Why losses at its commercial property unit could continue even after the market stabilizes
In 2008, the first full year of the recession, General Electric's (GE) commercial real estate business made a $1.1 billion profit. Now, even with signs of the broader economy improving, analysts estimate it could be five years before the unit earns another cent.
Such is the nature of economic downturns for investors in office buildings, apartment complexes, and shopping centers. Commercial real estate tends to be the last industry to lose money and the last to recover. What's different now is that players such as GE that didn't take too many risks will find themselves stuck in the quagmire of excess space, falling rents, and tighter credit even after demand picks up. While rental rates and property values should turn around in 2011 and 2012, analysts figure GE's portfolio may suffer at least until 2014. "There is a dramatic lag effect," says C. Stephen Tusa Jr., an analyst at JPMorgan Chase (JPMC). "They are going to take their lumps." He estimates GE's properties will lose $8 billion in value through 2012.
As one of the biggest real estate investors in the world, GE is a proxy for what ails the market. "If you were a dominant player, you've got problems," says Paul M. Fried, a managing director at investment bank Traxi. Like many, GE doubled its bets in the last two years of the boom as lending standards slipped. By the end of 2008 the company owned 3,200 properties and held the loans on an additional 4,800, altogether worth some $84 billion as of June—more than all but Wells Fargo and Bank of America (BAC), according to research firm SNL Financial.
Now GE is crashing along with the rest of the industry. Delinquent and bad loans climbed sharply to 2.9% in June from 0.4% in December. The weakness will weigh on the entire company. (The unit, which is currently losing money, accounted for 18% of profits at GE Capital in 2007.) To deal with losses and potential regulatory requirements, GE may have to raise $40 billion in additional capital, estimates Nicholas P. Heymann, an analyst at research firm Sterne, Agee & Leach. GE acknowledges the unit will lose money this year but says that it won't need extra capital.
GE's losses likely will continue long after commercial real estate stabilizes. Why? As old leases come up for renewal, GE and other owners are reluctantly locking in recession-era rents to fill vacant spaces. U.S. office rental rates, which hit $24.65 per square foot in 2008, will fall to $21.34 in 2011, estimates Victor Calanog, research director at Reis, a real estate data firm in New York. Players such as GE will be stuck with those low rates for a while since leases on office space run for 5 to 10 years. That means even when market rents start to rise, GE can't hike rates until current contracts end.
Meanwhile, the values on GE's properties continue to slide. It paid $2.2 billion for a set of office and other commercial buildings in Canada at the peak of the market. Among them: a 259,000-square-foot building in midtown Toronto whose vacancy rate is nearly 30%. The properties are worth about 25% less today.
GE can weather the storm better than its peers. "We are a real estate company, as opposed to a bank," says GE spokesman John Oliver. "We're better off in the sense that we're not afraid to have these assets on our books." For one thing, some 95% of its loans are first mortgages. When borrowers fall into foreclosure, the company recoups its money before others.
GE also owns roughly 87% of its buildings outright, meaning it didn't rely on a partner or a mortgage to buy the property. By paying cash, GE confines its losses to the building's price decline—say, a 10% hit if the value falls 10%. Property owners that used debt to finance their purchases experience a greater loss.
The company, which bought properties on the cheap after the savings and loan crisis in the 1990s, also has a well-worn playbook for dealing with distressed properties. When it forecloses on a borrower, GE moves quickly to salvage the existing value from the property. It may renovate, update the amenities, or use local connections to drum up new occupants. "We take over assets ... and run them like a factory," Ronald R. Pressman, CEO of GE Capital Real Estate, said in a conference call with analysts this year.
GE is also redeploying its real estate specialists. Teams in 97 offices across the world, which previously focused on dealmaking, are now managing buildings and reworking loans for troubled borrowers. The company has been working to extend the terms on nearly two-thirds of the debt coming due this year. It allows GE to collect extra fees along the life of the loan while reducing the chances of default.
But such measures will only do so much for GE. The bottom in the commercial market is still a few years away. And the broader economy is unpredictable; if the recession continues longer than expected, a recovery in real estate may be delayed. Says Christopher J. Panos, a lawyer with Craig & Macauley in Boston: "There are a lot of issues in commercial real estate portfolios that just haven't been dealt with."