So what’s the deal with the commercial lending environment?

In the midst of news and hype claiming that “our real estate markets have bottomed out and now is the time to buy real estate!!!”, I think this would be a good time to bring up how present commercial lending practices may be setting us up for a really big fall in the next few years.  I’m guessing that the coming years will have many more commercial mortgage loan defaults than what we are now seeing unless commercial lending and government policies are drastically changed really soon.  This will have a pretty direct effect on our overall economy.  But just how bad will it get?  I’m stocking up on cases of cheap macaroni and cheese and Ramen noodles even now as I type this just in case…

It amazes me how the backing of well-marketed news channels seems to give reporters and TV news anchors the credibility to talk about things they really don’t know much about.  For example, Maria Bartiromo is a financial news anchor at CNBC.  She is a very good news anchor who happens to report on financial events that occur mainly on Wall Street.  But because she is on a highly-publicized news channel like CNBC, somehow she was positioned as being a financial analyst and not just a news anchor.  Maria even authored (or was it ghost-written?) a book, “Use the News: How to Separate the Noise from the Investment Nuggets and Make Money in Any Economy“, to capitalize on her attempt to be known as a competent financial analyst.  I remember almost getting caught up in the hype to buy Maria’s book when it first came out until I remembered that all she does is read out loud from Teleprompters and interview true financial analysts.  She has no real qualifications to be called a financial analyst other than having learned the vocabulary from many years of working Wall Street’s business and social scenes.  So when I read a recent New York Times news story saying that “For three straight months, the nation’s employers have delivered solid job growth, easing some concerns that the economy could be stalling” but that has contradictory data in it showing that the unemployment rate rose as well, I had a pretty good idea that the writer of the article did not fully understand the data but just told us what he heard someone else say to him.  Someone like Harry Markopolos, who was one of the first people to uncover the Bernie Madoff Ponzi scam, is a true financial analyst (and investigator), not the news reporters and TV anchors who merely tell us what has already happened by looking in the rearview mirror.

The above being said, I should include a disclaimer that my background is as an engineer, not as an economist, so keep that in mind as I ramble on about the commercial lending outlook.  While I have a background that includes engineering economics, perhaps more relevant to this topic is that I happen to enjoy reading about what is going on in the financial world and like to treat it all as a big spreadsheet where I can play “what if” games in my mind to try and project the financial future.  But I’m not going to write a book on economics or financial projections and try to fool you into thinking that I know all about the financial universe, either.  Nor will I claim to be one of the many real estate and business ”gurus” who say that they never lost money on a deal from being wrong about the future.  I’ve made nice profits but have also taken big losses as well.  Any investor, who has been in this business for a number  of years, who tells you that they never took a loss is either blatantly lying or isn’t really an investor and is making money under the guise of being a true investor by trying to sell stuff to you.

So with all the contradictory data on our economy telling us that we are in for better times and that our future is going to suck for a while at the same time, what do we do?  What will really happen with the commercial lending industry?  I don’t know for sure but will take an educated guess and would like for you, dear reader, to try and poke holes in my logic so I can learn as well.

Investing is more than just numbers.  Investor sentiment, i.e., human emotion, plays a big part in how assets are going to perform and what returns on investment will be realized.  Regarding commercial income properties, capitalization rate (“cap rate” for short) has typically been more useful as an indicator of investor sentiment than as an indication of what kind of returns you can expect to get on your money invested in a deal.  Keeping in mind that our most recent recession supposedly started in December 2007, let’s take a look at how commercial real estate cap rates varied both pre-recession and afterwards.

When the market was booming prior to 2007, investors gambled on the future by assuming that net operating income (NOI) would always increase each year.  This increased demand for commercial income properties drove purchase prices up and cap rates down as people paid premiums with the belief that their purchased assets would “grow” into their purchase price, much like how you might buy big clothes for a young child assuming that the child will “grow” into them.

Around the middle of 2007, people started to realize that maybe things weren’t so hunky dory and decided to take less risk with their money by buying commercial assets at lower prices and driving cap rates upwards.  In an ideal world, in order to achieve the same investment returns, purchase price should fluctuate proportionately with NOI such that cap rates should remain approximately constant.  But as can be seen, cap rates started rising rather drastically from the middle of 2007 til 2009 when some economists believe that our recession ended (Hah!).  This shows a complete change in investor sentiment in that they no longer want to try to ”grow” into the future but have realized that there is no guarantee that the future will produce income growth.  Using the previous “growing child” analogy, it’s as if you realized that your child stopped growing after buying clothes that were too big with the expectations that the kid would “grow” into them, and then realized that it ain’t gonna happen after watching the poor kid trip around in them for several years.

Therefore, investors today, especially those in commercial lending, are still very protective of their principal amounts and pay lower prices for commercial assets which, in turn, drives cap rates upwards.  Being a quant is fine and dandy but you can’t put investor sentiment into a math equation and expect to get accurate results consistently.  So we are still in a time when investors are very cautious about their investment funds which is why cap rates remain higher than pre-recession levels.  It will take both better market fundamentals as well as increased investor confidence to get our commercial real estate markets to where they were when times were good prior to 2007.  Better market fundamentals, alone, won’t do the trick.

Okay, so all this cocktail-party psychology is nice, but where are the commercial lending and real estate markets headed?  How will an understanding of economics help us understand and project the future of these markets?  My opinion: it would probably be more appropriate to view this from the eyes of a political or social scientist rather than think about this like an economist.  Let me explain my thinking.

Most commercial real estate mortgage loans are interest-only loans.  Prior to 2007, this served two important purposes.  First, because the principal balance was never paid down, it ensured repeat business for the lenders when the loan term ended and property owners would refinance them into new loans.  Second, the payments on interest-only loans are significantly less than amortized loan payments on the same principal amounts so this helps property owners by giving them higher cash flows as well as the lenders by reducing the chances that there would be defaults on loan payments.  Here’s the problem…

According to the Congressional Oversight Panel, $1.4 trillion in commercial real estate mortgage loans are coming due by the year 2014.  Because of the previously described combination of deteriorating market fundamentals and lower investor confidence levels, properties have lost as much as 40% of their values from when many of these loans were made at the height of the market back in 2007.

How does this affect commercial lending?

Many of these loans were based on the London Interbank Offered Rate (LIBOR) interest which were at ridiculously low levels during the height of the market and have since been driven even lower by government policies.

Unlike many residential mortgage loans, typical commercial mortgage loans are not amortized for 30 years.  They are often interest-only loans that become due in less than 30 years, e.g., five to 25 years, after which it is standard operating procedure to refinance into a new loan with similar terms.  As mentioned in a previous blog post, our country is $14.26 trillion in debt and running at a deficit easily exceeding $1 trillion a year.  The only ways to reduce this debt are to increase income and reduce expenses.  Inevitably, interest rates will rise because of politics.  LIBOR will rise.  Commercial mortgage loan interest rates will rise.  The commercial mortgage loan debt service will rise as well upon refinancing into new loans with all of these loans coming due if the lenders want to even refinance at all.  I doubt that landlords will be able to squeeze enough income from their tenants to match the increased debt service and can only see increases in commercial mortgage loan defaults coming our way just from term expirations and not even including payment defaults.  Also, many lenders will not be able to allow refinancing since loan-to-value (LTV) will have drastically increased above their maximum limits because of decreases in property values.

While this has been a very simplified post on what we may expect in the commercial real estate markets, there are still plenty of good deals to buy as long as you factor in the effects of politics and investor sentiment into your purchase price.  To close this post, I’d like to ring the dinner bell for my fellow vultures with a brief list of commercial properties from my database where loan terms have come due already.  If you can negotiate directly with the lenders or owners, you may be able to get some incredible deals:

Bon appetit, my fellow scavengers!

Eat hearty by taking advantage of the present commercial lending environment rather than becoming a victim to it.

Stumble! for WP