Commercial Real Estate: The Bottom is Nearing

Why losses will deepen

Ric Edelman: It's Monday, June 17th. On today's show, we're nearing rock bottom and the commercial real estate crisis, but we're not at the bottom quite yet. I'm going to tell you what's going on and what's coming next. Well, this is a show about the future, right? So what's coming next, but first let me ask you, did you miss VISION this month in Austin? VISION is the premier crypto conference for financial advisors, RIA firms, and accredited investors. I've been hosting this event for the past six years. This was our best event ever, without a doubt. But I know you probably weren't there. How do I know? Because I was. I know who was there, and it probably wasn't you. This was a really big deal event, and I'm really sorry you missed it.  

So guess what we're doing? We have recorded all the sessions, and starting today, we're posting all 18 of the sessions that we held at VISION online, including the opening presentation I gave on why bitcoin is going to rise to $420,000 by 2030. Yeah. It's just arithmetic. It's not this crazy, obtuse explanation. It's simple math. And I walk you through it real quick, real simple, real easy to help you put all of this into context. That's just one of the 18 sessions that we've got. We also have Chris Giancarlo, who's the former Chair of the US Commodity Futures Trading Commission. He's known as CryptoDad these days and called one of the most influential individuals in financial regulation. He's working on the Digital Dollar Project and he tells us all about it. We also have another keynoter, Michael Saylor, the well-known Founder and Chair of MicroStrategy, the world's largest corporate owner of bitcoin. MicroStrategy at this point owns well over 200,000 bitcoins worth over $14 billion. Michael is at our event and you'll be able to see the fireside chat between Michael and me as well. All told, all 18 sessions, over 10 CE credits in total. And you can watch all of these for just $24.99, only available through June 30. So you've only got two weeks to watch all 18 of these, pick and choose the ones you want to watch. The link for more info is in the show notes.  

So, back to commercial real estate, it is getting ugly out there. The commercial losses are rising public and it's kind of a delayed reaction. And, and let me tell you why. Most of the commercial real estate in this country is owned by pension funds and endowments and major corporations and, you know, just big, huge institutional players. And they don't operate the same way that mutual funds do or exchange traded funds, meaning these big institutional investors don't mark to market. What does that mean? That's jargon, right?  

You know, when you own an ETF or a mutual fund, you know that that fund owns a bunch of investments for you, that’s why you invest it in the fund. It's a fund that is adding your money with that of other investors and together going out and taking the cumulative total of money invested and buying a wide variety, diversified portfolio of assets because you can't afford to do it yourself. You know, you don't have enough money to buy all 500 stocks of the S&P 500 individually. 

So you put a few dollars into an S&P 500 fund. And voila, you will now own the S&P 500 because your money's being pooled with everybody else's. Mutual funds and ETFs, because they are effectively owned by their representative investors, you and the millions of others who invested in the fund, they are required by law to report the value of the fund on a daily basis. It's every day, but the mutual fund industry every day at four o'clock, they post the value based on the closing prices of the stock market for the day. ETFs, because they're using more advanced computer technology and a little bit different set of regulations, they record the value of the fund moment by moment. So throughout the trading day, you see the price of an ETF fluctuate, just like you see the price of an individual stock fluctuate.  

So you, as an investor, when you own a mutual fund or an ETF, you know, exactly the value of your investment all the time. But that's not the same for a pension fund. You see a pension fund, even though that are money comes from all of the employees of that union or of that employer or of that industrial sector, even though they, as well, are beginning pooled money, they are a single investor under the law and they don't report the value of their assets on a daily basis. In many cases, they're buying illiquid assets, such as real estate. And you know, what's the value of your house right now? You don't really know unless you get it appraised today. You don't know what the value is today. You have a general sense of the value of your house, but you really don't know exactly. 

So that's how it works for pension funds and endowments and insurance companies as well. They're not valuing the assets in their portfolios moment by moment, like a mutual fund does, they only do it once every few months. They may do it quarterly, they may do it annually. So they're not marking the value of the investment to the market today, mark to market, they're not doing that. They're reporting today the valuation as of the last time they got the properties appraised, which might not have been for several months, even as long in some cases up to a year. So when they tell you the value of their pension fund, in many cases, based on the assets in the fund, they are reporting old data, which may not reflect the actual current market value. 

So that's kind of what happens in the world of pension funds and endowments and such. And so you might not know that your portfolio is lower in value than you think it is because they haven't mark to market, they haven't updated it. The California State Teachers Retirement System has $48 billion in commercial real estate. That's 18% of their total real estate holdings. And they have now recently reported that it's down 9% compared to a year ago. Privately managed funds that own real estate that fell 12% in 2023. They're only just now getting around to telling us this and that's twice as big a loss as they had expected. 

And the biggest pension fund of all CalPERS. The California Public Employees Retirement System. I mean, just give you an illustration of what they're now reporting in the early 2000s, CalPERS bought land for $87 million. They were going to take this land and build two huge condos, two 53 story towers. 

Now you fast forward 20 years later, that land is still empty. They've never developed it. And they've now sold the land that they paid $87 million for 20 years ago. They just sold it for $17 million. They also bought a building in New York, 10 East 53rd Street. They bought it in 2012 for $57 million. They just sold it for $7 million. 

And then there's the building near Columbus circle in New York, 1740 Broadway, it's a 26 story building. Blackstone bought it in 2014 for over $600 million. They borrowed $300 million against it. And they just sold it last month for less than $200 million. This is the kind of stuff that's going on in commercial real estate these days. And very often the entities that are owning these properties have not been reporting the declining market values of the properties because they don't mark to market.  

And there's more, and there's more. Canada's pension fund bought a property in 2014 for $219 million. They just sold it for $44 million. Well, now that these pension funds are selling the properties, even though they're selling them at massive losses, they are now marking to market because they have an actual price. So they were carrying the property on their books for $200 million, even though they just sold it for $44 million. So they're now suddenly reporting massive losses.  

In Washington, DC, 1101 Vermont Avenue, back in 2018, it was valued for $72 million. It just sold for $16 million. In Chicago, a pension fund in 2012, paid $51 million for 300 West Adams Street. They just sold it for $4 million, 12-year, 92% loss. The wall street journal quoted a law firm recently that is heavily involved in the negotiation of commercial real estate deals, especially dealing in cases where there are disputes over the value of properties and delinquencies and mortgage balances is outstanding and so on, and this law firm was quoted as saying quote, “There's a lot more trouble coming... if we think it's bad now, it's going to get a lot worse.” And Cohen & Steers, a big fun company, says quote, “We're not at the bottom yet.” All told there are seven hundred thirty seven billion dollars worth of office loans. We're talking three quarters of a trillion dollars there are those loans are owned by large banks, regional banks, insurance companies, and other lenders, so it's one thing for you to be someone who decides to invest in real estate, but what if instead you are somebody who decides to loan money to people who invest in real estate, who's really taking the big risk here? 

Well, both of you, I mean, think about it. If you buy a house and you borrow money to do it and you can't pay off the loan. You lose the house, which means you lose your investment in that house. But the lender also loses if the house has fallen so much in value that they can't sell the house for as much as they had lent on it. 

That's what's happening. We've got three quarters of a trillion dollars worth of loans on these real estate buildings. And the buildings aren't worth as much, forget about what they were paid to buy the buildings, they're not even worth as much as were lent on the buildings. So not only are the investors getting wiped out, this is posing big potential losses for the lenders, who are large banks, regional banks, insurance companies, pension funds, endowments. 

And we can see why the real estate market is suffering so much in the commercial sector. The national vacancy rate is 22%. In fact, it's gotten so bad that some of these lenders are engaging in what Wall Street is now calling extend and pretend. In other words, I'm your lender, and you bought a building for $500 million. I lent you $300 million to do it. That $500 million building is now only worth $100 million. So, you're out $400 million if you try to sell it. But wait, I'm out too, because I lent you $300 million. The market value of the building is only $100 million. I would lose $200 million if that building were to be sold. So not only do you lose, so do I. So what do I do? I ask you why you're not paying me your rent, and your answer is, well, there aren't enough tenants to pay the rent, and many of those tenants are financially struggling. They don't have the money to pay their rent. So you, the landlord of the building, you're in delinquency. 

You aren't paying me the mortgage payment because you're not collecting the rental income because you got 22% vacancy rate, and some of the people who are still there aren't paying you as much or all of the rent that they owe you so you can't pay it to me. Everybody's losing in this scenario. Well, I could foreclose on you, but that doesn't do me any good. It's a $100 million valued building against a $300 million loan I don't want to foreclose on you because I don't want to own a building that's worth less than what I lent. So what might I do? Here's what lenders are doing. Extend and pretend. We're extending the terms of the mortgage that I gave you. Instead of that loan being due this year, which would force that foreclosure issue, I'm going to let that loan go for another five years, and I'm going to hope that by then, the value of the property will rise where you'll generate enough tenants to generate the rental income that you need so that you can make the mortgage payment to me. I'm going to pretend that this is all going to work out with this new extended loan.  

Well, so far, this isn't working for anybody. Only half of workers are going into the office on a daily basis across the country. As a result, companies that are in those buildings have no intention of expanding their leases. In fact, they're shrinking because with only half the people in the office, they only need half the space. And as a result, we're seeing that new office leases are down 25% from 2019. So we've not recovered from the pandemic. You add it all up, and there's $56 billion worth of real estate at risk right now. 

But here's one piece of slivering good news. Most of the defaults that the industry is worried about is concentrated in 10% of all the office buildings nationwide. So most buildings are not suffering this cataclysmic scenario that I've been describing for you. Most buildings are either fairly priced, they don't have big mortgages on them, or they're fully leased and they're generating the rental income that they're supposed to be generating. 

That's true. Nine out of 10 times, but in 10% of the cases, we are anticipating defaults. We've already been experiencing some of them, but we're not sure exactly how many will. In fact, we're not even going to know how bad it really is until next year. And that's because of the delayed reaction that occurs in real estate. See, foreclosures are the key. When a lender takes over a building, we know at that point what the value of that building is. We know what the rental income is on that building and so on. But foreclosures don't occur until after the property owner falls behind on the payments. And that doesn't happen for a year. 

So all we can look at right now is the delinquency rate. How many landlords are delinquent on their mortgage payments? Right now, 7%. That's double from a year ago. So the number of delinquencies is rising at a fast clip. That's a warning sign. We haven't yet gotten to the point of foreclosures, but we're going to be. Already, there are three times as many buildings in foreclosures as a year ago, and this is going to spill over, not just affecting that tenant and that landlord and that mortgage lender. It's also going to spill over. To investors, not just the investors of the real estate, but investors in securities based on the real estate. 

Ever hear of a CMBS? Oh yes, you have. You remember them back from 2008. Collateralized mortgage backed securities. Yeah. You remember these. These were the cause of the real estate collapse of 2007 and 2008. And they're back. A lot of companies that have been providing loans to the real estate industry have been taking all of those loans, packaging them into securities, just like they did in 2008. And they are called collateralized mortgage backed securities. And the buyers of these securities, not only pension funds and endowments and insurance companies and other institutional investors, it's also mutual funds and exchange traded funds. Ordinary retail investors own these things in their mutual funds and ETFs usually without knowing it. One AAA rated MBS was recently sold for a 25% loss. The funds that owned the lower rated bonds in that CMBS, they just lost their entire $150 million that they had invested in it.  

So we need to recognize that the prices are collapsing in sectors of the commercial real estate market. We are near the bottom of this. We're not there yet. We'll know around this time next year, when the bottom can be expected to be hit, we're getting close to it. And what does it mean for you? It means that when we are approaching the bottom and we're kind of getting close. It's going to be an outstanding investment opportunity. 

Bad news. Woe is us for those who bought real estate over the last five and 10 years, but it's going to be exciting news for people who are thinking about buying real estate now, because the prices are falling dramatically. And that represents terrific investment opportunities. So stay tuned, pay attention. I'll continue to update you on the status of the commercial real estate market. 

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Ric Edelman: I’m glad you’re with me here on The Truth About Your Future. Ric Edelman here. If you like what you're hearing, be sure to follow and subscribe to the show, wherever you get your podcasts, Apple, Spotify, YouTube – and remember leave a review on Apple podcasts. I read them all! Never miss an episode of The Truth About Your Future. Follow and subscribe on your favorite podcast app. 

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