Gary Shilling on US Real Estate – Is It That Bad?

Introduction

I found Gary Shilling’s comments on US real estate in my recent posting extremely troubling. So I have asked a good friend who is a real estate expert to offer his views.

Richard Lundgren has spent most of his professional life in the real estate industry. He spent many years as a commercial real estate broker in Boston, later serving as President of NAI Hunneman Commercial Company, and as President of the Greater Boston Real Estate Board, a large trade organization.  Presently, he is President of Peirson Properties, a Washington, DC based real estate investment company.

Elliott: Richard, what are your thoughts on selling your home?

Richard: I agree with Shilling. If you haven’t sold by now, it is almost too late too sell.  If you own a home because you like living there, then you should only sell if you expect to be unable to meet future mortgage, real estate tax and insurance payments, and you see foreclosure or bankruptcy ahead.  If you can get out, do so and rent until better times return.

If you can hold on, then you should do so. The market is likely to bottom in 2010 (it peaked in 2006, and it usually takes 4 years to reach bottom).

If you own an unnecessary second home, or an investment house, you probably should sell, unless your rental payments are sufficient to carry the property.  Since the bottom is mostly likely no more than 10% lower from here, and you’re selling into an uncertain market, it may well be to your advantage to hold if you can.

If you have to sell the second home, do so and get out from under the mortgage payments and the negative cash flow, in order that you can go back into the market at its bottom, with your balance sheet rebuilt.  Past experience shows that the market is usually flat for 2 to 3 years after hitting bottom, which would mean the period 2011 to 2013 would be a great time to buy again.

Elliott: I hear a lot about continuing foreclosures. And Shilling suggested the Federal efforts to help out have done very little good. In fact, he and others have claimed the Federal efforts have hurt by getting people’s hope up to be bailed out, thereby delaying the sale of houses people cannot afford. What are your thoughts on this? And do you think the abnormally large inventory of houses (relative to past real estate cycles) might delay or extend the bottom somewhat?

Richard: I believe federal efforts to encourage banks to restructure or extend residential mortgage loans has somewhat lessened the foreclosure problem by making it easier for borrowers to keep current with the monthly costs of their loans. That is the positive.  Shilling is correct, however, in stating that some people, unrealistically in my judgment, are hoping for a federal bailout.  I don’t see that as being a likely scenario, especially now with Obama’s new focus on deficit reduction.

Certainly it is possible that the large inventory of unsold homes will cause the bottom to be extended out as far as 2014 or 2015, especially if the jobless rate remains high and the economy continues to rebound only sluggishly.  But my experience with past such real estate recessions is that they tend to come to an end pretty much on schedule (that is, four years from peak to trough).  Also, I believe that the Obama administration has gotten religion in the past week, and is more likely to focus on steps to get this economy going, even if it takes, God forbid, such drastic actions as tax cuts. 

Elliott: I understand you are now focusing on commercial real estate. What are your thoughts on this sector?

Richard: If you have not sold by now, it is again almost too late to sell.  It must be remembered that selling a commercial property is not like selling a stock or bond, for which there is instant liquidity.  A commercial property takes a minimum of 6 months to sell, and oftentimes more than a year in difficult times such as we are experiencing today.

The particular problem with commercial real estate, primarily office buildings, shopping centers, industrial buildings and hotels, is that their markets peaked in late 2007/early 2008, and will not likely hit bottom for another 4 years from there, or until 2012.  From that point on, they will also experience a flat bottom of rents and values of another 2 years, or from 2013 to 2014, before the next up cycle begins.  In an environment where values are continuing to decline, it is the rare investor who is willing to buy before the bottom is reached.  That means many of the properties that owners might otherwise wish to dispose of are simply unsaleable in this environment, except at fire sale prices.

The second problem with commercial real estate right now is that a sizable percentage of individual properties will see their term mortgage loans coming due for repayment before 2014.  At this point in time in early 2010, and for the foreseeable future, most of these loans are not refinanceable, as there are insufficient lendable funds in the financial system to accommodate all of the refinancings.

Elliott: Insufficient lendable funds? My impression is that the banks are flush with funds. What is the problem here?

Richard: It is true that banks have more lendable funds now than they did a year ago, but they are loath to jump back in to the frying pan of commercial real estate lending while they still have untold billions of dollars of underwater real estate loans on their books.  Further, they well know that knowledgeable real estate observers are projecting that the commercial real estate market won’t hit bottom until 2012, still two years away.

Given the very slow-moving economic recovery that we are experiencing, along with the assaults that are being leveled against the banking industry by the Obama administration, and particularly with respect to what lines of business they may or may not be allowed to pursue in the future, I don’t think it is reasonable to expect them to begin lending on any significant scale to a market that is still in trouble, as stated above.

Elliott: You were about to mention a third problem pertaining to commercial real estate.

Richard: The third problem is that many properties are underwater with respect to their mortgage balances, and the sellers will have to come out of pocket to make up the difference when the loans are paid off, assuming they are even able to find some level of replacement financing.  Such replacement financing will be based upon new lower appraisals, and will carry higher standards for loan-to-value ratios and for debt service coverage requirements.

What then to do now?

(1) Sell if you can, pay off the loan, and live to invest another day.  It should be noted, however, that the limited equity and debt money that is available to buyers today is for relatively small properties, for instance less than $25,000,000.  Office towers, regional shopping malls and large hotels are extremely difficult to finance except in unusual circumstances related to the strength of the buyer or the relatively low price of the asset.

(2) Seek to restructure the loan with your lender under terms that will allow you to make new lower ongoing payments for the mortgage, and to pay the expenses of operating the property.

(3) Seek a new equity partner who can contribute sufficient funds to keep the property afloat.

(4) Seek as part of the restructuring to extend the due date of the loan as far in to the future as you can.

(5) If you simply cannot hold on any longer, hand the keys back to your lender, as Tishman Speyer did this week with Stuyvesant Town in Manhattan, with the loss of all your, and your partner’s, equity.  You can then proceed to plan for your next round of investments at the approaching bottom of the market.

(6) A second alternative if you simply cannot maintain current payments or restructure is to seek bankruptcy protection, with the thought that a reorganization of the property may be possible.

With respect to buying, it is not anticipated that any significant acquisition activity for commercial real estate will occur until 2012.  And even then such activity may be weak if mortgage debt is not readily available.  No one expects the commercial mortgage backed security financing mechanism to return in a big way anytime in the foreseeable future.  Without that financing source, mortgage debt will continue to be difficult to obtain, and particularly for larger properties.

Elliott: A question about the commercial mortgage backed security financing mechanism: this mechanism does not increase funds available to the economy – the people that in the past that bought the mortgage backed securities still have their money to make investments. Won’t they find other mechanisms to use to finance real estate if the prospects are attractive?

Richard: First of all, the prospects for commercial real estate are not attractive right now, and it is unlikely that any financing source is going to allocate any large amounts of capital to the sector until the outlook improves.  As already stated, that is not likely to happen until 2012 at the earliest, although if selected properties come on the market in the near term at very substantial discounts to their former inflated values, then there will be both investors and lenders who will be prepared to step up to the plate, particularly if the properties are not large, such as no more than $25,000,000.

The mortgage backed security financing mechanism may not increase funds to the general economy, but it certainly was, and could well be again at some point in the future, a mechanism for targeting financing to the commercial real estate industry.  It did this in spades during the period 2004 to 2007, by providing easy credit for risky assets, resulting in very serious over-valuations of properties and the widespread phenomenon of underwater commercial mortgage loans that we are experiencing today.

The problem now is that there is little confidence in the CMBS vehicle because investors feel that:

(1)   commercial real estate is still a very risky asset class;

(2)   the rating agencies are not up to properly judging the risk, and

(3)    the rates of return that would be demanded by investors for the securities would be higher than the interest rates on the underlying mortgage loans, making such securities unsaleable.

Finally, the primarily institutional investors who bought these securities back in the salad days, such as insurance companies, pension funds, foundations, endowments, and various offshore buyers, do not now have the amounts of investable funds that they had several years ago.

Elliott: Are there any other things people wanting to sell can do?

Richard: There remains one dimly lit prospect for those who want to sell, as well as for those who want to buy, and that is in the market for apartment buildings.  Apartment vacancy rates have not declined anywhere near those of many commercial buildings, and apartment rents have generally remained stable. With large numbers of people seeking to sell their homes, demand for apartments might well increase going forward, and at a time when apartment construction remains at a very low level.  Additionally, mortgage financing for apartment acquisitions is available through the government-sponsored entities of Fannie Mae and Fannie Mac, although there is some thought that these agencies would be reorganized in the not too distant future.

Elliott: Richard. Ouch. Thanks so much for your comments.

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