Commercial Real Estate Mastery: Episode 44
A Mountain of Debt And A Flight To Quality
The $2 trillion commercial real estate debt problem is not going away, nor is the $40 trillion U.S. debt. In this Commercial Real Estate Mastery podcast we’re going to explore the impact of this growing mountain of debt on real estate investing, and what the corresponding lender “flight to quality” really means.
Episode 44: A Mountain of Debt And A Flight To Quality Transcript
I've been in the commercial real estate business for 42 years. And in those 42 years, I've seen a lot of stuff: scary, pleasant; but I've always seen it come in patterns. My very first adventure in the cycle, was back in the late '80s when we saw the Texas savings and loan crash, which just destroyed real estate down in Texas and the surrounding states. But it ultimately came back; only to be crashed again with the dot-com of 2000. And then that came back; only to be crushed again by the Great Recession in 2007-2008. And each of those respective recessions, there was one thing that came out of it, that everyone now realizes is just factual, and that's when the lenders do, what's called, 'a flight to quality.'
This is Frank Rolfe, with Commercial Real Estate Mastery Podcast. We're going to talk about this mountain of debt in America today, and the essential part of the cycle that you have to be prepared for, called, flight to quality. Now, when I say mountain of debt, man, am I talking a mountain of debt. You've got $2 trillion of commercial real estate that's coming up for renewal right now. It's going to be a bloodbath in some industries. You've already seen it. Some office buildings, people are losing 100, 200, 300 million on a single office building. It's brutal. There was a giant regional mall recently, that had a loan on it of like $240 million, that sold for $6 million on the courthouse steps. The largest building in all of St. Louis, the AT&T Tower, sold for only $4 million. It's a million-square-foot high-rise. Those are some pretty big losses. But the commercial real estate mountain of debt, has nothing to do with the US government mountain of debt. That's at $40 trillion, and only getting worse. And this is the worst things have ever been, between real estate, and consumers, and the federal government. We've never had a mountain of debt like this going into our next cyclical recession.
So here's what happens when these recessions hit. The banks, which still gotta make loans to make money... Banks can't stop making loans... What they do, is they go into a defensive mode, and that mode is called, 'flight to quality.' Now, what does that mean when the lender says, or does, the action of going to flight to quality? Well, the first thing what they're looking for then in properties, is they're looking for stabilized occupancy, given the new realities of what people want and what they don't want. In an office tower, for example, most people don't need office space anymore. We have this new thing called the internet. And so, people are doing remote work. And with AI and such, companies are running on fewer people. And so, a lot of business owners don't need as much office space. And throughout America, there's downtown areas where the vacancy is horrific. 50%, 60%. That's not going to be enough to probably pay the bills. And a bank's gonna look at that, and see that as a complete failure. They're going to see that as complete surrender on the part of the landlord to make that property fit into a modern world, and they're not gonna make a loan on it. They're going to say, "Well, my God. If that office building is at 50%, then why would I want to make a loan on that? Because if you're at 50 now, you'll be 40 or 30 in the near future."
But yet, there are some office buildings in America in very, very unique, glamorous spots: Fifth Avenue in New York, some other spots in Dallas, some in Los Angeles, some in Miami. And these office buildings are, basically, full. So despite all of the things with the internet, and people doing remote work, and all that kind of stuff, doesn't matter. They're still fully occupied. Those are the kinds of things that lenders are going to want. They're going to want things that have solid occupancy. They'll still make loans in retail, they'll even do hotels, but you gotta be close to full. If you're looking at a mobile home park, you gotta be at least 80% occupied. That's what they consider mobile home parks to be stabilized occupancy. But that's the first leg of when they say, flight to quality, what they're looking for.
Another one, is pride of ownership. That means that people who work in those spaces, who rent those spaces, they really care about what they have going on, and that the owners really care about their property, and keep them up in really good condition. If a bank goes and tours your property, and your property is a pit, they're not going to make a loan on it. Because they're going to think, "This guy doesn't really care. I don't want to make a loan with him. He's not even really a very good operator." And they're going to want to see that all of the infrastructure is in really good condition, that your roads and your parking lots, and everything, is mint and well maintained. And they're going to want to see that your financials are run on computer, and very tight, like down to the penny of everything being properly done. And then, they're also going to want to make sure that that property, even with some degree of stress testing... Which is where they put in artificial levels of vacancy that don't exist even... That the numbers are solid, and that you can meet a debt coverage ratio, and pay all your bills.
Flight to quality simply means they don't want to get burned. They want to do deals that succeed. Well, you as a buyer also just want to do deals that succeed, right? So the things that don't qualify for flight to quality, you shouldn't be buying. Don't buy things with lots of vacancy. Don't buy things in poor condition. Don't buy things that suffer from horrifically poor management that you can't fix. So if you really think about it, when banks start saying, "Hey, we're going to a flight to quality," that's a good thing for you as the buyer, because that's going to keep you out of trouble. That's going to watch over you, and make sure you do not get involved in real estate deals that you should not be involved in.
Now, you can also use this flight to quality, for other things. For example, many of these sellers know that the banks are getting tighter on their requirements. That's the perfect opportunity for you to make them do seller financing. Tell them, "Look, I can't get this property financed in its current condition. But if you carry the paper on it, we can still probably get the deal done." Many sellers know this, they understand this, and they embrace this. In past bouts of flight to quality, I've had no problem getting seller carry deals done. Sellers like it, because they get an above-market interest rate, and a first lien note on their property. And they're happy with that. But when lenders are robust, and making lots of deals, sure, a lot of sellers might rather just have the cash up front. But in environments where they can't, and they know they can't, they're more willing to take that deal. It also gives you the ability to get prices down on properties, because in times of distress, people know things are lower. And a lot of your sellers, they're more depressed, maybe, than you are, about the way things are going. And if you're a good deal maker, a creative deal maker, then you might be able to really get a bargain on top of that seller financing.
The traditional flight to quality, is nothing to be afraid of. It's just an opportunity. The old head of US Steel once said, that problems are only opportunities in work clothes. And that's exactly correct. Having bouts of economic cyclical recessions, has proven to be the one spot where most people could actually create a lot more wealth. All the way back into the earliest years of the world, you have people like the Krupp family in Germany, that during the era of the Black Plague, they sat outside the town on the little dirt road people left town. And everyone who came out of the town, they'd say, "Hey, you want to sell your farm, get some money for the road?" And they'd say, "Yeah. I'll sell you my farm, sell you my livestock and everything, because we're all going to die anyway." But everyone didn't die. And over time, they amassed massive amounts of property and land, and came out as one of the wealthiest families in all of Germany. You see the same function, cyclically, through every recession, if you're a smart buyer. And to be a smart buyer, you have to understand when that flight to quality moment comes, and to fully harness its power.
This is Frank Rolfe, with the Commercial Real Estate Mastery Podcast. Hope you enjoyed this. Talk to you again soon.
