“Sir, there are no seats left. You’re going to have to stand in the back.”
I was only 10 minutes late, but the conference hall was packed. Every seat was taken. The walls were lined with people.
At that point, I knew without a doubt, there was a lot more downside left in real estate.
Reincarnation of Tom Vu
Last week, I went to one of those “Invest in real estate: become a millionaire” type of seminars.
You know the ones. They show you all the “tricks” to making big money, the easy way.
It was like witnessing the meteoric rise (and inevitable fall) of Tom Vu all over again.
Remember him? He’s the late 80’s infomercial star who would teach anyone how to become a millionaire…for a price.
He came up with classic in-your-face lines like, “Do you think these girls like me? NO, they like my money” while standing on a boat surround by models. And he’d tell viewers, “Don’t listen to your friends. They’re losers!” (For the nostalgic among us, follow this link to a segment from one of Vu’s infomercials – pay close attention to the man who just made $15,010.50 and still can’t afford a decent haircut).
Vu made millions selling advice. But here’s the thing, Vu couldn’t have been successful without the 80’s real estate boom. You see, the herd always plows into everything at or near the top. Stocks, real estate, tulips…everything – they never fail to move in at the wrong time.
So when Vu started selling a real estate course at his seminars, he couldn’t help but be successful. He was great at selling advice people wanted. As we’ve seen time and time again, the herd wants advice on the hot sector. They want advice on what everyone has already gotten rich from. They don’t want advice on what they will actually get rich from.
That’s why when I saw more than a hundred novice investors vigorously taking notes and jumping at the chance to sign-up for a more advanced course, I knew there was still some downside to go. After all, I deduced their “secret” to success was leverage.
All of these “real estate is down, it’s time to buy” types need to get crushed first. Not until that point will we have a true bottom in real estate.
Going the Other Way
Now is the time to go the other way. There’s likely a lot more pain ahead for real estate and commercial real estate is about to get taken to the cleaners.
The Fed’s Beige Book report earlier this week warned:
Commercial real estate markets deteriorated in most Districts. Contacts in the Boston District described the commercial real estate market as grim and depressing, and market conditions continued to deteriorate in Richmond. In the Minneapolis District, a contact noted that the market remained in a downturn that has now lasted more than a year. Commercial real estate transactions in the Dallas District have reportedly ground to a halt…
It goes on and on to echo the “grim and depressing” and “deteriorating” conditions across the entire country.
A recent PriceWaterhouse Coopers report, aptly titled “Forget the Quick Fix”, warns:
U.S. commercial real estate faces its worst year since the wrenching 1991–1992 industry depression. Values will drop substantially, foreclosures and delinquency rates will increase sharply, and a limping economy likely will crimp property cash flows. The aftershocks of rampant “over-the-top lending” that batter the entire credit system leave property markets substantially overleveraged and vulnerable to significant depreciation.
The market is anticipating a lot of problems ahead for commercial real estate, but there’s still a lot more room for them to fall.
“Overdue commercial real-estate loans quadrupled from two years earlier in the third quarter to 4.73 percent, according to seasonally adjusted data from the Federal Reserve. That’s the highest level since 1994.”
It’s just the start. Overdue commercial real estate loans will continue to rise. If overleveraged homeowners were able to leverage themselves up to the point where as much as one-third of them are now underwater – there’s no reason to expect commercial real estate owners couldn’t do the same.
It’s all part of the vicious cycle. 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.
It’s the definition of a recession and why I’ve been concerned commercial real estate could spark a real panic in the financial markets (2008 was not a panic – a real panic is much, much worse – ask any Russian or resident of the Asian Tigers about what a real panic is like).
As you’ll soon see, this one could be the Big One. Of course, we can get prepared now. Here’s how.
The “OK To Fail” Sector
The problems in commercial real estate are well known. Most commercial real estate REITs, (the ones which own commercial real estate like malls, office buildings, and shopping centers) have already sold off quite a bit.
The big opportunity here is in the regional banks. You see, the small bankers were a lot “smarter” than most of Wall Street gives them credit for.
It was the small bankers who made a lot of the loans. They made all the loans to people they knew probably wouldn’t be able to pay them. Then they sold them to institutional investors, Fannie and Freddie, and the big banks.
Meanwhile, they kept the sweetest loans for themselves. They kept the loans for apartment buildings, malls, office buildings, and other commercial real estate on their books. After all, these were loans made against properties run by businesspeople that would have the wherewithal to actually make good on the loans. In addition, commercial real estate loans would collect 9% interest while home mortgages were fetching 6%.
They were smart…for a while. Now, commercial real estate debts going bad are going to cause a lot of pain for the regional banks. For instance, smaller banks like Marshall and Ilsley (NYSE:MI) and Branch Banking & Trust (NYSE:BBT) were leveraged more than 3-to-1 against commercial real estate loans. Fifth Third Bank (NASDAQ:FITB) and Regions Financial (NYSE:RF) leveraged themselves about 2.5 to 1.
The commercial real estate loans are not going to be someone else’s problem. These smaller banks are going to have to deal with the problem. And the question now remains, will Federal bailout funds go to these smaller banks which are not “too big to fail.”
If there’s no help for these banks, watch out. Many of these banks will go under and we’ll have a situation where it’s tangible to investors. So far this problem has been one that decimated Wall Street and has hurt a lot of people, but it’s just a bunch of huge numbers in headlines, and a bit of politics as usual.
It’s about to get tangible. When your ATM card quits working, you can’t access your cash held at your local bank, and it’s going to take months for the FDIC to sort out how much it owes you before you can even get your cash, the crisis is real. We talked about bubbles the other day not getting real hot until they were tangible, well the same is true in the inverse. The opposite of a bubble is a panic.
So, to repeat our mantra for 2008:
This downturn will go down in history as the buying opportunity of a lifetime. But I’d advise against going “all in” now.
Given the state of the economy and how much has to be worked through, a buying opportunity that only comes along once in five lifetimes could be around the corner.
Stay liquid, keep plenty of cash on hand, buy only great companies which will survive through all this, and just wait out the storm. We’ll be able to pick through the wreckage when the time is right which we’ll discuss in our 100% Free e-Letter the Prosperity Dispatch.
Don’t be like the latest class of newly minted real estate investors fueled by greed and armed with three hours of training, they’re bound to get crushed.
I’m not a doom and gloomer by any stretch, but we can’t avoid reality. We’ve got about a 1 in 5 shot of hitting a full-blown panic and we should be prepared. There’s a lot of money on the sidelines, so a panic is definitely not a 100% sure thing. But if it happens, it will be a truly great buying opportunity. One, I’m not willing (or going) to miss.
By Andrew Mickey