We Haven’t Seen Disruption Like This Since the 1930s, Says Chris Whalen

Mon, Jun 29, 2020 - 2:09pm

“Social distancing means financial Armageddon for commercial real estate and municipalities in coming months,” wrote Chris Whalen. He recently joined FS Insider to discuss this financial disaster as well as its societal effects. Chris is the chairman of Whalen Global Advisors and the editor of the Institutional Risk Analyst. See below for excerpts from his interview.

For audio, see Commercial Real Estate Facing a Big Price Adjustment, Warns Chris Whalen.

A Business Insider survey found that more than two-thirds of companies could be working from home forever. What do you do with all that extra office space?

You don't use it. And the pricing has to change. You know, New York was built by the Dutch and it was built for density. It was laid out in a grid intentionally. They wanted people to be close and be able to get from here to there. Remember, New York is an old city, the stock of housing here is old. There are a lot of old office buildings in this city, and I just don't think they're going to have any utility in this world of, shall we say, mobility.

In the past, we talked about that as a voluntary evolution. Now, I think it's going to be mandatory, because there's no commercial owner out there who's going to let people into a building unless they sign a waiver.

So, imagine theaters and other types of buildings that are set up for the public. We're very involved in the arts community here in New York. All of the major ballet companies are not working. American Ballet Theater and New York City Ballet—they cannot perform. They're doing stuff online, but that's not going to make it work. It’s the same issue with high-end restaurants that can't do takeout or won't do it.

If you have to cut density in half, we're going to double prices. That's it. There are a lot of rigidities here in the marketplace that are not going to change immediately. I have several friends in the restaurant business and what they've done is they've gotten rid of their waitstaff and they went to 100% pickup and delivery. And they can survive, because their costs have come down so much in terms of labor. But what do we do with these people?

You know, you look at these protests for Black Lives Matter and the horrible things that have happened in Minnesota and Georgia. And most of these are kids. These are kids who were working as freelancers, who were working in restaurants and other types of service businesses because they were trying to get started in life. That whole sector of the economy is gone.

What are we going to do with those kids? It's a huge problem. It's a social problem. And it's an economic problem that nobody anticipated...this is a black swan. This is what Nassim Taleb wrote about. It's totally out of left field.

You recently wrote that the commercial real estate sector is facing a financial Armageddon. Can you explain that?

It's going to be a case by case analysis and I'll try and explain. In the world of residential mortgages, we make observations and generalizations at the pool level, thousands of mortgages. And since the credit is all the same, most of them are guaranteed by some government agency. It's easy to do that. Commercial real estate, though, is totally different.

With commercial real estate, in many cases these are large loans and they will oftentimes have properties where there are multiple tenants. So, in other words, to assess the credit of retail space, office space, whatever it is, you look at the building, you look at the amount of debt, and then you look at the rent rolls, how much they get paid. You look at the taxes, all these components.

Now, there are times when you could have a commercial property that is underutilized, that is not fully let and they can still survive. In other words, they throw off enough income that they can pay the taxes and keep the lights on.

But, in this case, you have mass disruption of all these small and midsize companies, many of which are tenants and, in some cases, they own the property. That creates a big problem because it's not just a specific geography. It's not just a specific, narrow slice of the world. It's a horizontal slice of the world.

That's why I use that kind of grim terminology because we haven't seen this kind of disruption since the 1930s. It really goes back to the Great Depression. I think it's important for people to understand that while the financial system in the U.S. is well capitalized, and while they are going to be able to plow through it, it is going to be ugly.

For certain bond investors particularly, it's going to be extremely difficult because these deals will have to be restructured. And when you use that word, it gets people's attention. All the major agencies do great research on what are called commercial mortgage backed securities. They put out reports when the deal is first done and then they have surveillance reports as they go. These reports are very interesting because they show you the detail you have to get into.

They look at the mall, they look at the tenants in the mall. They look at the other factors, like are people coming to the mall, how’s traffic, those kinds of things. You have to analyze each one of these loans individually and that's what makes it so laborious.

That's why you have a cottage industry by the way of the major rating agencies and other firms that just do this. They just follow the credit of this asset class because it's big. It's a couple trillion dollars for the securitized commercial mortgages.

What are some of the ripple effects you expect to come from this?

I think it's going to slow down the economic recovery. The financial markets bounced back in large part because the amount of liquidity the Fed is pumping into the system right now. It's quite striking. We saw deposit growth in double digits in the first quarter of this year, and that's just the last two weeks of March. Just imagine what that's going to look like as we get to second quarter earnings.

But I think, overall, what we're dealing with in commercial real estate is to some degree a symptom. It’s related to a much broader problem, which is a disruption in services and the disruption in other industry sectors that are adjacent to services and it’s going to be medium to long term. I just don't see these restaurants and these other public establishments coming back soon.

You have to realize that when somebody opens a little bodega, or any kind of establishment like that, they usually don't have a lot of capital. And it's the vendors who extend them credit and say, here, I'll give you a delivery or soda, or whatever it is, right, to get something started, and they start making money. Over time, hopefully, they can build a little nest egg. But small businesses don't make a lot of money, especially in New York City, where it's very costly to deal with the city and all the other regulatory elements.

I think politicians naturally are going to have to become more business friendly. When we put aside the progressive rhetoric, we're going to have to find jobs for people because the federal government can't subsidize this forever and the states certainly can't.

I think that's going to represent an interesting opportunity for new leaders to come in and start talking in realistic terms about what we have to do to help these communities get back on their feet. You have hundreds of thousands of people right now that don't have any employment. What are we going to do with them? This is a 1930s scale problem and I think the government needs to think in those terms...

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