Are commercial properties and community banks the next financial dominoes to fall?
According to a report by the Congressional Oversight Panel, nearly $1.4 trillion in commercial real estate loans are coming due and will need to be paid off or refinanced over the next five years, but almost half of those loans are for amounts greater than the market value of the property. Unlike thirty-year home mortgages, traditional commercial real estate loans generally cover terms of only three-to-seven years and require larger down payments. Now, struggling tenants are going out of business or negotiating for smaller spaces, and loans secured during the height of the real estate boom are completely underwater, leaving many landlords scraping to meet their debt obligations and holding too little equity for refinancing.
The Oversight Panel’s report notes that a bank overexposed to commercial real estate might hoard capital to offset future losses: “The lack of lending may mean that small businesses that rely on the bank as a source of credit will be forced to shut their doors. This drives up vacancy rates on commercial real estate in the local region, which puts more downward pressure on real estate prices. And those falling prices can lead to additional write-downs in the bank’s commercial real estate portfolio.” Such write-downs, of course, might cause a bank to hoard cash, intensifying this vicious cycle. It’s bad for the landlords and bad for the banks, but not all landlords are created equal.
According to Paul Gamberdella of Radius Group Commercial Real Estate, “Commercial property owners in Santa Barbara County tend to be high net worth individuals who are not highly leveraged on their commercial assets.” This sets Santa Barbara apart from many commercial real estate markets. (Entrepreneurial investors don’t fall for the old adage, “This time is different,” but we do believe that, sometimes, “this place is different.”)
Jim Knell, founder of SIMA Corp., recently purchased a three-story building in downtown Santa Barbara. According to one local paper, “Where other landlords are feeling the squeeze of the credit crunch, Knell said he avoids banks altogether and pays ‘all cash’ for his acquisitions.”
Tom Parker of the Hutton Foundation says that Knell’s example is not unique. “A great deal of Santa Barbara real estate is owned with little leverage and most landlords can withstand the downturn and hold onto their properties.” Cash deals and alternative financing come to the fore in times like these, and savvy investors use both to act on exceptional opportunities.
Moreover, such landlords have greater flexibility to work with tenants. Gamberdella notes, “Because many South Coast commercial property owners are not in a ‘have to sell’ position, their number one concern is keeping existing tenants or doing what it takes to attract new tenants.” Strategies include aggressive promotions to “make the first deal,” since the next interested tenant may not appear for months, and “blending and extending” existing leases by lowering the rent but extending the term, locking in reliable tenants. Less leverage means more opportunity to adjust to market shifts.
When landlords do not rely on conventional loans, those loans are easier to get, further extending one’s flexibility in the marketplace. According to Parker, “Banks are always ready to loan when the loan to value ratios are very low.” He also points out that when vacancies rise and rents drop, the effect on a property’s capitalization rate might make it less attractive to a seller, but that doesn’t matter to landlords who aren’t selling. If one owes little and/or bought the property at a significant discount, one can remain cash flow positive with surprisingly low occupancy.
Broader economic and environmental benefits may spring from the character of Santa Barbara’s commercial real estate market, because low-debt landlords tend to invest in maintenance and improvements to their buildings. In addition to providing jobs, we suspect that many local landlords will seize the opportunity to make their buildings less polluting and more energy efficient. Our own office building received the first Leadership in Energy and Environmental Design (LEED) Commercial Interiors Remodel Platinum certification in Santa Barbara, according to the U.S. Green Building Council. LEED certification is a good fit for Santa Barbara’s culture and economy, so we expect to see many more green remodels in the area.
Whether one invests in real estate or stocks, leverage is a two-edged sword, making big deals possible in good times and treacherous in bad times. We believe that commercial real estate in Santa Barbara should weather the next round of recession aftershocks better than much of the country, but there will still be plenty of pain for over-leveraged owners and the community banks that provided that leverage. However, entrepreneurial investors think long-term, and must consider that a sparsely populated, beautiful beach community surrounded by magnificent mountains ought to do pretty darn well over time.