This sector is in serious trouble

She works the graveyard shift at a Florida motel off Interstate 75… but she doesn’t seem to mind much.  A rather buxom blond with more curves than hard angles, Stephanie would definitely be considered a “people’s person” and enjoys meeting so many out-of-towners.

Friendly and outgoing, she’s also incredibly smart… which is probably why she was such a great commercial real estate (CRE) agent.

Stephanie’s story is typical of the industry. She quit her job in 2002 and decided to cash in on the coming real estate boom. She studied hard, obtained her residential license, and immediately set out for a glamour photo and sexy business cards to pass out to potential clients.

According to Steph, the market became so saturated with agents by 2005 that “every bored housewife’s grandmother” was selling property. Steph took another exam and graduated to commercial real estate– what insiders consider to be the ‘cream’ of the industry.

Being on the commercial side of real estate (to them) is like being an investment banker. There’s a lot of pomp and pride associated with this more complex aspect of the business.  Now you’re dealing with big businesses and huge numbers instead of kitchen cabinets and local school systems– it takes a different kind of professional.

Commercial real estate is also unique in that it is on a completely different cycle than residential real estate; when residential properties started to collapse in 2006, Stephanie thought she was brilliant for making the move to the commercial side, which in her words was ‘immune’ to a residential downturn.

Three years later, most of the news about real estate has focused on the woes in the residential market… probably because it affects so many Americans, and reporters don’t understand commercial real estate– they think a cap rate is the price for baseball hats, and a triple net lease is only used by circus trapeze artists.

Behind the scenes, however, commercial real estate is dying a slow and painful death…. hence Stephanie’s new job at the roadside motel.  This has significant consequences for the US economy and its fairy tale recovery (CRE, not Steph).

Similar to how residential mortgages were packaged up into what eventually became toxic assets, commercial mortgages were also collateralized into large bonds and sold off in the secondary market.  In fact, securitization of commercial mortgages grew from $14 billion in 1995 to $230 billion in 2007, all while mortgage underwriting standards declined.

We all know the stories of the California bus driver who ‘qualified’ for a $600,000 home loan.  Banks were smoking the same thing when they approved risky commercial loans as well.

Commercial real estate valuations are highly dependent on the state of the economy.  If businesses are cutting back on costs and unemployment is high, demand for office property, retail property, etc. will fall dramatically.  If banks no longer have the capacity to make large commercial loans, the lack of capital will further erode prices.

Furthermore, if businesses are short of cash they will be unable to meet their debt service obligations on commercial loans.

This is exactly the environment we are in today.

Property values are cratering and office vacancy rates are soaring with the unemployment rate.  The downturn has also caused a spike in delinquent payments on commercial real estate loans.

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Just last week, Maguire Properties Inc., one of California’s biggest owners of office property, handed over 7 buildings to its creditors, accounting for roughly $1 billion in debt. Unfortunately for the banks, the buildings are worth far less than the $1 billion they are owed.

Similar stories will unfold in the coming months and years, and they will create substantial balance sheet carnage for banks who are already in a fragile state… and this is why Ben Bernanke is extending his bailout TALF program through next year to account for the losses in commercial real estate.

Translation? Even the pinheads at the fed know that CRE is going to tank.   Naturally, I’m looking for an opportunity to profit from this.

To me, shorting the banks is risky– the markets are looking for any reason to buy the banks, and considering all the banks are going to be de facto government-owned before long, I’m not interested in betting against the government’s totalitarian authority.

That leaves a lot of other options, including commercial property trusts, and my favorite, commercial mortgage trusts.  These are publicly traded stocks that invest solely in commercial real estate mortgages and mezzanine debt that is often in a subordinated position.

This means that if the value of the property falls (which it will) and the mortgagee cannot pay (which they won’t), the mortgage trust company will effectively get wiped out.

Ironically, despite the looming cloud hanging over commercial real estate, many of these commercial mortgage trust stocks have had spectacular run-ups over the last few months… this screams of a low-hanging fruit short opportunity to me.

I’m in the process of researching a few of these that I will publish later on, but would love to hear from you if you have other ideas for how to capitalize on this opportunity.

About the author

James (aka Simon Black) is an international investor, entrepreneur, and founder of Sovereign Man. His free daily e-letter Notes from the Field is about using the experiences from his life and travels to help you achieve more freedom, make more money, keep more of it, and protect it all from bankrupt governments.

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