Introduction
In several articles, I have referred to the so-called housing recovery as an illusion. That image aptly describes what has occurred in the commercial office real estate market. Let’s take an in-depth look at why the recovery in the office real estate market is nothing more than an illusion.
The Collapse That Never Was
I have often discussed how the commercial real estate bubble reached insane proportions in 2007. Let me explain why.
Between 2001 and 2007, commercial real estate sales soared. From a mere $81 billion in sales in 2001, they reached a record $522 billion by 2007. Underwriting standards completely collapsed in 2006 – 2007. In 2010, the Congressional Oversight Committee reported that close to 90% of all Commercial Mortgage Backed Security (CMBS) loans originated in 2006 and 2007 were interest-only or actually had negative amortization.
Because the federal government bailed out the Savings & Loan industry with American tax dollars after the S & L fiasco, commercial banks learned nothing from this bubble. They proceeded to pour money into commercial mortgage lending and holdings of commercial mortgages skyrocketed from $550 billion in 1990 to $1.55 trillion at the peak in 2007. This had become a disaster waiting to happen.
After the collapse of Lehman Brothers in the fall of 2008, the banking system plunged into its deepest crisis since the depth of the Great Depression in 1932-1933. Federal regulatory authorities and the US Treasury Department then decided that a scheme had to be devised to create at least the appearance of bank stability or the entire system might come crashing down.
In April 2009, the Federal Accounting Standards Board (FASB) changed the standards for when banks had to write down impaired loans. The banks were required to write down only loans which were “other than temporary impairments.” Even better for the banks, they were left to determine when a loan on their books was more than just temporarily impaired. That was like letting the batter decide when a pitch was a strike.
The banks have really used this opportunity to self-evaluate their portfolios in their own interest. In its Big Picture report for 2013, Real Capital Analytics showed that the total of the distressed commercial loan portfolio of all banks at the end of 2013 was a mere $33 billion. That was down by a whopping 18% from a year earlier. Remember that the total commercial loan portfolio for all banks stood at $1.55 trillion at the 2007 peak and much of that quickly went underwater.
By the fall of 2009, the FDIC had changed its policy and encouraged what it called “prudent commercial loan workouts” to prevent massive foreclosures of shaky loans. The banks got the hint and began a policy of loan modifications which derisively became known as “extend and pretend.”
Regardless of how you see this “extend and pretend” sleight-of-hand, it was – in a way – a stroke of genius. Buyers were enticed back into commercial real estate and this helped to halt the decline in real estate prices. Although much of this renewed buying in 2010 and 2011 was all-cash purchases, the market did seem to stabilize.
For the appearance of normalcy to return, two more things were necessary. Lenders had to believe that risks had subsided. One last thing – most key players in commercial real estate had to develop a kind of amnesia about all those so-called performing loans which borrowers could not really pay back. If no one talked about them, that would also work. Just like in the story of The Emperor’s New Clothes.
The Buyers Are Again Out in Full Force
Since the beginning of 2010, there has been a fairly steady increase in the dollar volume of commercial real estate sales. Take a look at this chart from Real Capital Analytics.
You can see that annual sales volume has returned to the level of 2005. That year was already well into the real estate bubble and only two years from the peak of the madness.
This purchase activity has been very concentrated in roughly ten major markets. Take a good look at this table.
Investors have poured money into these ten major metros many of which could be called tech-centric. Nearly 50% of all commercial real estate sales dollars were lavished on these ten markets in 2013. Because these metros are all large markets, they have a great weight in property price indices. This next graph shows how much they have pushed up the commercial real estate price index.
