in these rates for at least the next few years.
Anyhow, the S&P report is embedded below…
- Grubb & Ellis Releases Annual Forecast
- Cap Rates Still Hiking According to CoStar and Korpacz Survey
- August 2009 RREEF Property Cycle Monitor
- Congressional Oversight Panel Issues Report on CRE
- Goldman Revises CRE Loss Estimates