Remember the Last One?

Do you remember what caused the financial meltdown of 2008? Boston Fed President Eric Rosengren said it last week with elegant simplicity: the “significant decline in collateral values” of both commercial and residential real estate was “the root cause of the financial crisis,” he said. When real estate values fell below the value of the debt pledged against them, the shortfall blew a huge hole in bank balance sheets. As the banks struggled to cope, they stopped lending to their customers and themselves and the system crashed due to a liquidity crisis.

Mr. Rosengren thinks we face the same risks today. After an eight-year boom, financial institutions now hold $3.8 trillion of loans against commercial real estate (CRE), more than in 2008. Prices have gone wild. And now CRE prices are heading south once again. Green Street’s Commercial Property Price Index tracks the value of property owned by real estate investment trusts. The index fell 0.4% in May to the lowest level since May 2016.The downturn shows up in commercial real estate transactions, where problems usually first start to appear. Over the first four months of 2017, CRE transactions dropped 17% year-over-year to $121 billion and have plunged 30% from the same period in 2015 according to Real Capital Analytics. The priciest deals (over $500 million) are facing the biggest challenges with sales down 44% from the peak.

What’s the problem? This is not happening because there is some sort of crisis. This is not a crash, as during the Financial Crisis, when the spigot was suddenly turned off and liquidity disappeared overnight. Instead it’s a slow process of value destruction that is happening despite super-low long-term interest rates, enormous liquidity in the markets, and super-easy financial conditions powered by yield-chasing investors.

One of the primary drivers of the decline is the value of retail malls hit by store closings and bankruptcies as brick-and-mortar retail melts down. Consumers are cutting back and they are spending more of their remaining dollars online. So the sub-index for malls fell 2.8% in May and 5% for the past three months, and is down year-over-year. Industrial space – such as warehousing, which benefits from online retail – remains strong.

Online retailing is not slowing down…far from it. And the Fed is raising interest rates unlike in 2008.

So, we have to worry about cars and pensions and a stock and bond bubble as we have noted in recent posts. Add to this list commercial real estate, where the last crisis started. No dear reader, we never learn.