Commercial Real Estate Is Experiencing Its Own Hangover

The housing market wasn’t the only sector of the economy to experience a bubble earlier this decade. The commercial real estate market went through a bubble of its own. Take a look at the chart, below, which shows the NAREIT price index for equity REIT’s.

A REIT is basically a real estate holding company. Provided that it distributes at least 90% of its earnings in the form of dividends, it is exempt from corporate income tax. The NAREIT index is an index of REIT prices, similar to the S&P 500 stock index.

REITs typically finance their investments with a mixture of debt and equity. Their share prices measure the market value of their equity, so they are imperfect proxies for the value of their underlying real estate holdings. On the other hand, because the shares are actively traded on public exchanges, the quoted prices provide a current snapshot of what’s going on in the commercial real estate market. (In contrast, popular housing market indicators such as the Case Shiller indexes are published only once a month, with a two-month lag.)

REIT prices rose by more than 100% over a four-year period beginning in 2003. Following the peak in early 2007, prices fell steadily for the next two years. During that period, REIT earnings actually increased at a healthy rate. Prices fell because investors were concerned that future earnings might be lower. In the fall of 2008, they were proved right in a spectacular way. Over the course of just nine months, earnings (and prices) fell by almost 50%. Take a look at the chart, below, which shows an index of dividends for the NAREIT index.

Dividends didn’t peak until mid-2008. Since then, they have fallen by 46%, and are now at their lowest level in more than 20 years. Remember, REITs are required to distribute at least 90% of their earnings in the form of dividends. So the decline in dividends will have been closely paralleled by a decline in earnings.

The dramatic fall in earnings suggests that REITs will have increasing difficulty servicing their debts. Here in the Bay Area, for instance, the delinquency rate on commercial mortgages rose from 1% in the second quarter of 2008 to 4% in the second quarter of this year. Nationally, the default rate on commercial mortgages rose from 1.2% in the second quarter of 2008 to 2.9% in the second quarter of this year. Forecasters are calling for a continued rise in the default rate, to around 4% by year’s end.

Even if REITs successfully meets their debt service requirements, they may still face serious financial problems as a result of declining earnings. Unlike residential mortgages, commercial mortgages typically have brief terms of only 5-10 years. When a commercial mortgage is due, it must be paid off in its entirety. The common solution is to obtain a new mortgage and use the proceeds to pay off the old one. If the value of the property has fallen, however, banks may refuse to lend as much as the borrower needs to pay off the old mortgage. In that event, the borrower may face foreclosure, even if he hasn’t missed a mortgage payment.

That’s the situation that owners of commercial real estate are facing now. I don’t have hard any numbers, but the press if full of stories about borrowers in good standing who aren’t able to rollover the mortgages on their buildings. (In this respect, REITs are actually better off than most other owners of commercial real estate, since they generally use less leverage.) The result is likely to be an increased level of forced sales, which will put additional downward pressure on property values.

The NAREIT index touched bottom in February, and has risen 44% since then. As with the housing market, however, the recent bounce is primarily attributable to a collective sense of relief that the world isn’t descending into a second great depression. After all, REIT earnings are still falling rapidly, and the credit crunch hasn’t shown many signs of easing. Commercial real estate values are likely to be under pressure for some time to come.