July 3, 2009 - As I gaze out my window at the vast expanse of Northern Colorado real estate, I ponder what lies ahead for this great region. How will the effects of this global economic meltdown translate into commercial real estate for an area that, while not isolated from past slowdowns, certainly has been insulated from them? Where do the problems exist and what will it take to get us back on track?
Too much debt
Let's start with a broader perspective. By some estimates commercial real estate debt totals $1.4 trillion nationally, backed by everything from strip malls to apartment complexes - and it is set to mature over the next several years. Much like residential mortgages, these commercial loans were packaged and sold as complex financial derivatives known as Commercial Mortgage-Backed Securities. In recent years, the CMBS market has satisfied a whopping 40 percent of credit demand in the commercial mortgage sector.
Our friends on Wall Street have effectively turned off the spigot, leaving a massive gap in the refinancing needs of borrowers. This could lead to a flood of foreclosures and a considerable amount of supply for years to come.
Already in the first quarter of 2009, payoffs for maturing loans are at a meager 55 percent. This means that 45 percent of loans maturing are either being transferred to special servicing or are unresolved.
Recently the Fed announced plans to include legacy CMBS as collateral under the TALF (a credit facility to stimulate lending), but the stringent requirements to qualify may leave many borrowers standing around like the child who has just realized that the music has stopped and there are no more chairs. Trying to solve the problem of too much debt by creating more debt is akin to telling the guy who exceeded his three-margarita limit at the Rio the night before to just keep drinking. Eventually one has to face the hangover, as painful as it may be.
I have often said the only difference between pricing real estate and stocks is that you can see where your stock prices are every day by simply opening up the newspaper. If property owners could see where their real estate prices were by such a transparent measure, reality would likely replace denial. A valuation gap still exists between what buyers are willing to pay and the price sellers think their properties are worth.
Such a gap has led to a significant decline in activity. In Northern Colorado the numbers are staggering. For Larimer and Weld counties this year, through May 31 according to CoStar, there have been 74 commercial real estate transactions totaling $54,714,791, compared to the 203 transactions totaling $263,016, 509 for the same time period in 2008 (which was down roughly 50 percent from 2007). This translates to a nearly 80 percent decline in year-over-year dollar volume.
The denial promises to set in when the refinance wave hits. Let's take for example a property purchased for $1,000,000 with 25 percent down and a five-year term. If the value of that property erodes by 25 percent (highly probable in the current market), the owner's equity has been wiped out. When that owner goes to refinance the property the lender will require not only the 25 percent equity but possibly as much as an additional 15 percent, as lending standards are becoming more rigorous.
The owner is faced with the choice of bringing $300,000 to the deal to keep the property or walking away. This is the sobering reality.
Going forward
As we look forward, the picture remains cloudy. Northern Colorado is a hub for creativity and innovation. The area generates patents at the rate of 11.45 per 10,000 people a year, nearly four times the average U.S. city. We will continue to see the collaboration of cutting-edge research in renewable energy and businesses as new technologies in wind, solar and biofuels transfer to the marketplace.
While the region will likely remain insulated from the broader market, the macro environment will continue to weigh us down. Not only are we in a recession, but it is one caused by de-leveraging - a phenomenon most of us are still trying to figure out.
We recently learned the region shed some 3,700 jobs over the past year, the most on record. No real estate will recover without stabilization in the job market. Transaction volume will continue to be light as participants continue to probe into price discovery and get more realistic. Remember, there are no bad markets, just bad prices.
Both wealth building and wealth erosion for many will hinge on accurate and timely analysis of the commercial real estate market.
