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Are We Following In Japan's Commercial Footsteps?

August 13, 2009 – Comments (4) | RELATED TICKERS: MPG , MS , GS

Most of the recent economic indicators have illustrated that we may be at the bottom of the residential housing market. However, it’s quite typical for commercial property to lag in recovery to its residential counterpart. As more and more bad news floats to the surface about commercial property, one has to wonder what the U.S. has in store for itself, and whether or not we’ve learned enough to dodge the mistakes and malaise that doomed the Japanese only a decade ago?  

Unlike other property cycles, this one has been defined not by overbuilding, but by over-enthusiasm from investors. After the dotcom bust, investors eagerly looked for ways to diversify their portfolios -- real estate, an asset you could touch, feel, and see --  was the natural attraction. Years of low interest rates provided cheap money and investors threw as much capital into the commercial sector as they could. And then, the recession of 2007/2008 hit. The squeeze of the credit markets knocked down both property owners and developers, and commercial mortgage-backed securities (CMBS), property loans bundled into complex financial packages, added additional headaches to investors and counterparties alike.   

THE CONSEQUENCES

Prices

Commercial property prices have plunged 7.6% in May alone, down about 35% below their 2007 peak. And although owners are typically hesitant to sell in a market that’s nose-diving, some might soon have to step up to the plate and sell -- which could push prices down even further (see chart, courtesy of The Economist). Recently a credit rating agency suggested that 3.5% of the $828 billion CMBS market has become delinquent, and that by year end that number could rise to 12%. Add to that the cost of bad construction loans, and commercial banks could be facing losses anywhere from $200 to $230 billion. Imagine the number of small banks that could go under because of their exposure to CMBSs. 

In addition, if you view this graph (courtesy of The Wall Street Journal), you’ll see vacancy rates have become worse and worse since 2008, in some areas hitting the 20% mark. For example, in Midtown Manhattan, NY, the vacancy rate has doubled year-over-year, and in most of America’s largest cities, the rates have hit astronomical numbers.  

On the surface, Real Estate Investment Trusts (REITs) seem to have rebounded, bouncing back 60% since hitting their all time low in early March. Like residential property, can’t REITs slowly bottom, and then stage a comeback? Hmm, I’m thinking -- probably not. As opposed to residentials, which typically have 30 year maturities, REIT debt usually matures after 3-7 years and then have to be rolled over, not always the easiest thing to do when credit is tight and banks aren’t keen to lend. Already, Maguire Properties (NYSE:MPG), one of the largest commercial building owners in Southern California, have been thumped on the head and kicked in the butt by rising foreclosures and delinquencies. They recently announced their plan to hand over seven buildings with about $1.06 billion in debt to creditors, just another sign that falling rents and vacancies are taking their toll. After trading for about $12 a share a year ago, the company now seems like more of a penny stock. Most analysts expect this giant to fall.

As REITs and other investors tumble, commercial banks are sure to feel the ripple. Morgan Stanley (NYSE:MS) is now mounting problems of its own. In recent federal stress tests, the company faces potential losses of 45% on its commercial real estate loans. Their exposure to institutional securities was about $18 billion as of March 31st, about double that of competitor Goldman Sachs (NYSE:GS). On August 7th, Morgan Stanley declared a quarterly loss of $1.10, its third quarter in a row of negative earnings.

Falling equities and commodities, weak economic activity, and the bursting of a long overdue asset bubble in the late 1980’s in Japan seems eerily reminiscent to what has happened here on our own turf.  Just as in the U.S., financial liberalization and tons of cheap money led the Japanese to bet on a continual rise in real estate prices. At its most extreme, prices in Tokyo’s business district were equivalent to $93,000 per square foot! The result after the bubble burst were an average GDP growth of 1.5% from 1991-1999, as compared to 4% GDP growth in the 1980’s. The total sum of the devastation in Japan caused academics and businessmen alike to refer to this period as “The Lost Decade” or “The Great Stagnation”.   

Check out some of these startling differences that may make you think twice about how likely the U.S. is to follow in Japan’s footsteps: 

--- Japanese house prices rose by 51% (1985-1991); U.S. house prices rose by 90% (2000-2006)

--- Japanese commercial prices rose by 80% and U.S. prices rose by 90% over the same period

--- 30% of Japanese households held shares in the stock market; over half of American households hold shares in the market, thus creating a more substantial impact on consumer demand

Despite both countries utilizing fiscal stimulus, capital injections, and super low interest rates to combat the economic downturn, Richard Katz of Foreign Affairs (need subscription) suggests the two recessions are drastically different and therefore we should expect drastically different results in the years ahead:   

--- Japan’s recession was due to a structural flaw in their economy that depended on weak industry, low productivity, and low personal consumption, while America’s recession was due to flaws isolated to the financial sector and was only compounded by widespread investor panic.

--- Japan’s recession affected every corporation as their entire economy was overleveraged and undercapitalized, while the majority of American corporations remain healthy.

--- Tokyo reacted slowly and ineptly, taking nine years to lower overnight interest rates from 8% to zero, whereas Washington has acted swiftly and robustly over a period of 16 short months.  

SO WHERE DOES THAT LEAVE US?

However, the U.S. has faced two bubbles in the last ten years and has fallen into the habit of borrowing money to spend our way out of it. The aggregate amount of “non-performing” assets left after both of these bubbles will be two to three times greater than what Japan had to deal with in the 1990’s.  

And while Richard Katz makes the valid argument that Japan’s recession was caused by structural flaws, essentially a “thin social safety net” that protected jobs and prohibited competition, I wonder how America is so different? Some of the main culprits of our downturn -- excessive risk taking, financial innovation and blind faith in free market corrections, and a general distaste for government interference in the private sector -- seem to also be woven into the social fabric of American capitalism. So why label the origin of the Japanese recession as structural and ours as policy-driven? They both appear deeply rooted in cultural commonplace, and if that’s correct, then are we also doomed to follow in the shadowy footsteps of a country that faced ten years of flat, dreary, productivity?

-Jordan (TMFPhillyDot)

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