How Vulnerable is Commercial Real Estate?

There are rumors of trouble on the horizon for commercial real estate. The CMBX index (see earlier post) suggests that we can expect a substantial increase in defaults of commercial real estate backed bonds in the next year.

If we look at the current economy, we can see that there are three factors that will put pressure on commercial real estate. The first is the slowdown in the U.S. economy which is likely to put pressure on many classes of tenants. Some will be pushed into bankruptcy and others will be forced to scale back operations. We can therefore expect a substantial increase in vacancy rates. The second is that recent high valuations on commercial real estate have justified the use of significant leverage - it's been easy to take on debt. The third factor is that debt capital is drying up. Loans will be harder to get and interest rates will be higher as lenders worry about risk.

So how much pressure can owners withstand? We can build a simple model to analyze the effect of increasing vacancy and rising interest rates. Here's the scenario:

• Building X is a 100,000 sq. ft. commercial building.
  
• The operating costs are $10 per sq. ft.
  
• Tenants pay $20 per sq. ft. (S10 for operating costs and $10 as rent)
  
• The building is 95% occupied
  
• Current cap rates are at 7%
  

Based on these parameters, the building would generate $900,000 in cash flow each year. It would be valued at $12.86 million. In our scenario, we will purchase the building at this price using a conservative capital structure of 50% equity and 50% debt.

• Total debt will be approximately $6.43 million
  
• Invested equity will be approximately $6.43 million
  
• Interest rate: approximately 6%
  
• Annual interest payments: approximately $386,000
  

With this scenario we will generate a return on equity of around 8% each year. Our cash flow is more than twice our debt obligation, so the project seems secure. But what happens if the vacancy increases and the interest on our debt starts to creep up? The following table shows what will happen to our return on equity (ROE) as these conditions change:

The yellow colour indicates where we would exceed our debt coverage ratio (in this case 1.2) and the red fields indicate negative cash flow. As you can see, if interest rates rise by 2% (realistic since the CMBX has risen 200 basis points recently) and if vacancy increases by 20% (realistic in light of an economic slow-down) we will have negative cash-flow. At the same cap rate of 7%, our building is only worth $7 million. If cap rates also increase a bit, we will have lost all of our equity and we'll be in debt to the bank.

Keep in mind that this example is conservative. There are many buildings that have been purchased at less than a 7% cap rate. And there are many buildings that have more than a 50% mortgage against them. As credit dries up and as vacancies increase, many landlords will feel the pain.