The Writing is on the Wall: 2008 was a warm-up for 2017 | June 22, 2016
By William Hudson

Before any financial crisis, there are certain signs that appear that should cause homeowners and investors to batten down the hatches. Although this is an unscientific analysis, over the last three housing bubbles certain patterns emerged. First of all wages will stagnate, next the cost of living inflates, high-end condo sales slow, and then commercial real estate prices decrease while vacancies increase. After these events occur- the housing bubble appears next. We are seeing all of the economic indicators that were seen in 2007 before the Great Recession.

All of these issues are now in play, and at this time the state of commercial real estate is of particular concern. It is projected that commercial real estate prices will fall by 5 percent or more in the next year as the global economy teeters, retail stores are forced to vacate their brick and mortar locations, and debt matures. An International buying spree of US property investments over the past decade pushed real estate values to record prices that were unsustainable for many tenants.

As growth slows in China, South America and Europe, and the American consumer finds themselves once again spending all of their income on an overpriced mortgage- discretionary spending is halted. Without retail buyers store fronts go vacant. There is no doubt that the US commercial real estate market is in for another bust cycle.

The well positioned investor will be able to take advantage of properties at basement bargain prices when the bottom falls out, but you still need to have tenants. Without tenants and customers even a great buy on commercial real estate doesn’t do an investor any good. Manufacturing and office space demand are plummeting and as expected property values and rental income are now in decline. There is also the issue of debt maturing from the last boom cycle and will become due later this year. This will provide an opportunity for investors, but devastate borrowers who will be forced to short sale, sublet or face bankruptcy.

Commercial-property values in major US cities, which have seen the largest increases during the recent bubble, have declined 3 percent in the past three months, reports Moody’s Investors Service and Real Capital Analytics Inc. on June 6th. It has been forecasted that real estate transactions in New York, the biggest US property market, could decline by as much as 30 percent this year, said commercial brokerage Cushman & Wakefield.

The mass issue of commercial mortgage-backed securities has contributed to higher borrowing costs for landlords and curtailed future price growth. Smaller investors who own smaller properties and who are reliant on Wall Street banks for funding may find they are unable to secure additional funding. Regulations like Dodd-Frank made it more expensive for banks to hold securities and interferes with liquidity. The loss in liquidity results in investors dumping mortgage-backed security holdings. There is also the issue of who owns the securitized commercial real estate.

Retailers are currently struggling to maintain their physical presence. The Sharper Image was the first major retailer to close all retail stores, and last week Sports Authority said it would do the same. The fact is that retail vacancy rates never normalized following the Recession.

Although the apartment rental segment has done well as fewer Americans purchase homes and move to renting, retail vacancy rates remain nearly 3% above the pre-crisis levels. Although many analysts believe that a shift from brick and mortar to online shopping is the cause- there is more to this story. The American consumer is broke, their income has not kept pace with inflation, and the average worker has not had a pay raise in over 7 years.

Office vacancy rates remain elevated, too. While analysts blame the office space reductions on technological advances that fewer employees to produce the same amount of product or service- the reality could be that in the early 2000s over-building saturated the commercial market. The bottom line is that there is too much commercial real estate available and the longest economic expansions in the world has not corrected the situation.

Despite the glut of real estate on the market however, prices have never been higher. The Green Street U.S. Commercial Property Price Index (CPPI) more than doubled since May 2009. In June 2015, the index rose 11.3% on a year-over-year basis. The latest data showed the CPPI rising at a robust 7.5% rate. These numbers defy sound economic market practices. When demand slows prices should not rise- but this is exactly what has occurred. The blame can be assigned to commercial real-estate backed securities.

Prepare for a bust. When you have a commercial real estate boom that caused the markets to blast off like a rocket, the credit cycle will implode. Poor lending practices and underwriting standards that occurred during the commercial real estate boom will correct without intervention from the Fed.

In December 2015, the Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency warned about the potential risks to the banking system caused by irresponsible commercial lending. By the time these agencies announce there is a problem- the damage is usually done. The boom was caused by the easing of commercial real estate underwriting standards, including lenient loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements. These practices mimic the consumer housing lending practices that contributed to the 2008 bubble.

When the Fed warns you that there is trouble in commercial paradise it is likely too late. The Fed can assume some of the blame since their policies and three consecutive Quantitative Easing programs flooded the real estate markets with cheap money with few limitations. Analysts predict that the auto loan securitization fiasco is going to come to an ugly halt soon, but they worry that the commercial downturn is going to be an even bigger game changer and the Fed won’t be able to print themselves out of it this time around.

The bottom line is that the U.S. economy appears, on the surface, to be fine- but if you look under the hood the complete system is faltering. Labor statistics are awful, manufacturing jobs are being cut as manufacturing moves offshore and the only real growth is in bartending or waiting tables. Full time employment with benefits has given way to part-time employment with no benefits. At some point the American worker will not have the financial resources to purchase anything but household necessities and thousands of retailers will fold.

The United States never recovered from the 2007-2008 recession. If the Fed had not pumped a massive monetary stimulus into the economy the correction would have occurred back then. We now have huge imbalances, deficits, and slowing economic conditions worldwide.

The majority of the US population is losing ground financially. The upper middle class grew to 29.4 percent of the population in 2014, up from 12.9 percent in 1979. The rich – those making $350,000 or more – also grew, from 0.1 percent of the population in 1.8 percent of the population.

However, the middle class, that is considered to be the economic foundation of American decreased from 38.8 percent to 32 percent of the population during the same time. The Urban Institute defines the middle class as those making $50,000 to $100,000 per year. The lower middle makes $30,000 to $50,000 per year, those defined as “poor” make less than $30,000 per year. The economic divide between those who are rich and those are poor is also starting to create real conflict between social economic classes as the wealthy can leverage capital investments to exponentially increase their net worth, while the working poor live paycheck to paycheck with little discretionary income and absolutely no investments that generate returns.

The writing is on the wall. 2008 was a warm-up for 2016 or 2017.

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