The Real Estate Reckoning: Is a Replay of 2008 Coming?

Plus, my recommendation regarding managed futures

It's Thursday, August 15th. And yesterday I talked with you about problems we're having in the residential real estate market because of high interest rates and high prices and the challenge that that's creating for would-be homebuyers as well as their parents, who are often being asked to help out. If you missed yesterday's show, the link is in the show notes. 

Today, I want to talk about the other side of real estate.  Not the residential market, but the commercial market. We're starting to see the ugly truth about the commercial real estate market as a result of the challenging economy that we're experiencing. Credit agencies are a key player in the commercial real estate marketplace because the credit agencies determine: How solid is that building? What are its financials looking like? What's the value of the building? How much rental income has the building generated? How many tenants are there and how much rent are they paying? How long are their leases?  For how long are they going to continue paying their rent? That all determines what the market value of this building is.  

Now, there are studies being shown that credit agencies have mis-rated more than a hundred billion dollars worth of commercial real estate debt.  You see, what it comes down to is that if a credit agency looks at a building, looks at the value of the building, looks at how much rental income it's generating from the building, it'll determine whether that building's bond, which is how the owner of the building is raising the cash to buy the building in the first place, if that bond is worth AAA as a great rating. That's the highest, safest rating. Then the interest that the building owner is going to have to pay is a lot less than if the building is rated AA or A or BBB or BB. 

The worse the rating, the lower the quality of the bond and the higher the interest rate the bond issuer has to pay in order to raise the capital they need to buy the building. Well, obviously, it's in the building owner's best interest to have the bond rated as highly as possible, because the higher the rating, the lower the cost of borrowing. 

Well, the credit agencies seem to have been complicit in mis-rating these bonds. 100 billion worth of commercial real estate mis-rated.  One example, according to the Financial Times, 1407 Broadway. This is a 48-story office building in New York City. The owner issued bonds worth $187 million but hasn't made any payments on those bonds in over a year. But Fitch, which is a big rating agency, still rates the bonds AAA. That doesn't seem to make any sense. That seemed like shades of 2007, where there were mortgage-backed securities issued by Wall Street that were supposedly filled with safe mortgages that turned out to be anything but safe. 

That was the 2008 credit crisis. This sure sounds a lot like that. How about a AAA bond out in San Francisco, 600 California Street? The bonds are rated AAA, but they now trade for 74 cents on the dollar. A AAA rated bond is supposed to trade at par. 100 cents on the dollar, maybe 99 cents. Not 74 cents. 

That represents a 26% loss for the investors. Or how about 1818 Market Street in Philadelphia? This is a million square feet of building filled with office space. It was, and still is, rated AAA by both S& P and Morningstar, even though the mortgage lender says the owner is in default. 

In New York, Blackstone, back in 2014, bought a building: 1740 Broadway. They paid $605 million for it back in 2014. They just sold it for $186 million. The bond that provided the money was rated AAA. The investors have lost a ton of money. And the worst example? 135 West 50th Street in Manhattan. In 2006, the building was purchased for $332 million. The building was filled with tenants. But now, the building is two thirds empty. And the owners just sold it for $8.5 million. It's a 97& loss.  

Foreclosures of office buildings, apartments, and other commercial property…it's all surging across the country. $21 billion of foreclosures just in the second quarter of this year alone.  That's a 13% increase from the first quarter. And it's the biggest foreclosure rate in 10 years.  A cut in interest rates isn't going to help these buildings that are in distress. The issue is that there are no tenants there. And with the work from home movement, that issue is not going to be solved anytime soon. 

And what we're seeing is really just the beginning. The wave is coming. Bonds tied to these buildings are starting to mature. Between now and 2027, we're talking over the next two, three years, $2.2 trillion worth of mortgage bonds are going to be coming due, and there's no way that the bond issuers, the landlords, are going to be able to pay off these bonds when they come due. So we can all watch for massive losses in certain sectors of the bond market, and in certain bond mutual funds and bond ETFs. This is all going to spill over to the banks that provided funding to those loans as well. 

So far, it's not looking as bad as 2008. That's the good news. We're about half as bad as that. But I don't think any of us want to go through something that's even half as bad as ‘08 was. And guess what goes hand in hand with defaulting bonds? Bond fraud. This is a $5 trillion industry, and in any business that big, you can be sure there are some bad players involved. 

Federal prosecutors say that some loans were obtained based on false financial statements and appraisals. Isn't there somebody we all know being prosecuted for something like this? Landlords from Cincinnati to Hartford, Connecticut to Little Rock, Arkansas; they've all been pleading guilty to federal fraud charges over these shenanigans. 

And you can be sure there are going to be more announcements coming. One academic paper published last year looked at 39,000 commercial mortgages and found evidence of fraud in nearly a third of them. Like I said, this is not likely to be a repeat of ‘08, but it is going to get ugly. 

So, what do you do about this? You need to look at your clients’ investment portfolios. Look at the bond portfolio. How much of those bonds are invested in commercial mortgage-backed securities? It's better to make sure the bond portfolio is invested in U.S. government and high-grade corporate debt. Stay away from, or if you've got them, get rid of mortgage bonds and related agency bonds like those issued from Freddie Mac and Fannie Mae. 

We need to recognize that this is a dynamic environment, very different from anything we've seen recently, and we cannot be complacent and simply say, oh, this too shall pass or it'll be okay. No, it isn't. And no, it won't.  

I've got a question that was sent to me from Frank in New York: 

“You have never mentioned managed future strategies, how come?” 

Well, Frank, there are a whole lot of things I never mention. I don't generally mention things that I'm not a big fan of. Managed future strategies? This is generally speculative activity. Managed futures are generally speculative activity. This is definitely on the risk scale, high risk. What are managed futures? Well, first let's take a look at futures. Futures are essentially contracts where you are making an investment today, based on what you think the future price of an asset is going to be. You most commonly find this in the world of commodities. How big is the harvest going to be for corn at the next season?  Is there going to be a bumper crop or is it going to be terrible because of bad weather? So you're making a bet on the future price of corn and you're going to win or lose based on that outcome. You not only have to be right about what the future price of corn is going to be, you have to be right about when that price is going to be delivered because futures contracts all expire. 

You see, if you buy a stock, you're buying it because you think the price of the stock will go up. You can hold that stock forever and eventually be right. But when you engage in futures trading, you not only have to be right about the future price, you have to be right within a certain period of time because the futures contract expires within days, weeks, or months. 

So that makes it a doubly difficult bet to win. Should you engage in managed futures? This is where you don't do the futures trading yourself. You hire a professional money manager to engage in the trading on your behalf. They manage the account for you. Hence, managed futures. 

Should you hire such a fund manager? Should you invest in such a fund? Well, chances are they know more about this than you do, so maybe that'll be to your advantage. On the other hand, if this is speculation, I don't know that hiring someone to buy my lottery tickets for me is going to do any much better than me buying my own lottery tickets. 

So, I'm not terribly sure that it's going to work out necessarily better. And second, what are the fees that that fund manager is going to charge? Could it be that the fees are so high that it erodes much of the profits, assuming there are any in the first place. So bottom line, Frank, I have never mentioned managed futures strategies because I simply don't recommend them. 

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Links from today’s show: 

Yesterday's Show on Co-signing Mortgages: https://www.thetayf.com/blogs/this-weeks-stories/parents-co-signing-mortgages-has-election-implications

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