CRE At The Corner Of Wall And Main Streets

Macro economics is concerned with "the big picture", and micro with the small. There are elements of each which are leading to the likelihood of inflating a commercial real estate price bubble.

One element is the financial system. In a real sense the organization of the financial system generically named "securitization" is probably going to have an impact equal to the rise of corporations in the 19th century. The net effect is likely to be a leveling of the differential interest and rates of return between traded securities, say Wall Street, and previously illiquid financial and related assets, say Main Street. The late James Schilt put together a liquidity "yield curve" which ranged from the small Main Street firm to the large Wall Street. The yield differential was on the order of 400% higher for Main than for Wall Street.

Especially in an epoch when The Fed is pushing the Wall Street yields down close to zero, any plausible means to get greater returns receives attention, even to the extent of buying various sophisticated and illiquid bundles of previously unmarketable Main Street assets. "Chasing yield", particularly from those who purvey or accept the belief that "it will be different this time" has become a Wall Street stimulant of choice. Banks are also doing the usual time arbitrage between near term zero interest rates and intermediate term single digit rates. Both tactics are attempts to reap unusual profits and recapitalize from the late bust.

Banks' need for capital is being disguised to some extent as regulators condone the re-write of commercial real estate loans coming due on property the value of which may not equal the loan amount, "extend and pretend". Holding these loans on the books is similar to the commercial credit held in Japanese banks in the 1990s. At low interest rates the loans might stay current, but are not promoting productive economic activity. Meantime the banks are unable to make new loans. The Japanese term was "zombie* banks".

The bubble risk today may be in a convergence between "extend and pretend" supply constraints and "yield chasing" demand. Many, myself included, expected a large amount of commercial real estate (CRE) to be coming on the market this year and next. It's not, largely because of extend and pretend. Supply and demand says that if the higher demand from yield chasers intersects with that low supply, prices will rise. That is apparently happening in some locations and for some classes of CRE. The illusory good news, as prices rise, is that the bad loans mentioned above look better in the light of higher bubbly prices.

Please notice that is an unfortunate confluence with some Main Street CRE cyclical fundamentals. We went into this recession with something on the order of a billion square feet of excess retail space. Retailing hasn't exactly expanded over the last couple years. Office occupancy and rents are dependent on white collar employment. That isn't exactly soaring off the charts either. So getting elevated prices for CRE means capitalizing lower rents into higher values. The Fed with its low interest rates is forever blowing bubbles. In this case, promoting the illusion that their low interest rate environment is sustainable with the overhanging threat of inflation. So, if you hear that Greek chorus (pun intended) intoning "T-bill bubble. When it bursts, woe to yield chasers", you're not the only one. Still, the characters on stage are repeating to each other, "This time it will be different."

Over the long run, it is almost certain that the differential between Wall Street and Main Street rates of return will compress. It is also almost certain that with even a faintly credible threat of inflation Wall Street rates will rise. Higher rates of return mean lower prices. The T-bill bubble will burst. The actual onset of inflation will drive rates up at least to and more likely above long-run averages. As for CRE, absent significant increases in property income, a general increase in rates of return is bad news. The possibility of eventually increasing rents buffers CRE to an extent, but only to the extent that potential wasn't already built into the purchase price and present basis. Wall Street finance types blindly chasing yield without regard to the facts of Main Street commercial real estate life will not be rewarded simply because securitization levels the playing field between the two.

*http://www.charlesbwarren.com/zombie.html

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Charles B. Warren, MRICS ASA-urban real property Pleasant Hill 925.609.7241 www.charlesbwarren.com