The Soft Panic of 2009 Has Just Begun

Boston’s Clarendon Street sits on one of city’s most iconic buildings. It’s also the symbol of what could kick off what I call the “Soft Panic of 2009.”

Locals know it simply as “The Hancock.” The 60-story frame wrapped in reflective blue glass makes it look like the tallest mirror in the world. I’m sure it was an impressive sight when it was built in the 70’s. It still is.

The I.M. Pei designed building stood as a symbol of financial strength and ingenuity. Now, it’s looking a whole lot different.

And for those of us looking into this situation now we will be protected. And for more aggressive folks, we’ll actually be able to profit from it all. Here’s how.

A Sign of the Times

The Hancock Tower was purchased by Broadway Partners in 2006. It cost $1.3 billion. The vacancy rate was a mere 5%. Broadway looked like they had another big winner on their hands.

Broadway Partners was one of the rock stars of the real estate boom. The New York real estate firm snapped up $15 billion worth of real estate between 2000 and 2007. The firm stuck to red hot real estate markets in places like Boston, New York City, Washington D.C., and Florida. The strategy paid off too. Broadway earned an average 35% annualized return from leveraged real estate deals.

A lot has changed since then. The boom has turned to bust. In less than three years The Hancock Tower has turned from an iconic asset to a top-heavy liability. Now, Broadway had to sell out.

Earlier this week, Broadway defaulted on the Hancock Tower payments. The building had to be auctioned off. In a two minute auction (using the term “auction” loosely – there was only one bid) the Hancock sold for a $20.1 million and the assumption of $640.5 million in debt. That works out to a total price of about $660 million. That’s almost half of the $1.3 billion paid for the building back in 2006. More importantly, it shows just how far commercial real estate (CRE) values have fallen.

The thing is, CRE problems won’t be one for Manhattan real estate players. Not at all. This is a sign of things to come in the CRE market. And when we look at who owns most of the CRE debt, it’s easy to see it will affect a lot more people.

I’d go as far to say, the CRE crash could be even more disastrous than the housing bubble. The costs will run into the hundreds of billions of dollars. Here’s why.

The “Sweetest” Piece of the Pie

For long time Prosperity Dispatch readers, the problems of CRE shouldn’t be much of a surprise. We’ve been expecting this for a while. Back in Kicking Off the Panic of 2009, we warned of the vicious cycle about to hit CRE:

As unemployment rises, consumers spend less, retail sales fall some more, more shops close down and walk away from their leases, and overleveraged mall owners collect less revenue eventually defaulting on their loans and forcing the banks to take the losses. Throughout it all, unemployment rises even more from the retail stores closing up, manufacturers cutting back production because the retail outlets buy less from them, banks cut back staff, and start the cycle all over again.

Falling CRE values are a problem, but it’s not the big problem. The big problem is the debt.

As we’ve seen time and time again, markets do work – when they’re allowed to. The Hancock Tower is the perfect example. The owners were forced to liquidate. They lost all of their equity. The property and all the liens against it (primarily the $640 million mortgage) were sold to a new owner.

If the new owners can run the building efficiently enough to make payments, their equity will build. If not, the lenders will be forced to take the building, sell it, and write off the loan.

Markets work. And they will continue to do one-time deals like this. However, if there is a widespread downturn in CRE prices, most CRE transactions won’t go this smoothly. Sellers will outnumber buyers. And we’ve seen how prices can fall very quickly when that happens. At that time, the lenders (and those who bought the securitized loans) will be on the hook for falling prices. From here, there is no place to go but down.

Unemployment Soars, CRE Crashes

When you think about it, you can practically see the next big round of bailouts headed for CRE. Another vicious cycle has begun. And it all stems from rising unemployment.

It’s no secret unemployment is on the climb. At the end of February, the official unemployment rate in the U.S. was 8.1%. The next unemployment report is due out tomorrow. The consensus estimates forecast another 650,000 jobs lost and the unemployment rate to climb to 8.5%.

The march to double digit unemployment we predicted last year is continuing. It’s only a matter of time until we see the real consequences of 10%+ unemployment. One of the hardest hit sectors will be CRE.

During a recession, especially a bad one, commercial rents fall fast. As jobs are lost, offices shut down, and the office property market reaches significant points of overcapacity. Inevitably, the cost of leasing an office falls. Since CRE prices are based on rental prices, CRE prices fall just as fast.

The decline stems from the vicious cycle which was started a year and a half ago.

Trickling Down Economics

It’s the same vicious cycle we’ve been over before. Businesses cut back on spending, investing, and hiring. Unemployed people, or those who just fear they will be unemployed, cut spending. This, in turn, reduces revenues and the downward cycle continues.

This is nothing new. We see it every day. The key here is the cycle takes a long while to hit CRE.

The delay comes from many factors. For instance, businesses don’t renew leases every month. They don’t close up shop quickly. They try to survive until the last dollar is spent. This results in a long delay. Considering the recession began in November 2007, right about now is the time when it starts to hit CRE.

New York is the “canary in the coal mine” when it comes to CRE. A year ago, vacancy rates in the Big Apple were between 7% and 8%. The rate climbed to 10.9% at the end of 2008. Now, just three months later, the vacancies are up to 12%. And they’re still going to go.

Climbing vacancy rates have pushed the cost of renting way down. The lease rate on a square foot of office space went from $74.49 to $65.18 in just the past three months. That’s a 12.5% decline in just three months. Keep in mind; this is in New York City where some of the world’s most valuable CRE is. We can only imagine what is going on across the country.

CRE has its own vicious cycle. Unemployment increases, demand for office space decreases, rents fall, and then commercial property prices fall. CRE prices have already fallen and the next leg down could make the subprime crisis look like a cakewalk.

The Biggest Shoe of them All

The difference between the impact of the housing bubble bursting and the CRE bubble is critical to understand. The majority of residential loans were originated by banks or other lenders, packaged together (securitized), and then sold off to investors.

These mortgage-backed securities paid anywhere from 6% to 10% (depending on which tranche you bought). Investors were happy to have them. They were especially happy to buy them if they were buying insurance against a default from AIG – but that’s a topic for another day.

CRE is a whole different matter. Many of the CRE loans paid higher rates of interest. More importantly, they were backed by renters with businesses which generated revenue and profits. In other words, CRE loans were made to people who could pay them unlike a lot of the residential loans. So the banks didn’t sell them off to others. They kept them on their books.

These loans meant more interest income which would allow them to pay a higher interest rate to attract more cash from depositors and still make strong profits. Meanwhile, they could sell the garbage residential loans to someone else.

That’s why the CRE downturn will create even bigger problems…have a great impact on balance sheets…and end up in even bigger bailouts.

Of course, we went over how bad commercial real estate declines would be for regional banks months ago. At the time Wall Street was still riding high on hopes the new administration would provide a plan quickly.

The big problem though is not that banks kept the CRE loans on their books. The Fed, Treasury, and FDIC are making progress. They’re getting bad residential and credit card loans off banks’ books. CRE loans are a different story. That will change.

A Bigger Shoe to Drop

We’re not the only ones hot on the trail of commercial real estate though. A lot of people have spotted this storm on the horizon. But only a few have boarded up their windows and moved to higher ground.

Billionaire hedge fund investor George Soros sees it coming. He says:

“CRE has not yet fallen in value. It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”

The impact on the value of real estate loans is starting to appear as well.

The Wall Street Journal claims “Commercial Property Faces Crisis.” The financial news service reports:

  • The U.S. banking sector could suffer as much as $250 billion in commercial real-estate losses in this downturn. More than 700 banks could fail as a result of their exposure to CRE.
  • In 1993, less than 2% of the nation’s banks and savings institutions had commercial real-estate exposure. In 2008 that had risen to about 12% or about 800 financial institutions.
  • CRE in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt.
  • Deutsche Bank predicts about two-thirds of the $154.5 billion of securitized commercial mortgages coming due between now and 2012 likely won’t qualify for refinancing.
  • Matthew Anderson, partner at Foresight Analytics, expects nearly 50% about $524.5 billion of whole commercial mortgages held by U.S. banks and thrifts are expected to come due between this year and 2012 as they exceed 90% of the property’s value because, today, lenders generally won’t loan over 65% of a commercial property’s value.

A CRE crash would require an additional $250 billion (or more) bailout from the government. That’s another big number that Congress is going to have to muster up the political will to pass. Or the Fed will just cover it. Either way, it’s an ugly scenario shaping up. And one industry (insurance companies) will likely pay a big price.

Pockets of Weakness

Over the past few years, insurance companies bet big on CRE loans. It makes perfect sense from their perspective.

Insurance companies have the same motivation as banks do to seek out a higher return. They get a great return on the capital they are responsible for managing. They can charge lower premiums to attract more business. And they can still maintain healthy profits. It’s great – until real estate prices start to fall and the CRE loans are at risk.

The downturn has already taken a toll on most life insurance stocks. As you can see in the chart below, the decline of shares of major life insurers range from 63% to 91%:

Life Insurance Stocks

I think this is just the start of it though. Housing has got the headlines, but it’s CRE that can do just as much damage – if not more.

You see, there were never any runs on banks over the past few months. The public had confidence in the FDIC. So there was never any need to run and withdraw all your money – which you can’t really do anyway without a week’s notice. Insurance companies are a completely different matter.

There is no government backstop guaranteeing your life insurance. Maybe the AIG deal is an example of what will come, but you can bet there won’t be much public support for it. AIG, an insurance company, has done everything so poorly the public might just not be willing to allow Congress to foot the bill for the CRE downturn.

That’s the real risk here. If there’s a bailout – ok. Insurance stocks will be worth a tiny fraction of what they are worth today (I don’t think they can’t fall another 70, 80, or 90%).

Insurance firms have already started preparing. Earlier this week Principal Financial Group (PFG) announced it was going to do everything necessary to cut expenses. It stopped hiring. It slashed pay across the board up to 10%. It also cut back employee vacation time. These are not actions taken by a company expecting the good times to return during the anticipated recovery in the “second half of 2009.”

Irrational Crisis and Rational Opportunity

In the end (yes the end is near – this was a bit long, but it’s not a simple topic and the risks posed warrant the time), the CRE debt issues are a ticking time bomb. With unemployment on the rise, vacancy rates rising, rents dropping, and CRE loans on the brink of default, this is shaping up to be a big problem.

The deal to unload the iconic Hancock Tower is just a sign of what’s to come. There are buyers now. But when liquidations increase, you’ll see prices fall much faster than the three year near-50% decline in the price of the Hancock Tower.

More importantly, spotting problems like this early enough allows us to make the moves necessary to protect ourselves from the very real risks posed to the major insurance companies. You don’t have to short commercial real estate REITs or insurance stocks to take advantage here.

By focusing on the reality of what’s on the horizon, we have the chance to adjust our plans accordingly. We’ll have the chance to prepare psychologically, get prepared for some more bad news, and we’ll be able to make the right moves when this does become a problem.

And it is that, getting prepared to act rationally when others will be surprised and act irrationally, that will allow us to turn this potential crisis into a genuine opportunity.

By Andrew Mickey

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