I have been told for many years now from brokers that the commercial real estate is the safest and most secure type of investment I can do. Why? Cashflow. And when I disagreed with them that there is no such thing as fail safe investment, whether it'd be stocks, real estate, commodities, etc, they would either roll their eyes or look at me like they're talking to Dorothy from Wizard of Oz.
Fast forward to 2009 and apparently, we're not in Kansas anymore. In fact, the real estate foreclosure tornado is about to hit the commercial arena and with a full force.
In fact, much larger than expected. I hate to say this to those "investors" who paid for 5 cap properties in, well, crap neighborhoods, thinking that they're going to flip to another idiot. You know what they say: everyone has a dumb friend. If you need to look around to see who the dumb friend is, guess what. (I'll leave the punchline to your imagination)
Commercial real estate is safe in a sense that it is bought for business reasons (i.e. rent it out for cashflow). But it's riskier in a sense that there aren't (that I know of) fully-amortized loans. The loans are due anywhere between 1 to 10 years, depending on size, type, and terms of the loan. In another words, if you as an investor plan on amortizing the loan to $0 in time span of 30 years, you'll need at minimum 3 loans - 1 acquisition at time of purchase and 2 refinance (10 yr term loans) every 10 years.
What happens if you're positive cashflow but yet cannot refinance at your 10th or 20th year? If you refinance to an amount lower than what you owe and do not have the cash to make up for the difference, you're going to sell at a loss. Pretty simple concept. No rocket science here.
But what is happening in the market? First of all, there is the credit liquidity crisis, i.e. there are no loans. Second, even if there are loans, the maximum LTV on the loan has significantly decreased since the residential real estate foreclosures has begun:
With credit markets still shaky, about $171 billion in loans backed by offices, shopping centers, hotels and other commercial buildings are coming due this year.
....
But they've tightened their standards significantly from the easy-credit days. Lenders are requiring more equity – essentially a larger down payment – and charging higher interest rates on loans.
Where landlords may have been able to get a loan for 80 percent of a building's value during the boom, lenders now are limiting loan amounts to as little as 50 percent of value.
In another words, commercial real estate is going to see its ugly wave of foreclosures. In fact, the deflationary pressure on the commercial real estate market has started to take its toll:
Meanwhile, the value of commercial property has fallen in many cases as the economy has deteriorated. Across all types of property, values dropped 17 percent in 2008, said Rebekah Brown, a vice president in asset management for JPMorgan in New York. Forecasts call for values to fall 15 percent further before stabilizing.
When the economy tanks, businesses go, well, out of business. Less businesses there are, less tenants there are. Less tenants equals vacancy, which equals lower income and lower property value:
The demand for office space was negative in 2008, according to data from commercial real estate firm CB Richard Ellis. Although 7.3 million square feet of new office space became available last year, there was a negative absorption of 603,000 square feet.
In 2007, roughly 1.5 million of the 4.9 million of office space constructed that year was absorbed.
On top of that, construction continues on projects that will add another 3.1 million square feet of office space in the Valley.
In the industrial market, only about 630,000 square feet were absorbed of the more than 12.3 million square feet of space that was built in 2008 were absorbed. And 3.8 million square feet are still under construction.
And the industry "specialists" and "insiders" who have told us investors that commercial real estate market is a recession/trouble proof investment is now telling us otherwise:
“I expect it to get much worse in the next two years,” said Jim Rounds, an economist at Scottsdale-based Elliot D. Pollack Co.
With all this negative news, what's a small investor to do? Very simple. What naturally follows a problem? Of course, the opportunists:
Sales generated through auctions — including residential, commercial and agricultural properties — totaled $58.6 billion in 2008, up 38 percent from $42.3 billion in 2003, according to a recently released tally by the National Auctioneers Association, a trade group based in Overland Park, Kan.
In fact, wise real estate investors/developers are actually buying right now because the pain is so great. Donald Trump is no exception:
Donald Trump has sealed a deal to buy Lowes Island Club, a country club with two championship golf courses in Loudoun County.
The Washington Business Journal reported in January that Trump was in negotiations to acquire the club, and his organization has now confirmed that it bought the 800-acre site.
If I had a time machine, I would go back to 3-4 years ago when I was having a coffee with a broker named Milton who told me and my partner of an "amazing" 5 cap deal in Stockton, CA (highly agricultural, low-end market in central California). Instead of wasting an hour of my life listening to him pitch to me about these wonderful investment opportunities, I should have acted out lines from Wizard of Oz with my business partner:
Don't be silly, Toto. Scarecrows don't talk
