Commercial Real Estate Woes

As I walk to work in the morning I pass right by the headquarters of General Growth. General Growth is a corporation that owns over 200 shopping malls throughout the United States, along with other commercial properties. General Growth recently declared bankruptcy, stating that this filing will not impact operations at its properties. From their press release:

The decision to pursue reorganization under chapter 11 came after extensive efforts to refinance or extend maturing debt outside of chapter 11. Over many months, the Company has endeavored to negotiate with its unsecured and secured creditors to obtain the time needed to develop a long-term solution to the credit crisis facing the Company. Unable to reach an out-of-court consensus, the Company reluctantly concluded that restructuring under the protection of the bankruptcy court was necessary. During the chapter 11 cases, the Company will continue to explore strategic alternatives and search the markets for available sources of capital. The Company intends to pursue a plan of reorganization that extends mortgage maturities and reduces its corporate debt and overall leverage. This will establish a sustainable, long-term capital structure for the Company.

I am not an expert on the commercial property industry but am starting to learn more about it since it has an integral impact on the skyline of Chicago and many other cities around the country. Essentially the commercial property industry purchases properties mainly with debt, puts in a bit of equity, runs the properties, and then plans to sell them at a profit to another commercial property company. With low interest rates, easy lending terms, and many buyers, there has been an immense run up in commercial property, and companies like General Growth were flying high. GGP’s stock traded near $80 over the last couple of years, before collapsing near zero as the debt markets seized up.

The downfall of the commercial property industry, however, is the fact that many of the loans need to be “rolled over” every few years. On your home, for instance, you may have a 30 year mortgage. The debt on the commercial property industry, on the other hand, rolls over usually within 5 years. Given that a typical company has many projects, in the next 12-18 months many of these sorts of companies are finding loans coming due and they have no way to raise the money (except at punitively high interest rates, if they can find money at all), so they are all starting to go bankrupt and fall like dominoes. It doesn’t help that many of these enterprises bought properties in the go-go years of 2005-8, when prices were rising all the time and there were bidding wars – it is likely most / all of those properties today are worth less than they were purchased for which makes obtaining new financing even more difficult (try to refinance your home loan for more than the current market value of your home… it isn’t happening).

The Chicago Tribune had an article in today’s paper titled “Little Room to Operate – High debt load, declining revenue for hotels could bring glut of loan defaults“. This article discusses hotel construction efforts that are likely to stay half-completed (see my post on this months ago, from November, along with links to a video of Thailand)and the fact that many completed buildings are likely to be seized by lenders.

While I knew that many of these commercial properties and hotels were purchased with lots of debt and very little sweat equity, even I was surprised by this quote from the article:

In 2007, you could buy a $100 million asset and put $5 million or $10 million of equity in the deal… that same $100 million deal today, you would need a minimum of $50 million of equity.

An entire industry was built on optimistic assumptions on revenues, expectations of instant access to credit, along with low interest rates – and now that industry is going to be in for an immensely painful crackdown.

Once whatever is built is completed, don’t expect anything new and significant to come on line for many years to come, and those projects that do come will be built to meet known demand with well funded developers, not fly-by-night guys building on “spec” with a dream business plan.

As someone looking at a skyline, at least once it is built I am indifferent if the original builder loses his (tiny) equity stake and even if the bank gets hit with a big loss on the loan. I just don’t want to look at a half completed building for the next decade. Once built, the building will be occupied, unless the cost of operations is greater than tenant income, which seems unlikely. Given the high up front costs of construction and debt in this industry, once those are removed (i.e. everyone goes bankrupt and the loan is sold at a loss) an office building should be able to generate positive cash flow.

These new buildings, especially if they come through bankruptcy with a light debt load, will in turn put immense pressure on existing, non-bankrupt commercial retailers. After all – would you rather stay in an older building at or near market rates when you can move into a brand new building that is offering you a discount (because any tenant is better than no tenant)? The older lower quality buildings will soon be in competition with the new buildings and will have to slash prices or lose tenants, which will impact THEIR ability to roll over their financing.

All I know is that the commercial real estate shake out is far from over and I would expect virtually all of the heavily leveraged players to fall into bankruptcy and then many of the other players who still have pretty high debt load to fall onto hard times as they compete with the buildings that have cleared bankruptcy and have new investors. Given the fact that bankruptcy doesn’t “shutter” the competitor (just the company behind the operations), these markets are going to look a lot like the airlines, where the bankrupt companies just don’t go away and keep dragging down their healthier competitors. The prices are going to go down and down, and it won’t fix itself for many years until demand picks up again. Don’t count on many of today’s players to make it to that point, though.

Cross posted at LITGM

2 thoughts on “Commercial Real Estate Woes”

  1. Carl,
    Not only were they purchased with high leverage, but he prices offered and paid were often based upon cashflow projections that could and would never be met. It became clear to me in some of the work I did that some of the REITs and other real estate investment groups were purchasing under the assumption that they could flip the properties at a higher price in 5-7 years time based upon inflation of price. That is to say, they were following the same foolish course of non-expert real estate ‘investors’ who bought and flipped houses/condos.
    The shake out in Commercial RE is just beginning and will continue for some time. Many groups bought with “5-year money.” That is to say they purchased with a loan that is interest only for the first 5 years under the assumption that at the end of that term they could sell the property or re-finance it favorably. Those will liquidity will have to write a (very large) check to the bank. Those without liquidity will be in trouble. When the asset you purchased at an inflated price has gone down in value significantly and never cashflowed as you expected, life looks bleak. Look for lots of REITS and Investment Groups going under or organizing their own takeover by other in-the-money groups.

  2. It is unfortunate to read about General Growth’s bankruptcy. For more information about available commercial property, ZoomProspector provides listings of vacant buildings across the U.S. along with quick statistics on cities and communities.

    Here is a list of the top 50 cities to start a business according to BusinessWeek:

    They use ZoomProspector data to determine this– here is the top 50 cities page on ZoomProspector:

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