The Quiet Crisis: U.S. Commercial Real Estate

• The crisis that never was, or the one yet to come? The 5 checks in on commercial real estate

• Illinois digs itself deeper… market gives 1 in 4 odds of state default

• “Audit the Fed” is dead… how politics as usual scuttled the hope for Fed transparency

• Plus, Bill Bonner’s brave gold forecast… gold bugs, cover your ears

  In April 2007, we issued a report headlined The Second Wave of the Housing Tsunami: 2007-2011 in which we suggested commercial real estate was likely to be the second shoe to drop in what was already an unnerving collapse in the residential housing market.

Some of the more speculative plays we issued in the report panned out well for those inclined to follow them. A Countrywide put closed at a 417% gain. Another put on the “financial select” SPDR closed up 172%. And a third put on Lowe’s home improvement closed at 93%.

Today, we take another look at commercial real estate (CRE) because, despite headline-grabbing debt crises in Dubai, Greece, California and Illinois, CRE has continued to get worse.

(An aside: During the run-up in housing and commercial real estate, The New York Times Magazine called us “doom enthusiasts” because we saw the bubble brewing and recommended people steer clear and buy gold. It’s getting harder to remain enthusiastic when the doom pervades even the gold market… as you’ll see today’s episode of The 5 bear out.)

  Office vacancy rates hit a near 17-year high in the second quarter, CRE research firm Reis announced today. 17.4% of all American office units for rent are now empty, a 1.4 percentage point rise from this time last year — around the time this supposed “recovery” began.

Since early 2008, when vacancy rates began falling, the total rented office space in the U.S. dropped by 133 million square feet. That’s 4.7 square miles of nationwide empty offices… enough to cover Central Park more than three times over.

  To make matters worse: Effective rents (what tenants pay for office space) fell 0.9% from the first quarter and a whole 5.7% from the year earlier.

To the best of our knowledge, rising supply and plummeting prices are signs of a market in trouble… especially considering this great “recovery” we’re in. While stock markets may have rebounded, commercial real estate prices are up only 4.7% from their bottom, says Moody’s. And their nationwide average is still down a stunning 41% from the 2007 top.

Most estimates suggest that U.S. commercial real estate owners are facing over $1 trillion in maturing debt — the kind that will demand refinancing — over the next five years.

  One guess which city is not sharing in the depressed commercial market: Washington D.C., of course. Only 10% of office space is vacant there, the lowest of the 82 U.S. cities Reis tracks.

Ha.

  Of course, in this environment, as we’ve seen across markets, along comes China… the largest Chinese bank is entering the U.S. “large loan” commercial market.

The state-owned Industrial & Commercial Bank of China thrust onto the scene last month when it contributed $150 million in loans to the Caryle Group, helping the U.S. private equity firm keep this little number in Manhattan:

Essentially, you won’t get a meeting with ICBC unless you’re looking to take out a loan of $100 million or larger.

“Most commercial properties,” Dan Amoss notes, “purchased with high leverage during the bubble — if they haven’t yet been foreclosed on — now carry debt-to-asset ratios of well over 100%. In other words, the investors are underwater, like a homeowner with negative equity.

“But now we’re starting to see what bubble-vintage mortgages are worth. Lower property (collateral) values result in higher loss severities. And higher loss severities will prompt many bankers to accelerate the mortgage resolution process, which in turn adds to distressed supply. Loss severities on the trickle of liquidations are enormous.

“Here are 2009 loss severities by category, according to Fitch:

• Hotel: 81.9%

• Multifamily: 58%

• Office: 56.9%

• Industrial: 48.8%

• Retail: 48.2%.

“82% loss severity on hotel mortgages resolved in 2009 is mind-boggling. Translation: for every dollar loaned out to finance hotel purchases during the bubble, banks are recovering just 18 cents after repossessing, liquidating the collateral and eating foreclosure expenses.

“Fitch expects loss severities to remain very high through 2011.”

Along the lines of our April 2007 early warning “survival strategy,” Mr. Amoss had built up an impressive array of actions to take during the ongoing commercial real estate bust, including short plays of overpriced hotel stocks, makers of high-end cubicles and overleveraged REITs. It’s a portfolio worth checking out… do it here.

  Rest assured, the fates of commercial real estate and municipal debt crises are quite intertwined. Put simply, empty office buildings won’t fill up state tax coffers, nor will the ensuing higher taxes/lower spending help struggling businesses.

Thus, a chart like this is all the more stunning:

The State of Illinois owes over $5 billion in unpaid bills and is struggling to close a budget gap of $12 billion.

“This is not some esoteric budget issue; we are not paying bills for absolutely essential services,” Illinois comptroller Daniel Hynes told the Times over the weekend. “That is obscene.”

  Investors in credit default swaps are now giving 27% odds that Illinois will default on its debt.

Though we suspect Uncle Sam would come sweeping in before allowing one of his 50 sons to declare bankruptcy, it’s worth noting that sovereign debt risk — here and abroad — is getting worse every week:

This is getting pretty serious, eh? Better than a 25% chance that two U.S. states go under.

  Thus, global investors are losing faith in Build America Bonds. The spread between yields on U.S. Treasuries to BABs of similar maturity as spread to 228 basis points, the Financial Times reports. Just two months ago, the spread was 161.

  Heh, so of course… stocks are soaring today. Perhaps traders just want to take a break from the relentless selling campaign they’ve waged over the last two months.

The S&P dropped through all kinds of technical support last week… the infamous 1,040 mark being the most notable. The index is now also 16% off its highs. If you’ve been reading your daily 5 Min., you’ll recall that passing the 15% mark is not a good sign, either.

But never mind this today… the S&P opened up 1% this morning.

  That’s especially interesting, since the Institute for Supply Management’s (ISM) service sector index grew at a slower pace than expected in June. The group’s index read 53 in this morning’s release. The Street wanted 55.

  “I’d like to share one anecdote with you that says a lot about how the world is changing,” Chris Mayer wrote his Capital & Crisis readers on Friday… we think you should hear this, too.

“This week, Caterpillar, the world’s biggest maker of earthmoving equipment, said it was boosting its production in Brazil and China. It’s building a new facility in Brazil to build things like backhoes. And it is quadrupling its output in China over the next four years. It also plans to base an executive in Asia for the first time.

“Think about this: Caterpillar gets two-thirds of its sales outside of the U.S. It shed 19,000 full-time jobs last year. This year, it will hire 9,000 workers. But more than two-thirds will be outside of the U.S.

“I’ve said it before, but it’s worth repeating: Investors must look abroad for growth. In your next letter, we’re investing in Latin America, in one of the fastest-growing outfits in the region.

“Look for that new buy and your new issue! Check your inbox first thing Tuesday.”

Et voila, Chris’ new Latin American pick was just published this morning… get it by subscribing to Capital & Crisis. It remains one of the best values in our industry.

  “Audit the Fed” is dead, for now. Ron Paul attempted to sneak in his famous bid for Fed transparency in the even more famous financial reform bill. When its inclusion came to vote on the House floor, it was voted down 229-198 — despite having 320 House sponsors.

That’s fickle politics for you. Bleh. When it’s all said and done, the latest financial reform will end up making the Fed much more powerful and no less opaque.

  Interestingly, despite financial crises everywhere and blocked attempts to reign in the regulators, gold is having a lousy July thus far. From a June high of $1,261, the spot price is down to $1,190 this morning.

  “Why would gold go down so much?” Bill Bonner asked on Friday. “Because people are finally realizing that deflation is the real risk, not inflation. Gold could continue to slip and slide for a long time now… It’s hard to say. It can rise in a deflation. But it depends on how volatile and uncertain the markets appear. In a stable, Japanese-style slump, gold could go down and stay down for many years.

“But you know our thoughts on the subject. We’ll see all kinds of ‘flation’ before this crisis is over. Deflation. Inflation. Stagflation. Hyperinflation. You name it!

“But don’t worry, dear reader. There is almost no chance that governments will follow through on their promises to deleverage. Instead, they will reduce the rate at which they are adding debt. The private sector will continue to deleverage. Government ‘austerity’ measures will be blamed.

“And then? Well… who knows? But that’s probably when the printing presses get turned on… and gold enters the third and final stage of its bull market.” When the time comes, will you have a little precious metal stash of your own to enjoy? Consider adding to it here.

  “If your purpose in buying gold or silver is a precious metals play,” writes a reader over the holiday weekend, “forget about MS-anything!

“In my humble opinion, paying 1 cent extra for a slabbed modern coin (whether that be a Silver Eagle, Gold Buffalo, proof set or any other coin minted in the past 20 years) is a total waste of money. The Mint has become very capable of producing perfect (or nearly perfect MS-69) coinage. It is not rare! And it never will be.

“That is not to say that there’s no such thing as numismatic value. There absolutely is. They won’t be making any more 1794 silver dollars! There aren’t too many of those around, and are worth their high price.

“So my advice is to make a choice: Invest in precious metals and buy bullion coins without the slab (grade certification; forget proofs, too) or invest in numismatically scarce coins, where I think the slab is well worth the additional price.

”I really enjoy your publications. They have shaped my investing strategy quite a bit over the years. Thanks for the ‘eyes wide open’ analysis!”

The 5: “I agree with most things you say about buying graded numismatic coins if you want to make a silver play,” Nick Bruyer of First Federal wrote in response when we put the reader comments to him this morning by email. “It’s like buying a fully restored vintage Ferrari in order to ‘invest’ in iron!

“However, why mess with worn old U.S. coins when there are 99.99%-pure, 1-ounce silver coins from countries such as Canada and China? Easier to calculate the value and easily divisible if you ever want to divide your holdings.

“New issue coins are the single most widely collected category in the U.S. According to the leading grading services, about 65% of everything they handle are new issues. These have a huge base of collector demand, so that bodes well for their future. If your reader had bought one MS-70 graded example of each new U.S. Silver Eagle at release since they started minting them in 1986, he’d be grinning ear to ear about their current market value.

“Don’t forget that most highly collected and valuable coins started out their lives as mere pocket change. This includes the 1794 dollar he cites. It’s really a matter of budget. If you can afford top-quality mint-state 19th or 18th century U.S. silver or gold coins, by all means go for them! But expect to start at five figures per coin, with many in six figures and a 1794 dollar in seven figures. But whatever you collect, stick with a series that you enjoy or you’ll miss half the value of collecting them.”

For your reference, we assembled this special report to help you navigate the bullion and numismatic markets.

Hope you’re able to beat the heat,

Addison Wiggin

The 5 Min. Forecast

P.S. “Fraud,” reads a one-line email we received over the holiday weekend. We assume they’re referring to the SEC lawsuit against Porter Stansberry, an Agora Inc. affiliate, which last week was denied a hearing before the Supreme Court.

The original lawsuit harkens back almost a decade, to May 2001. Porter claimed to have some information regarding a deal being struck between a company that recycled nuclear warheads and the Russian government. The investor relations representative from the firm later denied important information on the deal had been given. The SEC filed suit claiming “fraud in association with the sale of a security,” and over a nine-year time frame won their case.

As this New York Times piece indicates, “It was the first time the SEC had gone after a publisher who did not have a stake in the stock in question. Normally, the laws against securities fraud are designed to prevent insider trading or manipulation by people who stand to profit through ownership of a stock.”

In fact, the information was correct and the stock did rise over time. But the contract in question wasn’t signed on the date advertised. The New York Times defends a journalist’s right to be wrong, quoting Justice Lewis F. Powell Jr., who in 1974 wrote “the First Amendment requires that we protect some falsehood in order to protect speech that matters.”

“Unfortunately,” the N.Y. Times opines, “the court missed an opportunity to uphold that principle when it refused to take an important First Amendment case last week.”

Amicus briefs filed by The Washington Post and Bloomberg also indicate a growing cause for concern over the encroachment of the SEC into an area of publishing it had not entered before. If you’re interested in hearing Porter’s point of view, you can find his essay titled “Why the SEC Sued Me — and Why You Should Care” here.

P.P.S. The one piece of information the N.Y. Times Op-Ed gets wrong, almost as if to prove their point, Agora Inc. is not Porter’s company. It’s the other way around. Agora Inc. is the parent company. Agora Inc. was dropped from the SEC suit and is not being penalized.

Neither, for the record, is Agora Financial, an independent LLC.