Next Meltdown Won’t Be in Home Mortgages. It’s Commercial Real Estate.

Most investors recall the 2007 – 2009 global financial crisis and recession as the result of subprime mortgages. These included “low doc” and “no doc” loans (meaning little or no documentation or verification of claims on the loan application), inflated appraisals, low or zero down payments and continual “flipping” of homes for more expensive ones with equally flakey mortgages.

There’s a lot of truth in that description but, as always, there’s more to the story including fear on the part of bankers and withdrawals of liquidity by the Eurodollar banks. In any case, we all know the result, which was a near 50% stock market crash that took years to recover, crashing home values, mass foreclosures, and high unemployment.

The recession that started in late 2007 was not formally over until mid-2009. A residential real estate mortgage crisis is extremely unlikely today. Lending standards have been tightened considerably. Down payments of 20% or more are required. Documentation is verified rigorously. Credit standards for borrowers have been raised.

None of this means that home prices cannot go down. It just means that losses will fall on borrowers rather than banks and outside investors. Does this mean we’re in the clear in terms of causes of the next recession (which may already be here)? Not at all.

The problem may not come from residential real estate, but it will certainly come from commercial real estate (CRE).

Financing for office buildings and industrial park construction typically has two stages. The first stage is a construction loan, which typically has a two- or three-year maturity depending on how long it takes to finish the structure. Credit at this stage is based on the developer’s equity, reputation, location and leasing prospects.

The second stage is a take-out loan, which is a long-term mortgage (20 or 30 years) used to repay the construction loan. The long-term mortgage is paid with rentals from the property or sales to third parties. Credit is based on the extent to which the building is pre-leased.

So far, so good. Difficulties arise when one or more of the assumptions behind the credit decision do not play out as expected.

A construction loan may not be taken-out by a long-term mortgage if tenants or buyers of the property get cold feet. A long-term mortgage may not be amortized if tenants do not renew leases or go into default themselves.

These adverse trends have been playing out since 2020 due to pandemic-related business losses and the rise of work-from-home (WFH) arrangements begun in lockdown conditions and facilitated by Zoom, Slack and other telecommunications innovations.

Banks can work with distressed borrowers by extending maturities, lowering interest rates and hoping for a turnaround; a process known as “extend and pretend.” That works as long as the original valuations can be maintained through the absence of mark-to-market accounting.

The collapse begins when some lenders are forced to foreclose, or some borrowers go into bankruptcy. Then the fire sales begin, and true values are revealed.

Accountants quickly force other lenders to write down their own valuations. Then the fire sales turn into an out-of-control wildfire. We’re at that stage right now. The collapse and fire this time will come from CRE.

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