The Coming Commercial Real Estate Bust

I remember when you could walk into a Sharper Image store and fiddle with an assortment of high-tech gadgets. Alas, the company’s bankruptcy relegated the brand to catalog and website form.

Likewise, many retailers are currently struggling to maintain their physical presence.

Some retailers will adapt. Others will simply fade into oblivion, unable to withstand the crucible of online competition.

We have more to worry about than just bankrupt retailers, though.

Store closings and consolidations are curtailing demand for retail space far and wide.

In fact, retail vacancy rates never normalized following the Great Recession.

U.S. Metro Area Vacancy Rates

As you can see in the chart above, apartment vacancy rates in metro areas have fallen far below the levels seen prior to the financial crisis.

Yet, retail vacancy rates remain nearly 3% above their pre-crisis levels.

The paradigm shift away from brick-and-mortar stores and towards online shopping is undoubtedly having an impact.

Office vacancy rates remain elevated, too.

Again, technology may be the prime culprit considering that companies need fewer employees to produce the same output. Also, over-building may be a contributing factor.

Whatever the causes, there’s a glut of commercial real estate (CRE) space, and one of the longest economic expansions in history has failed to alleviate it.

You wouldn’t know it from looking at CRE prices, though.

Prices and Fundamentals Diverge

The Green Street U.S. Commercial Property Price Index (CPPI) has more than doubled since May 2009. In June 2015, the index rose 11.3% on a year-over-year basis. The latest data showed the CPPI rising at a robust 7.5% rate.

However, we need to peer beneath the surface to figure out what’s really going on with CRE. As it turns out, the market for commercial mortgage backed securities (CMBS) isn’t acting healthy.

The Markit CMBX indices are each composed of 25 reference obligations that are tranches of CMBS offerings. The chart below shows the various series of the BBB-minus (lowest investment-grade rating) version of the indices.

Commercial Real Estate (CRE) Credit Derivatives: Markit CMBX BBB-Index

Essentially, the CMBS market has bounced back following a swoon at the beginning of 2016, but prices haven’t returned to their mid-2015 levels.

It’s clear that all is not well in CMBS land, and this is a warning signal for the entire CRE complex.

The Credit Cycle

The CRE boom has been quite magnificent. But as sure as night follows day, there will be a bust. That process has probably already started given the credit deterioration suggested by the CMBX indices.

It wouldn’t be all that surprising to see CRE prices start to roll over. Once this happens, the poor lending and underwriting standards during the boom will become all too apparent.

In December 2015, the Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency issued a joint statement warning about the potential risks to the banking system from CRE lending.

The federal banking agencies’ examination revealed an “easing of CRE underwriting standards, including less-restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements.”

Perhaps they should have said something before it was too late!

Furthermore, it’s ironic that the Fed would warn about how fast and loose CRE lending has become.  The Fed’s own easy money policies and three quantitative easing (QE) stimulus programs have actually fostered the CRE boom (just like the shale oil boom).

I’ve said that auto loans will be a problem area during the next downturn. Well, CRE is going to be an even bigger debacle.

Retailer woes, the glut of CRE space created by a shift towards online shopping, and QE-induced excesses all ensure a spectacular CRE bust.

Safe (and high-yield) investing,

Alan Gula, CFA

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