Saturday, June 19, 2010

Refinancing Commercial Real Estate

The 460 unit apartment complex that I manage in Charlotte is owned by the California pension fund CALPERS.  It is the mother of all funds and holds an enormous amount of commercial real estate.

Last week, members of the company I work for began due diligence on a property in Raleigh.  They are also looking to acquire a few more properties in the Charlotte area.

When I speak with the people involved with acquisitions and "upper" management, they explain to me how the market has bottomed.  They all use the word recession in the past tense, and if I used the words "double dip" they would think I was talking about ice cream.

Many of these esteemed decision makers actually believe that commercial real estate bottomed in the first quarter of 2009.  They say these things to me.

Of course I do not spend time trying to explain my point of view on the subject matter.  I would prefer to just continue learning how to best manage and operate the asset they own.  The asset that is losing value every hour of every day. 

I feel that CALPERS and other large investment funds are making a mistake by wading back into commercial real estate at this point in time.  I understand why they are doing it, and that can be a conversation for another day, but let's talk about why they shouldn't.

Commercial real estate is financed with balloon payments that typically have five year terms.  This means that five years into a mortgage an investor must pay the entire balance off or refinance.

The following graph shows the rise and fall of commercial real estate prices from 2000 through today.  As you can see, properties bought in 2005, 2006, 2007, or 2008 are now underwater.  (They are worth less than what was originally paid)


With their five year balloon payments, a vast majority of these properties will have loans coming due in 2010, 2011, 2012, and 2013.  The following graph shows the coming reset schedule:


How will these loans be refinanced if the properties are now worth far less than what was paid?

The answer is that they won't.  The majority of commercial real estate is located on the balance sheets of the smaller community banks.  The government does not care if these banks fail, which is why the FDIC is closing banks at an incredible pace every Friday night.

While the government has a vested interest in protecting the value of residential loans, (these loans house voters) they will be less likely to protect commercial real estate prices. (they are not on the balance sheet of their largest campaign contributors, the "too big to fail" banks)

It is this reason why I see commercial real estate as the next great investment opportunity.  I believe that when we reach the manic stage in the gold and silver bull market in a few years, it will coincide with the bottom of the real estate market.  Astute investors will sell their metal to the public rushing into the market and use their capital to purchase real estate at fire sale prices.

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