🐕 Commercial Real Estate Bubble: Muffin or Chihuahua? 🧁

I hope that you find yourself in the company of good friends and family celebrating the amazing quality of life and opportunities that we have in the United States that are anything but accidental. Today may we all remember the blessing of the wonderful country we call home, and the people that dedicated their lives to building it and protecting it.

For today’s newsletter I wanted to circle back on something else I hinted at in a prior one. Residential real estate is looking pretty healthy, but there is a bit of concern within the commercial real estate space. Commercial real estate has had a really big shake up since COVID that is still playing out. Namely, office space became pretty undesirable, capital flowed from certain geographic regions and into other ones, and loan interest rates were slashed to once in a lifetime lows that created some really high valuations.

Take all this together, and you can potentially get what some people call a “bubble.” People use the term all the time, but what is it? Well, bubbles are when an asset develops a valuation that’s unsupported by the underlying conditions or is susceptible to changing conditions so it can quickly deflate. But as we shall see, predicting whether a bubble will pop can be tricky to do - much like identifying chihuahuas amongst muffins.

Commercial real estate is bought almost exclusively as an asset to produce a return. When loan rates are low that means that the property cash flows more than when rates are high (all other factors being the same). Well, usually they don’t stay the same- price tends to go up during low rate periods because it allows investors to still get a desirable return while paying more for the property. The issue starts to come to a head when loan rates increase and it puts downward pressure on price.

In addition, during COVID a lot of people bought commercial properties with a type of loan called a bridge loan that is really really short (like 3 years) and used to flip commercial real estate. As those loans are coming due, a lot of our property owners are in a tough spot. When they bought, they were expecting rates to stay low and values to stay high, but they’re not.

Their properties are worth a lot less now, some of them less than what they paid so they can’t really sell without having to come out of pocket. They can’t really refinance into a new loan either because the bank doesn’t want to lend to them because the income the property makes won’t meet the “debt service coverage ratio” for a new loan at the current rates. At the same time a lot of the banks that made these commercial loans in the past few years are those stressed regional banks, and they really don’t want to foreclose and become the owner. They just want their money back. For some commercial real estate owners “How it started” vs “How it’s going” is pretty stark.

If you want to read a more in depth article on this, Charlie Munger, the vice chairman of Berkshire Hathaway was interviewed about this recently, and he’s got 99 years of life experience. Needless to say, he’s a lot smarter than me. Here’s the link.

Now that doesn’t mean that it’s going to implode. As I said earlier, there is a lot of stress in the commercial real estate space, but the bubble may not “pop” the way many fear. There are a lot of variables at play, and if the space starts looking way too stressed, the Fed could start slashing rates again or banks and property owners may negotiate some terms to get through the short term in hope things will improve once inflation is tamed. There are options for sure so let’s hope we as a country can dodge this bubble bursting.