The Coming Market Correction in Commercial Real Estate...by Bob Canter, Performance Realty Solutions

Implications: Finally someone in the main stream media has pointed out what needed to be said, the commercial real estate market is headed towards a major correction, especially in the DC/Metro market. The current credit crisis is not only a problem for the sub-prime lenders and bond holders, but for the commercial mortgage market as well. The untold truth is the change in underwriting standards which has been going on for 3-4 months has already affected the how investors will evaluate their purchases. Sanity has returned to the market much to the chagrin of the industry players...from the brokers to investors to lenders and finally Wall St. The foolishness in which all the above acted for the last couple of years will come back to bite them.

Analysis:

The current state of the commercial real estate market by all outward accounts is great. Even NAR commercial index indicates the market is healthy with all factors that make up their index doing well. Read any report put out by an industry insider and you will hear the same tune.
The sub-prime meltdown has no correlation to Commercial Real Estate.
That is an arrogant and uninformed statement.

Of course the credit crisis is affecting the commercial real estate market. Buildings are being withdrawn from the market due to low bid prices...why because the lending criteria investors used just 6 months ago has dramatically changed. What was driving the commercial real estate investment sales market was the cheap access to financing. What wound up happening is Asset Inflation. Too much money chasing a fixed asset class. What is striking is the fact that as soon as the Federal Reserve started inching interest rates back up to so called normal levels is when investors should put their foot on the breaks.
Human nature wouldn't allow for such an action, as long as the money rolled in and you weren't the last person standing when the music stopped!

For the past 18 months the Federal Reserve has provided every signal that their next target was going to be commercial real estate lending. In April 06 the Fed's Susan Bies put out a request for new guidance for banks with high amounts of commercial loans. That was bell that should have been heard. The lessons from the 1980's into the 1990's real estate crash were lessons I imagine that only the hardcore veterans of the industry remembered. Sam Zell heard it, or why else sell out to Blackstone. His market timing couldn't have been better.

To those that say the housing slump won't affect the overall economy are fooling themselves. Yes even the Federal Reserve made such a statement. It does not take a Harvard Business School Grad to know the vast number of industries that support housing sector will be affected.
Already there are signs and unless the Federal Reserve does something dramatic the next recession is only a few short months away.

What happens to all those investors that bought their buildings with high levels of leverage, meaning small amounts of equity and high debt levels? What happens to those owners who bought with that type of leveraged finance at the ridiculously low cap rates? What will it take to have a building that was bought say at 100% occupancy at a 5.5% cap rate to have a negative return? The answer is a 5%-7% vacancy. What this means is investors bought these investments with no cushion towards any downside risk and certainly with no exit strategy other than to sell the asset to next investor.

The other hype was that the market was so strong that demand for office space would create a huge spike in rents. That has happened in certain markets such as NYC and DC/Metro. But that is about to change as the economy slows down.
The demand in the DC/Metro area has already slowed as the Feds decrease defense spending etc.

Therefore the buyers that came out of the woodwork, who were able to buy these investments with little of their own cash are now out of the market. These types of investors were driving the market prices up to the point that institutional investors such as the life insurance companies and pension funds could not compete and refused to compete on purchases. Sellers don't care as all money is green.

Now we jump to the present and the institutional buyers are back in business and smiling. They know prices will have to either flatten out or go down. There are industry people saying there is plenty of liquidity in the commercial market. What they are not saying is that liquidity is now much more expensive and restrictive. That by defacto creates a credit crunch, because at the end of the day its what it costs to buy the loan.

I have been told by mortgage insiders that lenders actually changed the terms of loans at a closing! They required more cash put into the deal by the buyers...Do you think that changed what the buyers were expecting as per their return?

Over the course of the next several months you will see cap rates go up or sale prices start to come down. Those that bought during the frothy period are stuck. Who would buy now at a return that is less than your borrowing cost?

This is why the other shoe is about to drop....stay tuned and remember who has been predicting this event for months!