The last time commercial real estate trebbled like it is now was in the early 90s, and that collapse did lead to a series of bank failures, prompting bailouts like we see now. But the overall impact was muted compared to the bust of the recent housing bubble, and compared to the implosion many are expecting right now from commercial real estate.
For one thing: The oversupply problem was probably more of an issue than it is now, surprisingly.
Planned construction is actually way lower than it has been.
The silver lining in today’s environment is a general lack of oversupply in most markets. New construction in nearly every sector has been below long-term trends, though some markets are struggling with oversupply problems. While ample financing was made available for development projects in recent years, the combination of supply constraints and sharply rising land and construction costs helped to keep new supply largely in check.
Amazing. It’s almost as though market forces (rising land and construction costs) prevented excess, speculative building.
Another important difference is that a lot of commercial real estate is now owned by pension funds who, to some extent, are better-equipped to take the coming hits than a highly levered bank or, as in the 90s, an Savings and Loan.
But other comparisons are less positive. The government hasn’t established an RTC-like organisation to force writedowns and establish market clearing prices.
The complexity of the capital structure on deals has also grown, creating problems:
The demand for CMBS encouraged investment banks and conduit lenders to originate massive volumes of new loans. A new moral hazard in the model emerged because CMBS loans are not held on the originator’s balance sheet, causing reduced incentives for rigorous underwriting. Competition among lenders led to increasing loan-to-values and lower pricing, which helped fuel the sharp spike in real estate prices.
In addition, borrowers looking to minimize financing costs and equity contributions often supplemented senior mortgages with an increasingly complex array of subordinate financing, including mezzanine and preferred equity positions. The complexity of the new capital structures, especially for CMBS pools, has created a nightmare for workout situations.
In the last downturn, the workout mechanism was relatively simple, primarily involving a single lender and borrower. Today, the complicated capital stack makes sorting out the interests of the different players more complicated, time-consuming and expensive. With competing interests of the various tranches engaged in tranche warfare, it is even more challenging to form an agreement in the restructuring process.