The Coming Commercial Real Estate Crisis

As usual in Washington, it’s “Do as I say, not as I do.” While Ben Bernanke is talking up the U.S. economy, Congress and the IRS are scrambling to stop another real estate collapse.

First, the political left and National Association of Realtors are in the process of extending the now famous “first time homebuyer tax credit.” The initial plan, which was passed around this time last year and allows first-time homebuyers an $8,000 tax credit, is on track to cost about $15 billion — double the projected budget.

Heh, and just like “cash for clunkers” going massively over budget must be a sign of scorching legislative success. Thus, the new plan is to extend the tax credit into the summer of 2010, boost the credit to $15,000 and make all potential homebuyers eligible. Those who are content with their current home and/or unwilling to invest in a new one… well, they get the prideful assurance of knowing they played it safe — and their kids get the bill.

Also, the IRS has changed some rules to help keep commercial real estate afloat. It’s a technical matter (aren’t all American tax laws hard to understand?), but basically, the IRS fudged their rules on tax penalties for real estate investment pools. Under the new laws, certain commercial real estate loans could be modified or refinanced without hitting investors with a tax penalty.

We’ll save the details for more seasoned analysts, like our resident CFA, Dan Amoss. But you get the gist… the government is going out of its way to keep commercial real estate from going down.

“The fundamental outlook for REITs and commercial real estate remains bleak,” says Mr. Amoss, “and the market will soon wake up to this fact.

“The core of the bear case for REITs rests on falling comparative property values, falling rents, falling occupancy rates and tight to nonexistent refinancing conditions. Refinancing conditions are important because if lending remains tight, this will push up the amount of property foreclosures and liquidations. And conditions will remain tight because the regional and community banks that typically lend against commercial real estate collateral are not answering phone calls from desperate borrowers. They’re nursing hangovers from their existing commercial real estate loans, and have regulators watching their every move…

“Richard Parkus, head of mortgage-backed security research at Deutsche Bank, estimates that cumulative commercial real estate charge-offs will be in the range of 10% of the banking system’s $1 trillion in core commercial real estate loans. That’s a $100 billion hole in the banking system’s capital that many banks will not be able to ‘earn their way out of.’ I think 10% cumulative charge-offs could be conservative.

“Thus far, according to SNL Financial data, commercial banks have charged off just 1-2%. So in baseball parlance, ‘We’re only in the first inning’ of the process of recognizing and writing off whole commercial real estate loans sitting on bank balance sheets.

“As this occurs, this will lead to a flood of foreclosures and liquidations, which will push down market prices for commercial properties — the same types of properties owned by REITs.”