Fisher Investments Editorial Staff
US Economy

Other Shoe Blues

By, 10/22/2009

Story Highlights:

  • Commercial real estate woes are worrying investors.
  • Price declines may not be due to worsening fundamentals alone. As the market unfreezes, improved price discovery may be contributing too.
  • Liquid commercial real estate investments have turned higher and often lead the market, perhaps signaling future price stability.
  • Bank failures will continue, but haven't hampered stocks yet. And even if a full-blown crisis develops, the financial system is far more prepared now than last year. 


Since markets fell in earnest in 2008, folks have been anxiously anticipating the proverbial "second shoe." Commercial real estate woes have been widely touted as just that "other shoe." Real estate investments were front and center in last year's crisis, so why not again? Mostly because that shoe has largely already dropped and is back on the mend.


It's true commercial real estate prices have declined all year, but deteriorating fundamentals may not be the only cause. With sales virtually nonexistent until recently, valuations were hard to come by—there were few price points to compare. Falling prices recently may simply be a function of improved price discovery of late. That's not a bad thing—evidence the market's on the mend and moving again, not the other way around.


Further, more liquid forms of commercial real estate investment—Commercial Mortgage-Backed Securities (CMBS) and Real Estate Investment Trusts (REITs) for example—tend to lead physical real estate prices. After moving lower last fall, CMBS and REITs are both recovering, perhaps signaling a similar future recovery in property prices.


All this isn't to say commercial real estate losses and general weakness won't push more banks over the brink. The FDIC fully expects continued failures—but they've handled almost a hundred (and counting) this year as broad markets have moved higher.


But what if the commercial real estate market deteriorates significantly from here? There are some important differences between today and last fall. For one, commercial real estate isn't the behemoth residential real estate was. The market is just a quarter ($3.4 trillion) of the $13 trillion residential market. Banks are on the line for about half that amount—and only a further fraction will default.


Even if the effects of defaulting commercial real estate loans do snowball, the financial system is now stronger and more prepared for shocks than it was last year. The feds stand ready with numerous emergency facilities tailored to fit. Banks, in aggregate, are painfully aware of possible losses and have girded themselves appropriately. Regulatory capital ratios were almost double the required minimum 6% at the end of the second quarter, up significantly from the same time last year. Even with 25% in commercial real estate loan losses, banks would safely beat that 6%. Another key difference? The biggest banks are posting big profits, not taking huge losses like last year. Wells Fargo became the latest to report a quarterly profit Wednesday.


A lurking unknown may rearrange the equation—but today's known facts don't add up to any commercial-grade work boots knocking out markets.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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