Beware of green shoots: there may be snakes in the grass

There’s good economic news breaking out all over,  it seems.  The Fed’s Beige Book report, released July 29, suggests that the pace of economic decline has started to slow.  The stock market liked this news, responding with gains per Bloomberg. But does a little bit of economic improvement mean that the worst is over for commercial real estate?  or that we’ll have a fast recovery in CRE?  I don’t think so.

Despite all the talk of “green shoots” and economic improvement,  it is likely that CRE will suffer for a significant amount of time.

Why?  There is simply not enough growth to increase demand for commercial space.   Consumer demand, which for better or worse drives our economy, is way down, for a number of reasons:

  • The continuing high rate of unemployment (14.5 million Americans were out of work in July per the Boston Globe) scares even those consumers who have jobs.  So they spend less.
  • So many people overleveraged themselves through home equity extraction (and must either repay that money or have their houses foreclosed upon) that they don’t have much money to spend.  (Bloomberg reports that banks held a record $674 billion of HELOCs and $211 billion of closed- end home-equity debt as of March 31, according to FDIC data.)
  • So many people overleveraged themselves through credit card and other debt that they don’t have much money to spend.  And instead of buying more, they are apparently paying down their debts — probably good for them personally, but collectively not great for increasing demand and growth in the economy.  CNNMoney reported that since last August, the amount of outstanding consumer credit has declined, according to the Federal Reserve, with total consumer borrowing sinking a seasonally adjusted $10.3 billion, or 4.9%, to $2.503 trillion, and revolving credit, which includes credit card debt, fell $5.3 billion, or 6.8%, to $917 billion. 

Until consumer demand increases for goods and services, companies have no reason to increase their use of commercial real estate by taking on new leases or purchases of retail, office or industrial space.   In fact, since demand is down, many users of CRE will continue to look for ways to cut their expenses for CRE as a way to reduce their expenses overall — and to survive the downturn.   Obviously, if enough tenants default on their leases, this creates problems for landlords, who in turn may default on their mortgages.  This is happening now; for example, prominent Southern California developer Maguire Properties recently announced it will sell or return to lenders seven buildings in Southern California per Business Week.

In addition, the death (or serious incapacity) of the CMBS market has wiped out about 40% of the total financing capacity that was available to finance CRE.   That means that, over the next few years, unless an alternative source of funding is found, many CRE projects will have trouble finding refinancing at maturity.   Since CRE prices have fallen significantly, it is very difficult for many CRE owners to get financing.  For that reason, we should expect to see a lot more defaults (including maturity defaults), workouts and foreclosures. 

Many banks have been quick to extend loans and slow to foreclose, because they could not afford to recognize losses as doing so would increase their capital requirements and perhaps push them into insolvency — and the undesired embrace of the FDIC.  However, as banks move toward recovery, assisted by the massive federal bailout, their capital reserves should improve.  This should allow them to move forward to recognize their losses and foreclose on their troubled CRE loans over time.

So instead of thinking that CRE will recover soon, based on what I’m seeing,  CRE has not yet absorbed the brunt of the recession, and will likely continue to get worse over the next couple of years, until much of the CRE market has been significantly repriced downward.

Of course, the wild card in this is government intervention:  if the federal government decides that massive CRE failures would destabilize the financial system, it might well retool existing governmental bailout programs, invent new ones or change tax policies to cause the injection of more liquidity into the CRE market.   It is hard to guess at the government’s likely intervention, but this Fed and this administration have been very willing to use taxpayer money to stabilize the financial markets, and so might do the same for CRE. 

What do you think?  Share your views by replying below.


4 Responses to “Beware of green shoots: there may be snakes in the grass”

  1. 1 jstamp02 August 14, 2009 at 9:27 pm


    I think you’re right on with your analysis. Banks can only extend, amend, and pretend for so long. They have to prepare for the day of reckoning.

    But like you said, the Government is the wild card. I think the CRE market will continue to decline as an influx of distressed assets hit the market. The impact may be so severe that the Government will be forced to increase their efforts of providing liquidity to the market. TALF and PIPP have had minimal impact on the CRE market.

    I’m interested to see how things play out and the number of opportunities that arise.

  2. 2 Scott D Remphrey August 18, 2009 at 8:34 pm

    Very good observations and keep up the good work! The CRE Market is so fragile and hasnt hit at all yet….there are ‘one-off’ deals around the country but not the massive sell off that we experienced in the 90’s so until we get direction from above, its going to extend and pretend for the forseeable future…

  3. 3 ntfeldman August 19, 2009 at 7:19 pm

    Excellent article that is painfully true.

    Until unemployment stabilizes and absorbtion rates stop declining, vacancies will continue to drive the problem higher.

    There are larger issues looming in the capital markets related to CMBS and the gridlock of last year was just a symptom of the problems yet to come.

    The size of this adjustment to values is truly historic and will no doubt reach everyone on some level. Pretending just won’t work.

    FDIC needs to take down the banks and the toxic assets that fall outside of compliance; values need to be marked and a federally appointed receiver needs to dispose of these properties at true market values. Sooner is better than later – they are worth more today than they will be a year from now and the longer the dateline works on the drop, the more assets will fall into trouble. Time is of the essence in this play. For those assets and owners that are so seriously over leveraged that they can not stem this decline, it’s not if, it’s when. When should be as soon as possible so that healthy assets are not further effected.

    Save jobs, save values.

  4. 4 madrozie August 24, 2009 at 5:38 am

    Pretty cool post. I just came by your blog and wanted to say that I have really enjoyed browsing your posts.

    Any way I’ll be subscribing to your feed and I hope you post again soon!

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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.

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