Even as the holiday shopping season begins in full swing, the same events poisoning the housing market are now at work on commercial properties, and the bad news is trickling in. Malls from Michigan to Georgia are entering foreclosure.
Hotels in Tucson, Ariz., and Hilton Head, S.C., also are about to default on their mortgages.
That pace is expected to quicken. The number of late payments and defaults will double, if not triple, by the end of next year, according to analysts from Fitch Ratings Ltd., which evaluates companies' credit. ...
That's bad news for more than just property owners. When businesses go dark, employees lose jobs. Towns lose tax revenue. School budgets and social services feel the pinch.
Listen: This is just nonsense. The run-up in asset values that infected both residential and commercial real estate will not have the same kind of effects in both markets. In residential real estate, you see high vacancy rates in markets where the bubble was particularly large. That happens when homeowners stop paying the mortgage, the lender kicks them out and the house sits empty. The assumption in the news article is that the same process happens in commercial real estate. It doesn't.
Extended explanation and another example of financial illiteracy after the jump.
A house used as a primary residence is not an income-earning property, it's a good. The owners live there and derive other, noneconomic value intrinsically by virtue of ownership. The people who occupy it either pay what the lender will accept on the mortgage or they lose ownership and the right to live there. A hotel, mall or shopping center is an income-producing asset. It has no intrinsic value to the owner. When the revenue produced is not sufficient to pay the mortgage, the interaction between lenders and owners is different from the homeowner situation.
The value of a commercial property is determined by the flow of income it produces. Since it wants to protect the value of the collateral, the last thing a lender wants is for anything to interrupt that flow of income. Out of all the controllable factors that can disrupt that revenue, the worst is when the local community starts to believe the place is "in trouble." From the lender's perspective, it's much more important that the company that operates the property do the required maintenance and upkeep than that 100% of the debt service is being paid. Since the owners and lenders are often publicly-traded entities, they can't keep the problems a secret, but they do their best.
When individual stores in a mall or shopping center can't pay their rent, they will close. At some point, if enough stores close and new tenants can't be found, the owner defaults on the mortgage. "Default" in this context happens much sooner than in residential real estate. A homeowner goes into default only by missing payments; a commercial mortgage can be in default long before that, because most loan agreements have financial covenants that require the borrower to hit certain ratios. For example, when the debt service obligation on a property exceeds a certain percentage of the operating revenue, the loan is in default. And since the owner probably owns several properties and borrows from the lender on all of them, "cross-default" provisions throw all of those properties into default. This triggers obligations on the property-owning company, including giving the lender more control over the borrower's operations and paying down the mortgage by sending a larger portion of operating profits to the lender.
There is a saying among real estate lawyers about why their practice area is fairly recession-proof, "When times are good, you do the development agreements; when times are bad, you do the workouts." If the borrower falls behind badly enough, what happens is called a "workout agreement". The management company may be replaced, the lender gets additional protections in the form of the right to get paid out of future revenues, and in exchange the loan agreement is modified to write down principal and make other favorable changes in payment terms.
The point of all this mumbo-jumbo is this: All these mechanisms for what happens when a commercial real estate borrower gets into trouble exist because such situations are normal. The boom and bust cycle in commercial real estate is standard. You're always heavily leveraged. It's high risk, high reward. When things go well, you score, and when things go bad, you get wiped out. (See Trump, Donald.) Whatever's happening, it's in everyone's best interest to keep the business of the mall, shopping center or hotel running normally on the surface. Behind the scenes, the financial people and the business people are screaming at each other. But in commercial real estate, that's normal too.
Of course, if the economy turns down enough that tenants have to close, and enough tenants in a mall, office building or shopping center go bust, then that particular project may fail entirely. Closed stores make shoppers think the place is "in trouble", and they start going elsewhere, driving down the operating revenues in a vicious cycle. The operating company can't cover their costs for maintenance, repairs, light, water, and security. At that point, the whole place does close. People are thrown out of work if their companies can't send them to another location. But that process is largely due to the economy's effect on the businesses of the tenants; it has nothing to do with commercial real estate finance. If each of the stores that closed had their own stand-alone locations, the effect on the local economy and tax revenues would be about the same.
Here's Exhibit B, a post from Paul Rosenberg, a front-pager at OpenLeft, discussing tax policy with regard to Obama's infrastructure spending plan:
Of course, the infrastructure will be beneficial in and of itself. But if tens of millions of people will not only pay for it with their taxes, and then pay for it again with higher rents, or costlier mortgages, while a relative handful of wealthy real estate investors, land speculators and the like pocket literally billions of dollars, then it should not be hard to see how this doesn't exactly qualify as government for the people, of the people and by the people. ...
What I'm saying, essentially, is that if you capture the externalized benefits, rather than letting wealthy speculators, investors and others pocket it for themselves, then large infrastructure projects can literally pay for themselves, leaving the construction profits, jobs and all the multpilier [sic] effects as pure gravy. It is, in fact, the legendary non-existent free lunch made manifest.
The fact that he thinks he's invented an economic perpetual-motion machine should raise a red flag right off the bat. Also, he's wrong in his premise: Wealthy real estate investors don't count on asset appreciation to make money; they largely want assets to hold their value against inflation and count on the rent revenue the property throws off to make money.
But let's pretend that capital gains are where the action is for "land speculators and the like." The paradigm he's set is up is this: The government decides to build a transportation project like a highway or a train line. Real estate nearby goes up in value. Real estate investors who own such property sell it for a unjust amount of gain. Rosenberg wants a windfall profits tax levied on them, leaving the owners with what he considers to be a reasonable gain. The revenue generated would more than pay for the project, so everybody wins.
Who would pay this tax? Rosenberg doesn't say explicitly whether he'd exclude primary residences from the tax, but talking about "investors" and "speculators" implies he wouldn't tax peoples' homes. You can easily understand why politically you would have to exempt them. American homeowners see their home equity as savings. People who live near a new train line would not be persuaded that whatever gain they realize is "unjust", because among other things no one would compensate them if they lost a great deal of money on a house due to some extraneous factor.1 Such a tax on primary residences would be even less defensible in poor and middle-class neighborhoods. There would be an enormous groundswell of opposition among affected residents and local politicians alike. What legislator would touch it?2
So you can't tax peoples' houses this way. Taking residential real estate off the table means you lose a large chunk of the tax base that will realize capital gain. As of June 30, 2008, the total value of U.S. residential real estate was a little under $22 trillion. The total value of U.S. non-farm commercial real estate was only $9 trillion. Over 70% of of the value of all U.S. real estate would be exempt from the tax.
That leaves commercial real estate. For the tax plan to work, it has to be easy for the taxing authority to learn that a particular property has sold, what the sale price was and how much the profit was (if any), and there has to be a reasonably reliable means of collecting the tax. There also has to be little opportunity for buyers and sellers to structure deals in order to avoid the tax. These things are all true of home sales. Residential real estate is owned and sold in discrete units. Ownership is represented by a deed that is recorded with the local government. For each house sold, there usually is a separate sales contract setting forth all the terms of the deal, including the price. When the transaction takes place, the local government often imposes a transfer tax on the sale already, so the extra duty could be added to that. All the elements needed to impose the windfall profits tax are present, but we can't tax residences for political reasons. Applying the tax to commercial properties would only work if they are bought and sold the same way as houses, but they're not.
Commercial real estate is owned, bought and sold in a completely different manner from residential real estate. Most commercial properties are owned by special-purpose entities which have just one property each, and those entities are in turn owned by a parent company. When the parent company wants to sell a particular property, it usually sells ownership of the applicable special-purpose entity. No new deed is recorded; the only change that might occur is the address to which real estate tax bills are sent to be paid. If 100% of the ownership interests in the special-purpose entity are sold, often the transaction will be subject to the same taxes as if the underlying real estate were sold. But what if only 75% of the ownership is sold? 51%? 25%? If the buyer doesn't end up controlling the entity, then it's often not treated as a sale. Pennsylvania, for example, long followed the "89/11 rule" which did not treat the sale of ownership of the entity that owns the property as a sale of the property so long as less than 90% of the ownership interests were transferred over a 3-year period.
It gets worse. About 10-15% of all commercial real estate is owned by publicly-traded entities known as real estate investment trusts, or REITs. This lowers the cost of borrowing and lowers the risk of real estate price changes to the investor because they can buy shares in the REIT instead of actually buying any real estate. Since, as I wrote before, the value of a commercial property is determined by the revenue it generates, the capital appreciation these investors get is in the form of increases in the share prices of the REIT. For example, take Pennsylvania Real Estate Investment Trust. PREIT owns several malls in the Philadelphia area. As the economy improves in 2011 or so, stores will make more money and rents paid at those malls will go up. The value of PREIT's stock will go up accordingly, as investors pay higher prices to reflect the expectation of a greater flow of income in the future. PREIT doesn't need to sell the mall for its owners to realize capital gain, so you couldn't collect the extra tax. And if PREIT does sell it down the road, it can use the tax-avoidance tactics to minimize the effects of the windfall profits tax then.
Follow all that? If not, good. The point is that the real estate industry has long been the target of taxing authorities and has developed a lot of sophisticated methods of avoiding taxes that can be avoided. The only people who would end up really getting nailed by this tax are unsophisticated commercial real estate buyers, such as small business owners.
There's one final big problem: Timing and causation. Say you run a fledgling real estate development company. You buy an office building located in Chester, Pennsylvania, in 2008 and convert it to apartments because you accurately predict Delaware County is going to experience a population boom. Because more people are moving into the area, in 2012 SEPTA adds a regional rail stop less than a mile from your property. In 2016, you sell for a capital gain that is large enough to be subject to the windfall profits tax. How much of the gain should be attributed to your foresight about population growth, and how much to the transit project? What if you sold it the same month the train station opened? After the announcement of the project but before it opened? What if you sold while it was being built, and the construction activity was hurting your business, not helping? What if the train station were 3 miles away, rather than less than one mile? 6 miles? 10 miles? Wherever the boundary line is, property on one side of a street would get taxed more than a property on the other. You get my point.
To sum up: You'd have to exempt residential real estate from this tax, but that takes 70% of the capital gain off the table. Most commercial real estate is owned by businesses whose ownership structure and tax savvy would minimize or avoid the tax altogether. The tax would just be a trap for the unwary, unsophisticated investor and would present possible inequities in how it was applied that may even be unconstitutional. All you might accomplish is deterring such people from investing in real estate.
The point of this post is not just to say, "I know more than these people."3 The point is that before you can advocate for a policy, you really need to understand the underlying issue. We've been hearing a lot lately about the conflict between being progressive and being pragmatic. What many progressives like me hated about the Bush years wasn't just that they were practitioners of an evil ideology, it was that they elevated ideology over an understanding of the things they governed. Putting a horse lawyer in charge of FEMA is one example; putting corporate and religious allies in positions of authority over scientific and regulatory agencies is another. What they wanted to do was bad, but - fortunately in some cases - they were too inept to do it. They didn't know what they were doing.
Now we have a Democrat in the White House and greater Democratic control over Congress. Progressives want them to use their power to carry out good, progressive policies. As bloggers and activists, we should argue for those policies. But first, you have to know what you're talking about.
1 - Except for property law claims such as nuisance, which would not apply in most cases and require significant transaction costs.
2 - Rosenberg dryly alludes to this problem: "The conceptual challenges [to implementing the tax] include ethical considerations as well as other concerns." If the tax were to apply to houses, I expect he would say that the tax should apply only to wealthy homeowners. There are practical as well as legal obstacles to such a tweak. For example, the "uniformity rule" of Article VIII, section 1 of the Pennsylvania state constitution would forbid it.
3 - I do know more than these people.