Diary

Residential Real Estate is Small Potatoes...

Compared to commercial real estate. And guess what’s sneaking over the horizon. If you guessed a BIG debt bomb, you’d be correct.

Here’s a little fundamental stuff for you. First of all, you can’t compare the same benchmarks for residential and commercial real estate, they are drastically different animals. For instance, if you look at the loan portfolios of the major banks you get a dramatically different picture. Let’s take a look at Bank Loan Performance, a great site to evaluate the health of banks.

Note: I’m not doing an in-depth analysis of BLP, I’m simply using the following as an example of the difference between commercial and residential real estate benchmarks. Let’s look at Wells Fargo. Their loan portfolio for all types of loans is $772B. Of that, $225B is residential real estate and 16% of that portfolio is at least 30 days delinquent and about two-thirds of that delinquency is over 90 days. That, gentle reader is a huge deal. Historically about 5% of 90+ day delinquencies cure. Bottom line, Wells Fargo’s residential portfolio is in really deep do-do. While Wells is in worse shape than about everybody else, nobody is in “good” shape in their residential portfolios.

How about Wells commercial real estate portfolio? Well, it doesn’t look bad. It’s $87B, less than 4% total delinquency (which is still historically very high) and less than 2% over 90 days. Relative to residential numbers it doesn’t look so bad as a snapshot. Please note that over the last five years 90+ day delinquencies have typically been below 0.1%. Way below.

But here’s the bomb. All commercial real estate loans are balloon loans. They are typically “low” loan-to-value (50% to 75% of appraised value at the time of the loan) and commercial appraisals are much, much more stringent than residential appraisals. Commercial loans are typically fixed for 4 to 10 years and then must be renegotiated and they don’t just “adjust”, they are called and they’ve got to be paid off with a new loan.

Read all of Megan McArdle’s current article in The Atlantic – and you should read the whole thing – about $250B of commercial real estate loans are going to pop every year for next several years. And guess what’s happened to the value of commercial real estate over the last five to seven years. Yep. It’s dropped faster than Barry’s popularity. So, the bottom line is that a whole bunch of loans are going to balloon and the value of the property securing those loans is going to be 100% or less of the current principle value of the loans. Makes refinancing more than a little difficult. For example…

A joint venture put together by Tishman Speyer and BlackRock carried the day through its willingness to, as The New York Times noted, “pay up—way up—to unlock future profits in the sprawling Manhattan properties.” [Stuyvesant Town and Peter Cooper Village, the twin housing projects that sprawl across 80 acres of the Lower East Side in 2007] At $5.4billion, their winning bid made the sale the most expensive real-estate deal of all time.

Three years later, however, those profits were still securely locked inside the property’s 11,232 apartments—many of which remained rent-controlled, despite strenuous efforts to convert them to upscale market-rate rentals. With net income well under projections, the partnership started spending down its reserves. Then, in October 2009, a court ruled that the partnership had improperly decontrolled the rent for thousands of apartments, and would have to return them to their original status. As of this writing, analysts are predicting default in a matter of months unless the partnership’s debt of $4.4billion can be restructured—a shaky prospect, given that the owners may owe tenants of formerly rent-stabilized apartments as much as $200million in rent overcharges and damages. Stuyvesant Town might soon set another record: the biggest real-estate default in history.

That default would be one of the first tremors of an earthquake about to roil financial markets: a commercial real-estate crisis mirroring the catastrophe in the residential market.

And HERE’S the bad news…

…most U.S. residential mortgages were bundled into mortgage-backed securities, only a fraction of commercial mortgages were securitized. Some bank or finance company still carries the rest on its books and will have to write them down if they can’t be rolled over; some of those banks will ultimately have to be taken over by the FDIC. As the banks’ loan portfolios are sold off, the write-downs of the underlying collateral will give bank examiners a new, lower reference price for the collateral held by other banks, possibly tipping those banks into insolvency as well.

So, here’s a peek into the future of real estate.

  • The residential real estate market is no where near the bottom.
  • Nobody’s even talking about Fannie/Freddie. Think in terms of maybe $500B to “fix” that little problem.
  • Commercial RE has the potential to bust the FDIC.

The next time some Realtor looks you in the eye and says “hey, nobody’s making any more land…” hit him with a hammer. Oh, and you ain’t seen nuttin’ yet.