After Seven Lean Years, Part 2: US Commercial Real Estate: The Present Position And Future Prospects

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

The fundamentals of demographics, stagnant household income and an overbuilt retail sector eroded by eCommerce support only one conclusion: commercial real estate in the U.S. will implode as retail sales and profits weaken.

The first installment of our series on U.S. real estate by correspondent Mark G. focused on residential real estate. In Part 2, Mark explains why the commercial real estate (CRE) market is set to implode.

In the early stages of the sub-prime mortgage crisis it was widely believed that US commercial real estate (CRE) would manage to dodge the bullets. In the end CRE was found to be as vulnerable as anything else.

© 2014 Real Capital Analytics, Inc. All rights reserved. Source: Real Capital Analytics and Moody’s Investors Service. Used by permission.

These three graphs of relative prices show that in CRE the “core” is doing better than the “periphery”. The gap in relative price performance of major metro CRE over smaller cities and towns has approximately doubled from where it was in 2008.

And as with residential real estate, some CRE sub-sectors and cities are obtaining far greater benefit from bailout, stimulus and quantitative easing programs than other areas:

© 2014 Real Capital Analytics, Inc. All rights reserved. Source: Real Capital Analytics and Moody’s Investors Service. Used by permission.

Commercial real estate has a more complex structure than residential real estate. There is greater specialization in function. For instance strip shopping centers and indoor malls are generally not exchangeable with warehouse facilities.

We can simplify this a bit by classifying CRE by consumer sector and function. Industrial real estate will not be considered in detail. Current industrial construction spending is near a record high. But the value of current industrial CRE can still be depressed due to existing plant obsolescence and rapid shifts in activity location.

This leaves us to consider consumer retail and consumer service CRE.

Consumer Retail Spending & Retail CRE

The value of commercial real estate is driven by the revenues and profits earned by the businesses occupying CRE. This relationship is similar to the relationship between residential real estate prices and average household income.

The Two Drivers of Consumer Spending: Population Size and Average Household Income:

These two parameters show continuously increasing population size and declining average household incomes. The subsequent data shows this is resulting in a small increase in total consumer spending and also large shifts in spending patterns.

Real inflation adjusted total retail spending has increased slightly over its peak in 2007.

Essentially all of this increase has occurred in food spending. (A smaller portion has gone into clothing). And this is the only reasonable expectation given the twin conditions of an increasing total population and a declining average income per consumer. We can also note that “food” is a minuscule part of eCommerce. The retail food trade occurs almost entirely in neighborhood groceries, markets and convenience stores. The other non-food retail sectors are flat to declining. But within these sectors there is a large zero-sum game being played out between eCommerce and local bricks ‘n mortar stores:

The Rise of eCommerce

Since 2008 eCommerce retail sales have nearly doubled. But as we just saw, the entire increase in total consumer spending since 2008 is accounted for by the increased food sales which occur at local markets. “eCommerce” is therefore taking sales away from other local retail sectors. And the biggest single loser is:

Local Retail Department Stores

This macroeconomic data is well-supported by the current financials of both Sears and JC Penney. Sears’ trailing twelve month (ttm) earnings per share are - $14.11. This loss will increase once Sears reports its fourth quarter earnings at the end of February, 2014. Sears is widely expected to lose one billion dollars in 2014. J.C. Penney meanwhile is currently reporting ttm losses of -$7.32 per share.

One or both of these chains will be in bankruptcy by 2015 even if the current “recovery” continues. And outright liquidation of one or both companies is at least as likely as reorganization. There is little reason to believe either of these companies would be more viable following mere debt reduction.

The third major department store chain is Macy’s, which is still reporting profits. Oddly enough Macy’s management celebrated their 2013 holiday season by announcing 2,500 permanent layoffs from their local retail department stores. This was paired with a mid-December announcement of an increase of 1,500 employees in a new eCommerce fulfillment center in Oklahoma.

In these circumstances it is unsurprising that retail CRE prices are showing weak recovery.

© 2014 Real Capital Analytics, Inc. All rights reserved. Source: Real Capital Analytics and Moody’s Investors Service. Used by permission.

The Coming Implosion of the Regional Indoor Shopping Mall
(and adjacent strip shopping centers)

There are approximately 1,100 indoor shopping malls in the USA. Sears has about 2,000 stores. JC Penney’s has almost exactly 1,100 stores. There are very few malls that don’t have at least one of these chains. The vast majority of malls have both as major anchor stores. Macy’s is typically the third major anchor now. A regional department store chain or two round out the large anchor stores.

A virtual stroll down the typical mall concourse will reveal plenty of other money losing chain retailers with names like Radio Shack et al. Adjacent strip shopping centers
This should not be surprising. The regional indoor mall is a middle class income institution. It grew up with the post-WWII rise in average incomes. As middle class incomes now disappear so are the former favorite shopping venues of the middle class.

Every time a mall store closes shoppers lose another reason to go to the mall. “Dead mall” syndrome will soon afflict most of this sector.

In addition to decaying tenant revenues the mall owning Real Estate Investment Trusts are dangerously overleveraged with low-cost to free ZIRP and QE funding. Now that the Federal Reserve is tapering QE their financing costs will be rising as commercial balloon mortgages come due and have to be rolled over. And since the typical commercial mall mortgage does carry a large balloon payment at the end they have to be refinanced. Assuming honest loan underwriting a higher risk premium will also be attached due to the deteriorating retail fundamentals of the tenants.

General Growth Properties (GGP) is probably in the best condition. This is because GGP just exited a Chapter 11 reorganization in 2010. It was placed into involuntary bankruptcy in 2009 by two mortgagors holding matured recourse balloon mortgages. GGP was understandably unable to refinance these balloons in the spring of 2009.

This entire sector will collapse when the next recession appears.

And since history hasn’t ended, the next recession will appear at some point. It may be appearing already. At the beginning of October, 2013 the analyst consensus for retail profit growth for the strongest October – December holiday quarter was 5.5%. At the beginning of the reporting cycle in January expectations were down to 0.5% profit growth. That is a 90% reduction in analyst expectations in just three months.

Barring a turnaround, many retail chains still reporting profits will be reporting quarter-on-quarter profit declines in April. And by the end of the third quarter more will start reporting outright losses.

Part 3 will examine the other major part of local consumer oriented CRE. These are consumer services like neighborhood banking, investment, insurance and other services. Experience to date demonstrates that in the next few years the internet, expert software systems and robotics/automation will eliminate 50% and more of the jobs formerly associated with these businesses. These same trends will also shift most of the surviving positions away from the traditional storefront strip center and local office park locations.

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Seasmoke's picture

I always thought the Big Commercial Real Estate collapse was suppose to happen in 2009-10.......How come that never happened ??

quintago's picture

Collapse? They used ABS/MBS to hike prices to induce long term owners to transfer/sell assets. They imploed the ABS/MBS market, and there was an orderly transfer of assets into the hands of few. Was a genius way to consolidate wealth over the past 10 years actually. Unfortunately it was done on the backs of the sheeple.

It was all done according to plan, going back to the late 90's with the repeal of laws setting up the MBS market for doom. 

Manthong's picture

Many folks are desperate for some yield over the medium term and are reaching for it in what they think is a growth place.

But they don't know how dark and shackled the future is.

Unfortunately, with the dot Gov and Fed in place now, they will be left with nothing but strained muscles.

I am more equal than others's picture




Declining interest rates (lower debt service) and lower operating costs (attributed primarily to energy saving) saved CRE for the time being.  Energy savings are a zero bound game.  Not much more can be had in that category.  Interest rates are also zero bound.  The day is coming when there will be some type of reversion - controlled or uncontrolled - and you will see CRE fall like a rock. 

TideFighter's picture

Correct. And...after 3-5 years, foreclosure was still not an option. 

Rainman's picture

The 'collapse' was papered over with 'orderly transfers'..... or "pulling a Morgan Stanley". Foreclosure is for the little people.

kaiserhoff's picture

That's what I've seen on a local level.  Extend and pretend. 

Hopelessly underwater stuff gets refied because the bank doesn't have any options.  Auditors and regulators don't care.  No money in the FDIC to close out the bad banks, so the evil circle jerk continues.

TuesdayBen's picture

CRE avoided collapse because money flowed into it with nowhere else to go, driving up values, which, combined with record low rates, allowed owners to refi and lock in fixed-rate debt for the long-term with debt coverage sufficently low to make these CRE investments viable...

Sudden Debt's picture


The fact that those malls and large stores will go bankrupt is actually a good thing for the little independents and they'll create more jobs in the future. The jobs that where killed by those large stores and chains.

Stuck on Zero's picture

I agree.  There's absolutely nothing in malls to attract men. I have no interest in names like Armani, Balenciaga, Sass and Bide, Hugo Boss, Bulgari, Burberry, Calvin Klein, Roberto Cavalli, Chanel, Chloé, Juicy Couture, Christian Dior, DKNY, Diesel, Dolce & Gabbana, Ed Hardy, Fendi, Salvatore Ferragamo, Diane von Fürstenberg, Valentino Garavani, Jean-Paul Gaultier, Givenchy, Gucci, Guess, Hermès, Lacoste, Polo Ralph Lauren, Yves Saint Laurent, Marc Jacobs, Moschino, Oroton, Prada, Oscar De La Renta, Narciso Rodriguez, Sergio Rossi, Chado Ralph Rucci, Ferdinando Sarmi, Victoria's Secret, Elsa Schiaparelli, Versace, Louis Vuitton, Vera Wang, Vivienne Westwood and Ermenegildo Zegna. 

All crap.

I want some real men's stores with names like: Bridgeport, Hooters, Toro, Schlitz, Jim Beam, Barrett, Ruger, Cragar, Cobra, Nitro, Skeeter, and sriracha!


disabledvet's picture

I keep forgetting about the "CMBS" craze too. But I've had a great first hand look at the distribution center system built out nationally because of it. The number of stores in the USA has remained relatively constant going on 20 years. But the build out of a US based distribution system has been truly massive. Atlanta, New Jersey, California, Chicago, Pennyslvania...these facilities are not only numerous but huge. Basically "built in cornfields." the extent any of them are even being do they become "economic"? If your answer is "by Americans going Galt" then I think you might have a problem here.

Caviar Emptor's picture

Yes, biflation bites! Spiraling costs, lower median incomes doesn't make for spiffy 'aspirational' consumers. Nobody believes or cares that they can 'have it all' anymore. Whatever that meant. It's hip to be spare!

mayhem_korner's picture



The present position of commercial real estate is "elbows on the table"..

TideFighter's picture

In the lending world, having an anchor in your mall like Sears or JCP was critical for approval. Now, I'm building fallout scenarios (the "ugly" of the "good, bad, and ugly" when JCP or Sears is there. Albatross it is, calculating traffic loss due to Anchors diving. Our traffic demos in those are a sea of red, not appealing to underwriters. Leases sq/ft dropping horrifically in some areas, add crime, and I wouldn't touch retail with a 39 1/2 foot pole.


Payable on Death's picture

In general, CRE value has recovered to pre-crunch levels via record low cap rates. Income is still low. Yeah, ZIRP!

kaiserhoff's picture

Some truth it that, but if the friggin' mall is vacant, it's gone.

There's a future for well located apartments, not for retail, and who needs office buildings any more?

My office is the closest Panera or Starbucks.

Payable on Death's picture

Apartments are most certainly a bubble. FNMA kept lending through the crunch. Prices are above replacement cost.


Yeah, yeah. Who wants to own a home? Who has the credit? Pretty much BS. Apartments have credit standards, too. Where is the household formation?

QQQBall's picture

Apt values have been ramping in Socal. Still lots of buyers. I would have thought apt sellers would opt into strip centers as many did back in 2006-2006. New apt construction is picking up. SBA has kept C&I going, but investor sales are much fewer. The leverage and rates offered by SBA make mortgage payments competitive with lease rates. Not really much NOI growth, but multipliers are high and cap rates are low. The search for yield has stretched to teretiary markets - again. 

NOZZLE's picture

Take a drive North or South on Cicero, Pulaski or Central Ave., in Chicago or any of the major E/W thourofares, all you see is one empty storefront after another that used to be occuppied by small stores up until around two or three years ago. 

thefirstabomb's picture
Everyone is thinking that the housing market is set to explode.  I think so too, just not in the good way 

over45's picture

I was asked to list 3 commercial buildings for someone who was underwater on all of them.  Said no.   He bought all of them with 5% down on a 10 year balloon.  He said most commercial property was financed that way in the hay day and local and national banks are sitting on thousands upon thousands of un-refiable property due to lower values or insufficient cashflow.  Many were given an extra few years but it's all coming to an end.  Just because there are tenants in a place doesn't mean it's servicing the debt.  He wound up losing all 3 which are all nearly empty.  Ka-boom coming at some point. 

Watch Bird 1's picture

Yep, ka-boom coming. Servicing the debt is but one challenge. We're seeing the premiums for commercial insurance go sky high. The huge premiums take a real bite out of cash flow.

Au Shucks's picture

And let us NOT forget the property taxes on these commercial and multi-family dwellings!  Also known as the King's ransom for the privledge of using his land for the purpose of improvishing ones self.

Xploregon's picture

Granted, major anchored indoor malls are challenged and the future isn't rosy. And it's true, E-commerce is hitting retail where it hurts. However, regarding neighborhood strip malls, many are heavy tenancies of SERVICES rather than "goods" For example- hair salons/barber shops, dry cleaners, medical, dental, dog day care, florist, dance/gymnastics/martial arts, fast food, sports bars, etc., the kind of SERVICES you cannot get over E-commerce. The kind of things you don't commonly find in major anchored indoor malls. Local, often in walking distance, valued especially WHEN gas prices really spike again. An old adage is that even when times are tough, people seem to find money to drink with no matter what. Around this is food and gambling. Places like the neighborhood sports bar, dive, hangout and meeting/socializing place will survive providing that there's not too many of them in one compressed neighborhood. People who are unemployed yet still have the monetary means might be wise to look and think long and hard as to what services your neighborhood doesn't have that can't be obtained on the internet, aren't "typically" located in major malls and, what regular or semi-regular services are lacking or non-existent in their own (or close by) neighborhoods and jump into entrepreneurship.

Also, you'd usually find many services priced competitively compared to major malls and, when considered being closer to home saving time and gas, a savings even if priced equal to major malls. Granted, it is location, location, location AND local income, income, income that may make or brake any strip mall. Also unfortunately, all you have to do to "poison" any concentrated commercial area is have a "socially questionable" business next door or close by (you name what you think that might be).

Now you have to excuse me. I have to go out and do a drive-by rent raising.


Xploregon's picture

Woops! Double post...sorry.


JailBanksters's picture

Yes, there is going to be an explosion, that's for sure.

An explosion of wealth and debt AR THE SAME TIME, because wealth is debt and debt is, well debt.



rsnoble's picture

When the next recession appears? Oh boy i'm getting tired of hearing that.