We are past the problems in just the sub-prime residential real estate markets and the financial collapse continues to spread into other sectors. The financial markets are not yet solid. Look at the Bear Stearns bailout. Financial institutions have halted all transactions with them. What happens next will be Chase taking them over. Still, expect some class-action lawsuits to erupt as many feel very shortchanged.

The Next Collapse

Having said that, what about commercial real estate properties? Are they next to see a drop in value? Some are saying it’s around the corner. This is from The Smirking Chimp :

The comptroller of the currency, John Dugan – who is presently investigating commercial real estate loans – discovered that commercial banks “wrote off $524 million in construction and development loans in the third quarter of 2007, which is almost nine times the amount of 2006”.

The commercial real estate market is following residential real estate off a cliff and will undoubtedly be the next shoe to drop.

Dugan found out that “more than 60 percent of Florida banks have commercial real estate loans worth more than 300 percent of their capital, [which is] a level that automatically attracts more attention from examiners,” [according to the] Wall Street Journal.

He said his office was prepared to intervene if banks with large real estate exposure maintained unreasonably low reserves for bad loans. Dugan is forecasting a steep “increase in bank failures”.

According to Reuters: “Dozens of U.S. banks will fail in the next two years as losses from soured loans mount and regulators crack down on lenders that take too much risk – especially in real estate and construction,” predicts RBC Capital Markets analyst Gerard Cassidy.

Apart from the growing losses in commercial and residential real estate, the banks are carrying over $150 billion of “unsyndicated” debt connected to leveraged buyout deals (LBOs), which are presently stuck in the mud. Like CDOs, there’s no market for these sketchy transactions [that] require billions in cheap, easily available credit. They’ve just become another anvil dragging the banks under.

Others say the collapse is already under way. This is from the Financial Times:

The volume of office space sold in the final quarter of 2007 fell 42 percent to $26.5 billion compared with the same period in 2006, according to data released by [real estate data company] Real Capital Analytics (RCA). Sales of property portfolios fell to $5 billion after logging $105 billion in the first three quarters.

“What’s happening now is a capital markets event,” said RCA managing director Dan Fasulo.

Spreads on CMBX (an index that tracks commercial mortgage-backed securities) have recently suggested that default rates are expected to reach three times historical levels. Analysts, though, say commercial property is not expected to suffer the same slump as housing because it has not experienced such high levels of overbuilding.

However, if the U.S. economy experiences a deep recession, commercial property is considered to be at risk. Demand for space is largely driven by the health of the business environment.

Real Estate Markets Are Unique, But…

It is very interesting to hear local and national real estate pundits talk as if they really understand what’s going on in real estate because they have 20 or 30 years in the real estate market. Their observation is always that real estate markets are unique, and even if the market is soft in Manhattan or Phoenix, that doesn’t mean Chicago or Milwaukee will be affected.

What they don’t understand is the technology that tenants are looking for in buildings has changed. The three most important words in real estate are no longer location, location, location but location, location, connectivity.

Many traditional real estate “experts” have no clue when it comes to the valuation of a building based on what intelligent amenities it offers. Intelligent amenities? That was a phrase coined more than two decades ago when comparing office buildings and what they offered in technology-based services (i.e. network connectivity, IT services and other automated capabilities).

Those who didn’t understand the shift in what is important in real estate will soon find out as their buildings become technologically obsolete and the values plummet. Appraisals on commercial purchases don’t take into consideration technology that’s embedded in the building’s infrastructure.

Class A Will Fall to Class B

Once they overspend, it’s too late. They’re stuck with an office building that perhaps would be better to turn into a warehouse. No Class A tenant would want to pay any real lease on something that can’t support broadband connectivity. Will commercial real estate feel the big plummet in values?

The short answer is “yes”. Don’t get caught with the hot potato of the 21st century: a building that’s technologically obsolete.