If You Believe All The Negative Hype About Commercial Real Estate, I've Got A Few Thousand Vacant Office Buildings To Sell You

Benjamin N. Dover III's picture

As the lone voice of optimistic reason on this naysaying website, it's my responsibility to intervene now and then to set the record straight for the benefit of all those benighted readers who don't consult reputable traditional media outlets like CNBC.

For months now, ZeroHedge (and unfortunately other bloggers and even some mainstream publications) have been warning of an impending commercial real estate meltdown that's supposedly going to crush banks, petrify credit markets, stall the economy's V-shaped rebound, and usher in an epoch of plague, locust, boils and the slaying of every real estate lender's first-born. Yet despite their continuous calls of "timber", the "commercial fake estate" tree refuses to fall. And just like an unheard tree falling in the woods makes no sound, if a borrower fails to repay but no one marks down the loan, there really hasn't been a default.

 

One of the wolf-crying anti-capitalists at the Wall Street Journal paints a grim picture: $1 trillion in mortgages backed by commercial property that's fast losing value, total losses on core CRE holdings reaching between 11.6% and 15.3%, or $115 billion and $150 billion, and the fact that more than 3,000 banks have more than 300% of their risk-based capital in commercial real-estate loans. And those are among the more optimistic of the pessimists' forecasts.

They also keep harping on certain macro-economic irrelevancies: businesses floundering, revenues flatlining, rents dropping and employees still being shown the door in droves (empty office space that most likely will be used by remaining employees to expand the size of their own offices). But none of those factors bodes badly for CRE. They're all what we experts call "lagging indicators," which means that they look backward instead of forward, and therefore can be safely ignored.

But more importantly, the doomsdayers are making the classic mistake of confusing subjective value with objective value. (Bear with me here even if you don't have an advanced economics degree.) These economic relativists think that a product only has value to the extent someone is willing to pay for it, i.e., to the extent that, in the subjective opinion of some prospective buyer, it has value. But we all know that's not how the real world works. Goods and services have intrinsic value. That's why FASB had the courage to yield to the greater wisdom of Congress and the banking industry and relax mark-to-market accounting. No market exists for CRE loans and CMBS, just like none exists for commercial real estate generally. But that doesn't mean that CRE, and the loans and securities that are derived from it, don't have value. They retain their objective value despite the fact that everyone thinks they're so worthless that they're unwilling to buy them at virtually any price.

A simple example illustrates the principle. Suppose I produce a giant steaming turd. Now if I put that turd up for sale, I probably wouldn't get any offers. Why? Not because my bowel movement is unsaleable, but because no market for it exists. Sure, the relativists will claim that the absence of a market is an indication (if not irrefutable proof) that my feces is worthless, but they'd just be describing its subjective value. Their opinion wouldn't indicate anything about it's all-important objective value. And since I produced the product, I'm in the best position to know its objective value and account for it accordingly.

So, for lack of a more palatable metaphor, the CRE market is analogous to a pile of crap. Just because everyone thinks it stinks doesn't mean it actually does. Because no market for it exists, we'll never know what it's true value is at this moment, which means that CRE lenders should continue to value their legacies at whatever price they subjectively believe they're objectively worth. Later on, that fetid stool I produced might just be used to fertilize a garden, and what seems like worthless shit today might end up smelling like a bouquet of flowers tomorrow. And that's what REITs and banks with CRE loans are doing. They're looking ahead to the brighter future of CRE, where today's turds are tomorrow's tulips.

"High-falutin' economic principles and academic theories are all well and good," the doubting Thomases like Tyler Durden and Contrary Investor will say, "but where's the proof?"

Right here, my scaremongering colleagues.  Exhibit A: The infallible discerner of jewel from junk, quality from crap, and objective from subjective value -- the equity market. Not only have the stock prices of REITs like Kimco skyrocketed since their March lows, they've been getting more equity financing than even Larry Kudlow ever dreamed possible -- a vote of confidence that proves that the credit markets that refuse to re-finance these REITs simply have no testicular fortitude. Why on earth would the stock market pour so much cash into CRE-related stocks if the CRE market were about to collapse like a mall of cards? Remember, there is wisdom in mobs crowds.

Exhibit BThe best judges of CRE value -- the major banks (along with the interdependent CRE analysts they employ) that have hundreds of billions in loans to CRE players -- have upgraded their outlooks on REITs and enthusiastically underwritten billions in equity offerings to them. The fact that the upgrades come within days (sometimes hours) of the announcement of a new offering and that the proceeds are explicitly earmarked to repay the REITs' loans to the underwriting banks doesn't suggest they're motivated by a glaring conflict of interest. It just means that the analysts' new recommendations are more current, and thus more reliable than their previous negative recommendations.

And who can blame them for seeing the light and becoming more bullish? The CRE market has nowhere to go from here but up.