by David Fessler, Advisory Panelist
Friday, April 17, 2009: Issue #980
There’s another shoe that’s quietly starting to drop in the commercial real estate sector… one that could deal a fatal blow to some of the largest banks like Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC), Morgan Stanley (NYSE:MS) and most of the other big boys in the news for the last year.
But you wouldn’t know that by looking at the headlines…
Earlier this week, Goldman Sachs announced a huge upside surprise in earnings, a $5 billion share offering, and its intention to pay back federal TARP funds ASAP.
The average investor might view this as a sign that things are returning to normal in the banking sector, and be tempted to start shoveling money back into banking stocks.
Let me suggest you wait a while. “A fool and his money are soon parted,” as the old saying goes.
Put another way, if you think a one-month rally in the stock market can begin to erase a financial crisis that’s been going on for the better part of two years now, I’ve got some great Florida swampland for you.
Yesterday morning investors got a taste of what lies ahead as General Growth Properties filed the biggest real estate bankruptcy in U.S. history. The impact of a commercial real estate collapse will continue to ripple across the markets, and it’s why we need to take a closer look…
Commercial Real Estate: Sad State of Affairs & Getting Worse
It’s no surprise that the market for commercial office space has come to a crashing halt. Last year, commercial real estate sales fell off a cliff, plunging 73%, according to data from Real Capital Analytics.
But it’s going to get worse… much, much worse.
At the end of last year, the vacancy rate for commercial office buildings was 14.5%. This year it’s expected to hit 16.7%, as more and more companies and individuals file for bankruptcy. This chain reaction has led to an explosion of commercial property defaults.
According to Mark Scott – Senior Vice President of NorthMarq Capital LLC, a New Jersey commercial real estate brokerage and property management company – 2009 could be a banner year for commercial defaults:
“In the office market, you’re starting to see signs of mammoth job losses, and as people aren’t buying as many goods, they’re not shipping as many goods, so [now] we have stress in the industrial market.”
Namely, banks seized 464 commercial office properties worth $7 billion in March alone, nearly triple what was seized in December. And that leaves banks holding millions of square feet of space that’s plunging in value by the minute.
Part of the problem is certainly lack of demand, but part of the reason for the increasing default rate on commercial loans is the way they were structured in the first place. Many of them were based on a payment structure that included increases in future rental rates and revenues.
And as if exploding office vacancies and mortgage defaults on the properties weren’t bad enough, now there’s another problem area surfacing in the commercial real estate market: industrial properties.
Industrial Property – The Other Shoe
When it comes to industrial property, two-thirds of the space available consists of warehouse and distribution centers. Torto Wheaton Research – the commercial research unit of CB Richard Ellis – predicts vacant space will climb to 12.6% in 2009 from 11.4% in 2008.
But according to NAI Mertz Corporate Service’s Director Stephen L. Blau, the commercial market shows nary a sign of stabilization. In fact, he says we’re just now seeing the beginning of what he expects to be a huge wave of commercial mortgage foreclosures.
And Jeffrey DeBoer, President of the Real Estate Roundtable agrees, “This is a rolling problem that’s only going to get worse.” This year, DeBoer estimates $400 billion worth of commercial real estate mortgages will be due and payable.
Tougher, loan underwriting standards combined and declining property values will make it virtually impossible for some owners to refinance, setting off a chain of events that usually culminates in bankruptcy and foreclosure.
There are a number of ways we can profit from this “next” loan crisis…
Shorting Commercial Real Estate With ETFs : 3 Ways to Profit
You might think the best way to play this new problem for the big banks would be to short them directly, or to invest in one of a number of bank-shorting ETFs. But there are more direct ways. Here are three commercial real estate ETFs ripe for short plays and their losses for 2009:
- iShares FTSE Industrial/Office Index (NYSE: FIO) down 15.5%
- Vanguard REIT Index (NYSE: VNQ): down 22.2%
- Dow Jones Wilshire REIT (NYSE: RWR ): down 23.6%
Investors might also want to consider going long the ProShares UltraShort Real Estate (NYSE: SRS). This seeks investment results equal to twice the inverse of the daily performance of the Dow Jones U.S. Real Estate Index.
Commercial and industrial loan failure represents a risk that few have talked about, and even fewer know what to do about. The impacts from this fallout are only starting to be recognized, and it’s only going to get worse.
And going long banks with this shoe starting to drop? Not with my money…
Today’s Investment U Crib Sheet
We’ve been talking about the multifaceted real estate sectors a bit recently. We touched on the housing markets starting to turn in our recent Blackboard article, Housing Recovery Here We Come.
And yesterday, Lou Basenese gave investors a great way to hedge the value of their home with a new real estate investment that about to hit the markets, Hedging Home Value With ETFs: How to Buy and Sell a Home on the NYSE.
Real estate and by extension, REITs, are part of our Asset Allocation Model for Maximum Gains.
Stay tuned next week as we bring you more on the recent developments in real estate and thoughts from economist Mark Skousen on why residential real estate is looking like the buy of the century.