Not all real estate is created equally. We all felt the pain when the housing mortgage bubble burst last year. Lately the chatter in certain financial circles about the situation in the commercial real estate market has been heating up.

The word is that the commercial real estate market today is “eerily similar to the subprime crisis” (see 10/22/09 IBD article) before the bubble burst. Regulators are trying to prevent the inevitable (see 11/2/09 Minyanville article) by “encouraging banks to modify loans, rather than foreclose and repossess property, even if the value of the building has fallen below the amount of the loan.”

Regulators are also allowing big banks to put off recognizing commercial real estate loan losses. This strategy only pushes the pain into the future. The only way this could diminish the problem would be if real estate prices rebounded to their previous unrealistic levels before the write downs were to become unavoidable. Nobody thinks that’s going to happen.

SmartMoney author James B. Stewart paints a bleak picture of the affair. He refutes claims by optimists that “the sector’s problems are likely to be contained because they’re valuation-driven, a result of easy credit and the inflated prices it encouraged.”

When it comes to “apartments, retail and industrial space,” vacancies are “rising sharply” and rents are falling at the highest rate ever recorded. “Goldman Sachs now predicts that asset prices will fall 40 to 42 percent on average. Private-equity firm Blackstone has marked down its commercial real estate portfolios by 45 percent.” The number of commercial real estate loans with a debt-service-coverage ratio of less than one (meaning the loan is technically in default), “will rise from a negligible level as of 2008 to 49 percent of all loans by mid-2010.” Forty-nine percent!

From his analysis of this year’s market rally, Stewart believes that most investors have failed to adequately factor in the risk in the commercial real estate market. In other words, he is saying that the market, similar to its condition before the subprime crisis took hold, has not yet considered the developing crisis, although, the information is available for anyone to see. Drawing parallels between the two crises, he writes:
“Stocks in general, and bank stocks in particular, kept hitting new highs in 2007 even after rising default rates in subprime mortgages were the subject of widespread press coverage. Only when banks started taking multibillion-dollar write-downs did investors finally wake up to the scope of the problem, and then they overreacted.”
So as we giddily watch the Dow press past 10,400, we are apparently oblivious to the fact that another crisis as severe as the last is coming. It is close to impossible to accurately predict the timing of the bursting of this next bubble. But I think it is safe to make some forecasts regarding it.
  • Politicians will use the crisis to increase the grasp of the federal government as well as to increase their own political stock.
  • Financial firms will successfully apply to the federal government for hundreds of billions (or even trillions) of dollars in aid.
  • The Fed will seek to expand its power while continuing to insist that it is doing a fine job of stabilizing the money supply and that it needs ‘independence’ to do so.
  • Regular American investors will lose a lot of money again.
While investors may be ignoring the impending calamity, I guarantee that politicians are not. Even as I write this, some politicians are scheming about ways to use the crisis to achieve their desired goals. Will we allow ourselves to be taken in again?

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