Peter Pays Paul

The San Francisco Chronicle is reporting in Commercial real estate market softens that some smaller office buildings are on the edge of foreclosure.

Owners of several small commercial buildings in San Francisco already are behind on payments, and local industry observers are laying odds on which large property could be the first to be seized by a lender.

…

“Real estate fundamentals are softening dramatically,” said Richard Parkus, research analyst at the German bank. “Over the next 12 to 18 months, we expect to see pretty significant deterioration.”

Of particular concern for San Francisco is the fact that nearly 75 percent of the Class A – premier – office buildings downtown traded hands in the past four years, according to Tove Nilsen, director of market research at Colliers International. The flurry of activity propelled sales prices to record highs and drove the ratio of rental income to cost to all-time lows.

According the article vacancy in San Francisco has risen by 32% from the 1st Quarter of 2008 to the 1st Quarter of 2009.

Marcus & Millichap predicted in their 2009 National Office Report a rise in vacancy of 400 bps to 15.1% in 2009 for San Francisco. As well, they predict that effective rents could drop as much as 10.7%.

Falling rents and rising vacancies will drive the value on a leased office property lower. Lower values make it more difficult to obtain financing.

Another factor that is hurting owners’ ability to refinance is rising cap rates. Investors are acknowleding the greater risks inherent in real estate and are expecting a greater return. This desire for a greater return is driving cap rates higher.

It may be a while before we see the end of the commercial real estate cycle. Properties that provide a strong cash flow now may still be a good buy. Don’t expect to find financing in today’s market for a property that cannot service the debt at a ratio of $1.10 of income to $1.00 of debt service. More institutional lenders are requiring even hire debt service coverage ratios of 1.3 or greater.

California’s cities may be some of the biggest casualties of the real estate bubble:

RIO VISTA, Calif. — California may soon have more bankrupt towns on its hands.

The city of Vallejo, Calif., gained national attention earlier this year by filing for Chapter 9 bankruptcy protection. Now, two neighbors are fighting to avoid the same fate, as the state’s economic crisis spreads.

More California Towns Face Bankruptcy

City Income

Many of the cities and towns in California derived a major portion of their income through two sources.

First, fees paid by developers to expand the city and tap into existing services. As the housing market took off developers could afford higher fees. Cities realized this and decided to charge higher fees.

The second major source of income is property taxes. Since the passage of Proposition 13, California homeowners only experience a significant bump in tax revenue when a home sells or when additions are made to it.

During the wild and woolly days of the housing bubble, houses were selling fast and property values were skyrocketing. Cities saw their incomes increase as they collected more and more property taxes.

Political Wisdom

As a model to other Americans, the city politicians realized that a greater income should not go to waste. “We have more revenue therefore we should spend more money. And we should project to spend more money each year into the future,” these wise politicians said.

The wily politicians noted that to fuel demand for housing, their public services should be top notch. In order to attract the best and the brightest police force and firefighters the politicians decided to promise them the moon.

City Expenses

So the police and firefighters received great salaries and great benefits. Some of the cities could not afford their own pension plan, so in order to attract qualified public servants they joined up with the California Public Employees’ Retirement System (CalPERS). The city’s cost of joining CalPERS was less than the cost of offering a similar retirement guaranty independently.

Municipal police and firefighters often have contracts with guaranteed pay increases.

Now that the housing madness has cooled, city revenue has not grown. However, city expenses, related to salaries, are increasing. [Begin Sidenote: Sounds like the auto industry. End Sidenote] In many cases city revenue may actually fall. As housing prices fall, tax payers can ask for a reassessment of their taxes which may lower their tax burden.

This powerful combination of flat or falling revenue and increasing expenses is forcing some cities, like Vallejo, to file chapter 9 bankruptcy.

Insult to Injury

Let’s return to CalPERS:

Pacific Grove, a coastal town south of San Francisco, already faces a budget crisis. Now losses by California’s giant pension fund could make the pain worse.

“Calpers could bankrupt us faster than anything else,” says Mayor Dan Cort. City officials say other towns face financial stress unless the California Public Employees’ Retirement System is able to quickly recover from its investment losses.

Calpers Losses Add to a City’s Stress – WSJ.com.

Since July CalPERS has lost almost 25% of its value. This marked loss limits its ability to pay current and future employee retirement guarantees. In order to make up for the short fall, CalPERS may charge cities more in the future in order to recoup and adjust for the losses.

Coming Full Circle

CalPERS has been in the news lately for losing tremendously on investments in, wait for it. You guessed it residential real estate. Ouch!

The cities and CalPERS made bets that real estate would continue to go up. Now they are paying the price for foolish planning.

Square Feet Commercial Real Estate Blog details some of the difficulties that commercial real estate owners may have if they want to refinance or sell with US Treasuries at such low returns.

Treasury Yields Create Defeasance and Yield Maintenance Nightmare | Square Feet Commercial Real Estate Blog.

I first learned about defeasance in October of 2007. (Not something we use every day.)

The idea behind it is that a mortgage investor wants a guaranteed yield or return for a specified amount of time. If they are repaid early on the mortgage, the yield is affected. In order to maintain the yield a clause is written into the loan that the borrower has to buy a basket of “safe” securities to replace the payments that investor would have received over the life of the loan.

Defeasance was mostly used on CMBS loans. This calculations are so complex that defeasance companies have sprung up to help borrowers accomplish this feat.

With US Treasury yields at low levels, investors have to purchase massive amounts of Treasuries in order to generate a yield to replace their interest payments.

This additional cost limits the ability of an owner to refinance or sell their property.

Calculated Risk has a great summary of what is transpiring in commercial real estate.

Calculated Risk: The CRE Bust: Quick Overview.

CoStar.com is reporting:

In a real estate alert to its clients, the law firm of DLA Piper in Atlanta, GA, wrote, “For taxpayers who have exchange funds at LandAmerica 1031 Exchange, the automatic stay imposed by the Bankruptcy Court in connection with the Chapter 11 filing will require Court approval of the release of any funds.”

“Accordingly, it is highly unlikely that those funds will be immediately available, and they may not be available in time for the scheduled exchange closings, if any.”

Another Blow to Faltering 1031 Real Estate Industry – CoStar Group.

CoStar reports that there are 450 exchange customers with transactions pending.

It is likely that some of these exchanges may fall out of contract because those in the “upleg” of their transaction will not be able to purchase the property.

If the bankruptcy court does not move quickly to free the funds, some of the exchanges may incur tax consequences if they do not close within the IRS mandated time frame. This could be a terrible mess for commercial real estate investors.

Looking ahead, with the economy somewhat weak, readers can count on all sorts of commentary lamenting the death of the consumer, and with the latter, the death of the economy. Nothing could be further from the truth. If we’re productive as workers, consumption will take care of itself.

RealClearMarkets – Articles – Christmas Shopping and the Consumption Myth.

Interesting counter-intuitive article from RealClearMarkets.com.

I especially like the last sentence that is quoted above. If America heeds this one sentence, we will recover from this recession in no time.

Straight Talk About Mortgages and Real Estate Investor Sues to Block Mortgage Modifications.

Forbes.com is reporting that JPMorgan will be keeping WaMu’s employees in the mortgage centers in CA. It looks like the bulk of the job cuts will occur in WaMu’s Seattle headquarters.

JPMorgan Plans To Ax The WaMu Suits – Forbes.com.

WASHINGTON Reuters – The number of problem U.S. banks and thrifts jumped in the third quarter to 171, from 117 at the end of the prior quarter, marking the highest level since the end of 1995 and adding to expectations that more banks will fail, regulators said on Tuesday.

It looks like we are not out of the rough yet.

U.S. problem banks rise to 171 at end of third quarter: FDIC: Financial News – Yahoo Finance.

The AP is reporting today that California’s jobless numbers jumped to 8.2% this month, a 14 year high.

Subprime’s Impact

Much of the unemployment is related to the collapse of the subprime industry and the ensuing fall of the housing market in California. Countrywide, IndyMac Bank, and other now defunct lenders have gone out of business throughout the state, leaving their workforce unemployed. Locally Diablo Funding closed in October of 2007 leaving 650 mortgage consultants without a home.

The Contra Costa Times is reporting that WaMu/JPMorgan Chase is laying off 1,600 Bay Area workers. The East Bay cut almost 3,000 jobs in Ocotober, bringing the annual total to 22,000 so far in 2008.

A number of the nationwide home builders have been forced to layoff their work force. The construction trades have been dramatically impacted as companies are hesitant to spend money on structures they may not need if consumer demand continues to decrease.

Unemployment Fund Depleted

On top of rising unemployment the AP is reporting that California’s unemployment fund is almost insolvent.

The state’s unemployment insurance fund is expected to have a deficit of $2.4 billion at the end of 2009, forcing it to borrow from the federal government for only the second time since the program was established in the 1930s.

Commercial Real Estate Stress

The unemployment numbers can negatively impact commercial real estate in a number of ways.

1. Vacancy rates may creep up. When companies downsize they need less space. Expect to see rising vacancies in the office and retail sector. The sector least likely to be affect is multifamily, because people still need a place to live and will sacrifice conveniences before they give up their apartment.
2. Rental rates may decline. The basic tenets of supply and demand impact commercial real estate as well. A larger supply of vacant space provides tenants more bargaining power to get rent concessions or to ask for lower rental rates. If the cost of owning a home drops to a level that compares with renting, multifamily rental rates may decrease.
3. Consumer spending is decreasing and will continue to go down. Those without jobs tend to spend less money. (Thank you Captain Obvious.) This hurts both retail stores and service companies. My barber told me that men in lean times will space their haircuts farther apart than during years of plenty. Women will paint their own nails, men may mow their own yard, and Grandma may babysit rather than the au pair.
4. Capitalization rates will rise to their historical averages. Investors will want to be compensated for the added vacancy risk and potential lower income from rent. This compensation will come in the form of higher cap rates. As well, interest rates are likely to rise over the long run due to the affects of inflation and investors will require higher cap rates to cover this costs.
5. Values will decline as capitalization rates rise. Value and cap rates are inversely related. When one rises the other falls.

All of these things are signals that commercial real estate will go through a cyclical downturn. There will be a period of decline as households, banks, and nations deleverage.

Opportunity Knocks

All this news does not mean that commercial real estate is in a death spiral. Quite the contrary. The darkest of night comes before the dawn.

I believe that now smart investors will begin to reenter the market. Not the speculators, that were looking for a quick buck and were hoping for appreciation.

Property values will actually make sense down here on planet earth with real numbers and real calculations. The mythical world of the last 5 years will have to be forgotten.

The bubble has burst and a new day is dawning.