Commercial real estate is defined as any multi-family building with 5 or more units, office, retail, or industrial/storage space. There are a few main factors that separate commercial real estate from residential, and the differences are important to understand how the coming crisis will unfold.
The most important difference is the way they are priced. Residential property prices are determined by the selling price of local comparable properties. If your neighbor sells their house for X amount, that is used directly to determine the value of your home.
Commercial real estate value is determined by only one factor: the income the property generates.
Investors then look at that income stream and determine how much they are willing to pay for it. For example, let's say that a property generates $100,000 per year in income after expenses. If an investor needs a 10% return on their money every year, then they will pay $1,000,000 for the property. The 10% return is known as a cap rate, something you will be hearing more about as commercial property enters the crisis.
The second major difference between commercial and residential is the way they are financed. The bulk of commercial real estate is financed on a 30 year monthly payment schedule (similar to residential), however, commercial loans have "terms" between 3 and 10 years meaning after the term expires the property needs to be refinanced.
For example; you bought an apartment in 2005 with a 30 year fixed loan with a 5 year term. Every month you pay a 30 year payment, but in 2005 the loan comes due and you must pay off the entire loan amount or refinance. While prices falling drastically have hurt the commercial market considerably, it is this financing schedule that will bring on the apocalypse.
Okay, now let's apply what we've learned to a real life example.
This week down here in Charlotte BECO property group purchased the Meridian office park. The property was bank owned after entering foreclosure in 2008.
The property was originally purchased for $150 million with a $120 million loan.
BECO's closing price: $42 million
This means that the bank will have to "write down" $78 million on their balance sheet to represent the loss after the sale. ($120 mill loan - $42 mill purchase price = $78 million loss)
The banks are reluctant to take these losses and sell the properties because many do not have enough capital in reserve. For example, if this bank had only $50 million in reserves and they were forced to sell this property and take the $78 million loss, the FDIC would show up at their door and close the bank.
Now that you understand how commercial real estate is valued and have seen a real life scenario, let's take a look at the size of the coming problem......