Investing Caffeine

Ross Warns of Commercial Shoe Drop

November 9, 2009 at 2:00 am 6 comments

The next shoe to drop in commercial real estate has been highly telegraphed for some time now. Wilbur Ross, restructuring specialist and founder of WL Ross & Co, has a long track record of success and he weighs in with his views regarding the impending crash in commercial real estate through several recent interviews.

What exactly is Mr. Ross worried about? He sees a correlation of what happened in the residential mortgage markets to what we are now beginning to see in the commercial real estate markets:

Fast forward to minute 4:20 to hear real estate commentary

Click Hear to See CNBC Interview with Wilbur Ross

“I have felt for quite some time that the same reckless lending that characterized the subprime mortgage business in residential was also characterizing what had gone on in commercial real estate in the mid-2000s. You had properties being bought at a 3% cash-on-cash yield. You had properties being financed at on such an aggressive basis that the lenders had to give them an advance – several years worth of interest – because there wasn’t enough cash coming from the properties even to pay the interest. And the theory was that rent rolls would go up, occupancy would go up, and eventually the property would grow its way into paying interest. Well now that clock is ticking – rents haven’t gone up, they’ve gone down; occupancy hasn’t gone up, it has gone down; and capitalization rates that people require from properties have gone up. So everything is going in the wrong direction, and I think we are going to see quite a lot of tragedies in that sector. “

Although Mr. Ross unequivocally sees a “huge crash in commercial real estate,” he puts his pessimistic views on impending destruction into perspective (read more about pessimism). The size of the commercial real estate market is quite a bit smaller than residential:

“The total of commercial mortgages is only about $3.5 trillion versus $11 trillion for residential mortgages.”

The commercial crash is already happening and forecasts for commercial property are expected to drop to the lowest levels in nearly two decades, according to according to property research firm Real Capital Analytics Inc. The sign of the times is evident by the recent Chapter 11 bankruptcy filing by Capmark Financial Group Inc., a company that originated about $60 billion in commercial real estate loans in 2006 and 2007 (Bloomberg). Anecdotally, at a professional event I just attended in southern California, I bumped into a real estate broker who informed me on the state of the market. The property across the street from the event location had a 50% vacancy rate and a glut of hedge funds were bidding on the building for 50% of its replacement value…ouch!

Reis Inc., a property research firm also notes:

“U.S. office vacancies hit a five-year high of almost 17 percent in the third quarter, while shopping center vacancies climbed to their highest since 1992.”

And from a fiscal response and taxpayer liability standpoint Ross is less worried because he thinks Washington, for the most part, will be watching the train wreck from the sidelines, with a bag of popcorn in hand:

“I don’t think the federal government’s going to do much to help the commercial building side because individual homeowners vote but buildings don’t vote.”

As Wilbur Ross has definitively communicated, he’s confident the commercial real estate mortgage market will cause the next surprising shoe to drop. Fortunately though, he feels the crash will be manageable. With all these shoes dropping, maybe I can find a new pair of shoes to wear?

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

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Entry filed under: economy, Profiles. Tags: Bloomberg, Capmark Financial, cnbc, commercial real estate, foreclosure, King of Bankruptcy, Reis Inc., Wilbur Ross, WL Ross.