This sounds really terrible, but if you thought you missed out on profiting from the massive real estate market collapse in 2008, then this may be your second chance. However, we are not talking about subprime mortgages this time. We are talking about commercial real estate. Retailers and malls have been struggling for years now, but 2017 might just be a pivotal point where the whole industry may start to implode.
The Impending Commercial Disaster
Wall Street bears are piling on bets against commercial loans and they have good reason to do so. During 2016, approximately $3.5 billion in retail loans were liquidated. The reason behind this is many shopping centers and malls depend on retailers like Macy’s, J.C. Penny and Sears to fill up their rent rolls. Unfortunately, many of these tenants cannot pay their rent anymore.
Brick and mortar stores are experiencing falling sales, which is causing store closings at an unprecedented rate since the 2008 financial crisis.
Shopping malls depend on a few big name retailers to drive foot traffic to their centers. However, when these big name stores start closing down, fewer consumers will be inclined to make the trip to these malls. With less foot traffic, smaller and less familiar retailers start losing sales, which leads to more store closings. This cycle becomes a downward spiral, leading to more vacancies and even less foot traffic.
This is very unfortunate, considering Commercial real estate prices have increased dramatically since 2009. However, with vacancies on the rise, prices have leveled off.
Commercial Real Estate Rents reached a peak during the second half of 2016. On top of reaching a high in commercial rents, the government started to enforce new laws, which require lenders to hold at least five percent of the loans they write in their books. In other words, these lending institutions could not just sell all of their loans to outside government agencies, such as Fannie Mae or Freddie Mac…like how residential real estate lenders did back in 2008. This means that lenders have skin in the game and can experience significant losses if multiple loan defaults occur simultaneously.
These two significant factors have made commercial lenders less inclined to loan money, which stalled commercial loan growth. In addition to the waning commercial lending dilemma, the whole industry seems to be on the decline. Wall Street analysts are expecting about a third of American malls shutting down in the coming years. Furthermore, Morningstar Credit Ratings is expecting about a 40% default rate in commercial loans, coming this year.
A large majority of commercial debt holders include pension funds and insurance firms. When shopping centers and malls fail, these pension funds and insurance firms will be forced to write down billions of dollars in bad loans. This will cause uncertainty in the financial system, which will lead to enormous volatility in the markets.
Investors should stay away from retail real estate investment trusts (REITs) now. This sector has been underperforming the overall market since the second half of 2016 and there is zero indication that things are about to reverse. The largest retail REIT, Simon Property Group is down over 13% YTD.
If you look at the above YTD chart of SPG, you will see big declines on large volume starting at the end of February to mid-March, and more recently from May 10th to today. This seems to be the downward trend SPG has been following since their 52 Week High at $229.10 per share on July 29th, 2016.
All the ominous signs point toward the early stages of an imminent commercial real estate collapse. Now could be a good time to short Retail REITs, like SPG. Welcome to the Next Big Short, or Big Short Jr.