Picking Through the Wreckage

With a few notable exceptions (like Noriel Roubini, “Dr. Doom”), most economic forecasters seemed surprised when the collapsing housing market overwhelmed financial institutions and sent the global economy into recession in 2008.

This is surprising.

The housing market has historically followed a cyclical pattern that can be readily discerned and, within reasonable limitations, anticipated.  And its significance as a major driver of the economy has been well understood for decades.

The commercial real estate market also follows a foreseeable pattern – one which tends to lag months behind the direction of the overall economy.  As a consequence of this interval, the commercial real estate market hasn’t yet reset itself and, in some fundamentals ways, is still sorting itself out.

Peter Linneman (of the University of Pennsylvania’s Wharton School), one of the real estate industry’s true luminaries, recently gave an insightful interview (the transcript of which you can find here) that frames a cautionary guide for the road ahead.

The most significant uncertainty in the commercial real estate market’s future is the huge number of commercial mortgages that will roll over in the next few years.  The Real Estate Roundtable, a policy advocacy group representing a variety of interest in the real estate industry, estimates that, by 2012, $1.8 trillion of commercial mortgages will come due for refinancing.

But refinancing is, in many cases, going to be a difficult proposition.  Real Capital Analytics estimates that $1.3 trillion of equity – represented primarily by properties purchased at the apex of the last market cycle – has already been wiped out.  In other words, the table is set for another market adjustment that could have profound repercussions for the economy.

What does this mean for you?

First, it is essential to conduct some extra due diligence on properties that you now lease or are considering.  Specifically, you need to know if the property – and its owner – are financially viable.  Properties that get into trouble with lenders often suffer from reductions in service, maintenance, and management.

Second, if you are now leasing – or considering leasing – do a thorough lease versus own analysis.  Although it rarely makes a lot of sense for a business to own its facilities (more about this in a future post), the benefits of buying near the bottom of a cycle may be compelling.  Just be careful.  Projections based on irrational exuberance are apt to be grist for problems down the road.  If you buy, have a plan to sell that is keyed to clear metrics and milestones.

Third, think outside the docks.  There’s a lot of stimulus money – an expanded array of incentives – that will not likely be around forever.  You may be able to use the trough in property values as a way of addressing emerging issues – like cap and trade.  A number of states have developed aggressive alternative energy programs that can make facilities carbon neutral – or even carbon negative.  Buy low.  Use the programs to fund green improvements.  Reap the rewards immediately (lower operating costs) and down the road (higher value).