“History does not repeat; but it does rhyme.”

– Mark Twain

You’ll never hear me claiming to be an economist or historian, but I am often asked to share my opinion on real estate from time to time. I am thankful to share my experience and insight for the benefit of others, and the industry. With that warm introduction, allow me to make some controversial assertions.

Commercial real estate is narrow in its focus, and extremely broad in its scope. I’m not sure if ‘extremely’ is a descriptive enough word. The ‘Commercial Property’ identifier spans the universe of real estate to generalize: office, industrial, retail, multifamily, hotels, land (agriculture, parking garage, etc.), special purpose (car wash, self-storage, etc.), mortgage lending (on all of the above, including single-family residential).

Within this vast assortment of parcels, plats, and tracts are a myriad of operations, offerings, and obligations — most of which are unregulated, under-regulated, non-conforming, or exempt securities offerings. This, accompanied with problematic pricing indexes, and the commercial real estate market appears to be propped up by several unsustainable legs that may be showing signs of stress fracture.

The Regulatory Overhaul

The financial crisis of 2007–2008 resulted in what is coined as the Great Recession and is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s. One of the largest contributing factors began in 2007 with a crisis in the {subprime} single-family residential mortgage market and its derivatives- packaged as Mortgage Backed Securities (MBS).

From a 30,000 foot view it’s simple to predict what would happen when under-regulated consumer banks deployed excessive risk-taking strategies, offering more loans to more people — it inevitably creates more buyers for the same amount of properties. The result leads to frenzied bidding wars, inflated pricing, fabricated or over-zealous appraisals, opportunistic brokers, etc.

Just as the derivatives compounded, so did the consequences — which developed into a full-blown international banking crisis with the collapse of many investment banks, and trusted depository banking institutions.

Tracing the steps back to the source, authorities responded aggressively to the over-leveraged single-family mortgage market, making substantial changes to all federal financial regulatory agencies, and almost every part of the nation’s financial services industries. This is known as the Dodd–
Frank Wall Street Reform and Consumer Protection Act.

These reforms have proven to be worthwhile in preventing history from repeating itself in the single-family mortgage marketplace, but what about the commercial markets?

The Crowdfunding Effect: Unregulated Underwriting

Following the economic downturn and decrease in small business activity from the wake of the 2008 financial crisis, congress considered a number of solutions to help spur economic growth. The Jumpstart Our Business Startups Act, or JOBS Act, is a law intended to encourage funding of small businesses in the United States by easing many of the country’s securities regulations.

The JOBS Act substantially changed a number of laws and regulations making it easier for companies to either go public, or to raise capital privately and stay private longer. Changes include exemptions for crowdfunding- a more useful version of Regulation A, general solicitation allowance for Regulation D Rule 506(c) offerings, and an easier path to registration of an initial public offering (IPO) for emerging growth companies. Title III, also known as the CROWDFUND Act, has drawn the most public attention because it creates a way for companies to use crowdfunding to issue securities; something that was not previously permitted.

The underlying intention of the JOBS Act was the bolstering of start-up companies, further funding for existing companies with alternative financing options (unrelated to banking institutions), and to substantially increase the job opportunities of a very unemployed America.

The commercial real estate marketplace has exploited the financing ***opportunity*** of the regulatory changes, raking in multiple billions of capital that is deployed directly into commercial real estate. What does this mean? I’ll tell you.

Historically, commercial loans came directly from depository banks, institutional banks, or mezzanine debt obligations from large institutions. As commercial markets escalated, these disciplined (and regulated) financiers would throttle down lending, which in turn let the market cool off a bit. Now, aggressive debt funds with massive war chests are taking over, and offering better rates and terms, easier access to capital, and are pressuring banks to loosen standards in recent quarters (Fed surveys show).

Consider underwriting. Large scale commercial projects are highly complex with many moving parts requiring weeks of review, and research. However, the risk management component of these alternative financing groups does not match those managed by a regulated institution’s appointed underwriting experts, but are instead built on a zero barrier of entry platform, whereby deal evaluation could be administered by a team of rather inexperienced or newbie ‘underwriters’.

Soaring Prices a Concern

Even before the financial crisis of 2008, we saw how the availability of cheap debt helps investors stretch on price, or to put it bluntly, pay more than they should. In an investment where the driving investment decision is based on the amount of income the property produces, the capitalization rate (cap rate) is crucial, and is directly affected by the price of the project. Recently, we’ve seen commercial real estate prices rise, and cap rates fall; they are now down significantly for most property types. With that being said, the buyers of commercial real estate are often overpaying and settling on weak returns that may evaporate quickly.

Many buyers gamble by assuming they can improve their yields over time by raising rents and requiring their tenants to pay more. However, with so many billions that have been placed into brand new commercial projects, the competition is fierce for attracting tenants. Brand new buildings have better amenities, more parking for clients, newer restaurants for team members, or may be offering better tenant improvements (TI) for on-boarding lessees. Competing with a brand new building can be challenging without spending hundreds of thousands (or millions) on a facelift for a building; not including the downtime and loss of income during the remodeling stages, not to mention increased insurance costs. This may be manageable for larger firms, but much harder for smaller speculators.

Years of economic growth and easy-to-access financing have driven the prices of commercial properties to record heights. Professionals and executives are speaking out to say they’re concerned for buyers who are behaving presumptuously, acting as if they can just keep raising rents.

In fact, Janet Yellen (prior Federal Reserve chair, 2018) offered a warning the day before announcing her resignation, “Commercial real estate prices look strikingly high.” Her successor, Jerome Powell, flagged prices again a month later. According to a Bloomberg article, Goldman Sachs suggested in Q2 2018, that properties may be overvalued by as much as 16 percent; Wells Fargo Chief Executive Officer Tim Sloan went on television saying some deals looked “frothy”, and that his bank was pulling back. As of Q4 of 2018, executives from regional lenders including U.S. Bancorp and KeyCorp have chimed in with similar concerns.

Brick and Mortar Online

“There are many areas of commercial real estate where supply has caught up with demand.”

Retail is making up a smaller portion of commercial mortgage bonds as more shoppers buy online; just think of how many big-box retailers have closed their doors for good. Online ‘window shopping’ is the new standard for retailers.

More developers and municipalities now plan for mixed use buildings; these same builders and developers have neglected affordable housing and have focused primarily on bringing too many high-end units to the market. Apartment rents have slowed or decreased in many large U.S. cities. In downtown Seattle, coined ‘Silicon Valley North’, apartments are luring the city’s flourishing treasure of computer coders with gift cards and free electronics to satisfy the imbalance of so many apartment buildings.

Optimistically Over-leveraged

The optimism in the commercial landscape remains undeterred for the most part. In Q4 2018, Deloitte*(advisory firm) predicted that the volume of commercial real estate
transactions will increase 13 percent in the next 12 months. Many private equity firms continue to raise substantial capital to acquire commercial properties and debt lending contracts.

According to the Mortgage Bankers Association’s 2019 Commercial Real Estate Finance Outlook Survey, commercial and multifamily loan originators (LO’s) in the U.S. expect 2019 to be strong in lending activity. Nearly all originators (97 percent) reported their own firm had a “strong” or “very strong” appetite to generate new loans last year (2018). A similar share (91 percent) expect their own firm’s appetite to be “strong” or “very strong” throughout 2019.

From inception, the commercial lending and hard money field has been formally unregulated by state or federal laws, although some restrictions on interest rates (usury laws) have been implemented. The hard money mortgage market has greatly expanded since 2009; the reason for this expansion is primarily due to the strict regulation put on banks and lenders in the conventional mortgage qualification process. The Dodd-Frank and Truth in Lending Act set forth Federal guidelines requiring mortgage originators, lenders, and mortgage brokers to evaluate the borrower’s ability to repay the loan on primary residences or face huge fines for noncompliance. Therefore, hard money lenders only lend on business purpose or commercial loans in order to avoid the risk of the loan falling within Dodd–Frank, TILA, and HOEPA guidelines.*

Total multifamily commercial debt outstanding rose to $3.32 trillion in Q3 2018, an all time high for its sector. Personally, I do not believe this accounts for all commercial lending; i.e. short-term bridge financing, etc. For example, in Seattle alone, there are well over 200+ firms advertising hard money offerings, and over 1 Billion in funding — each year. Most of these loans are short-term; less than 12 months.

Measurements Matter

The writing isn’t necessarily on the wall as they say. Collecting accurate data on commercial properties over their ever changing lifespan has proven difficult. Specifically, this has resulted in an inability to create an accurate depiction of the marketplace; like an index. Because of the individuality of property assets and the relatively low (and slow) rate of transactions, commercial property indices are normally valuation (estimation) based, rather than transaction based.

For example, when considering mezzanine debt — it’s difficult to know the sales price of an asset without knowing the private equity details of the 2nd position obligations, swapping equity positions, the convertible notes, or short-term bond payout structures, etc. That skews the data of the sale.

Let’s face it — it’s difficult to really know what the commercial market is doing. Some investors pay special attention to publicly traded REIT’s (Real Estate Investment Trust), I don’t personally; they are built entirely on a structure that can crumble with oversupply of either too much capital or too many properties. It’s also difficult for them to attenuate oversupply, which is affected by their structure, which can effect their rate of leverage. Public REIT stock prices do not reflect commercial real estate performance. That’s like trying to determine the compatibility of features between an iPhone and Android based on Apple’s stock price.

My conclusion is that the commercial real estate market is due for a correction, maybe a regulatory overhaul, or perhaps just a reset. Something is coming; I know where I’ll be.

“The challenge of limited data, is that when the measurement really matters— like when going into and during a recession— it magnifies the unknown.”

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