I watch/look at CRE every day.
One fundamental difference between commercial and residential is this:
1. The worst of residential loans were where the borrower put ZERO money down, lied about their income, borrowed on a floating rate, and paid more than anyone could possible afford, even if they had a job in the area around the home. This was a highwire act, and there was no net.
2. The worst of the commercial loans were 15% down (fairly uncommon though, most were still at least 20%, if not more), with income that you had to prove to the lender, at rents that were historically relatively high, but in my experience (which goes back about 15 years), not outlandish, and, for the most part, at fixed rates.
If you had a long-term lease to a stable business, with long term debt, the owner of the CRE has YEARS to reserve extra cash/figure out what to do IF they are overleveraged based on today’s rents/values. Some of the most highly leveraged loans were made in 2006/2007, and were 10-year loans at low interest rates (so we have a ways to go before those hit the wall). Also, much of the debt has recourse provisions, so, even if the property is underwater on value (because it is overrented, etc.), there is an incentive for the owner/guarantor of debt to keep paying on the mortgage as opposed to simply walking away.
There are only points of stress when the property no longer provides enough cash flow to service the debt, which happens less with commercial property than with single-family residential (that started out unable to make the payments).
Look at some of the most overleveraged commercial property REITs as a case study. As an example, DDR–in 2009, when people were worried that it was going to topple over under the weight of its own debt, it was STILL 90%+ leased, with largest amount of its income from WMT and Target, and, the most critical part, its debt service coverage was nearly 2x. Meaning if it’s interest payments were $50, it had cash flow of nearly $100 to make the payments. The risk was with being able to roll over the debt at the same leverage levels, NOT inability to make the payments if there was a willing lender. At it’s low, the stock price was at ~$2. Today, after raising a lot of equity (and diluting the shareholders by roughly 50%), it is generating cash flow of about $1 per year (even with the increased number of shares), and the stock price has recovered to nearly $12.
Ditto for First Industrial (FR; their occupancy fell more, but they didn’t need to dilute existing shareholders as much).
Where CRE has been most impacted has been with buildings intended for smaller businesses (rents could be substantially down, and it costs $ to re-tenant the buildings, which might not be economical given the capital structure), or buildings that were under construction during the crash (where the owner couldn’t make the interest payments with $0 in rent).
It will take longer for the CRE market to “reset”.
What is happening on the ground is as follows:
- DPOs (Discounted Payoffs), where the bank realizes that the group willing to pay the MOST for an asset is the existing ownership, so they allow the existing ownership group to raise the money to buy back the debt at a discount–since it is better economically than foreclosing/selling as REO;
- Bankruptcies/Restructurings, where the cash flow is more than sufficient to pay debt service, or there is demonstrable equity based on today’s values, but the bank doesn’t want to (or can’t, based on loss sharing agreements with FDIC, etc.), the court will either force an extension of the maturity, or let the property go to the bank;
- Short sale, for those banks that are accepting of the economics behind a DPO, but not willing/able to make a deal with the borrower
- Foreclosures/REO sale
The worst of the loans were to land (with no cash flow to service the debt, and the greatest collapse in values). These loans were the first to be worked through. The next worst are those with some cash flow, but not enough to service the debt–the resolution to these varies. The next category are those with cash flow to service the debt, but that there is too much debt relative to what a new lender would provide today.
The number of assets in the above three categories is large, and will create a lot of mini-crashes (asset by asset). To be candid, the number of mini-crashes is too great for it to all work through at once, so it will take time.
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