Here’s where the incentives for the bankers get interesting. If this is a local bank financing a local commercial product, the conversation probably gets rather personal. That local banker knows the local market and has a sense of what kinds of rents are possible. They are taking depositors' money—literally the money of their neighbors—and investing it in this commercial enterprise. Hard questions are asked and whatever is finally agreed upon, we can guarantee the developer has a disproportionate amount of skin in the game.

Unfortunately, that’s not how banking works today. If the local bank has any involvement at all, it is as a broker—getting paid to make the transaction happen and then selling that commercial loan onto a secondary market—and so their main concern is twofold: (1) Getting paid the fees associated with the transaction and (2) making sure the loan meets the underwriting criteria and therefore can’t come back to bite them if and when it goes bad.

So, if the banker can legitimately certify that leases are in place to justify a $1 million valuation, that vacancies are only temporary, and that there's a good faith effort underway to fill them at rates that justify the loan, then it’s all good. Extend and pretend.

This is why you’ll often see commercial space offered with free rent at the beginning of the contract. If the developer lowered the rent by 20%, then they become insolvent and are pushed into default (that was Option #1 explained above). If they give you 20% of the rent for free—say the first year free on a five year lease—and the rest of the time charge you the elevated price, then they can claim the free months were just an incentive and the real market price is the elevated one they need the bank to certify. It's the same dollar amount just expressed in two different ways.

Centralizing commercial real estate finance dulls the direct feedback loop a vacancy should create. It changes the incentives for all the players and makes “extend and pretend” the only viable option for them to avoid serious pain. This is why we witness aggressive commercial construction simultaneous with high commercial vacancy rates and insatiable demand for housing. It’s a paper marketplace, a financial construct, divorced from reality.

So what happens when reality intercedes? What happen when we can no longer pretend?

What Comes Next for Commercial Real Estate

We’ve centralized the finance of local real estate transactions and made our markets less responsive to local conditions because it was an efficient way to pump money into the system. It was an easy way to create jobs, growth, and economic development. It was an easy way to drive up real estate prices, which benefits nearly everyone involved. In short, our desperate pursuit of inflation as a proxy for a real economy created a bubble in commercial real estate.

The dramatic slowdown of life in response to the Covid-19 pandemic has popped that bubble. We’ve seen how many corporate tenants have already stopped paying their rent, threatening the entire finance model. Billions in bailout dollars were aimed at this part of the market. The Federal Reserve is buying commercial real estate and corporate bonds in a desperate attempt to keep their prices stable. This is all an attempt to buy time in the hopes that things turn around soon. The cries you hear about restarting the economy use small business and the poor as their rally, but this is all about keeping the tear in the many bubbles we’ve blown from expanding.

The longer this goes on, the more businesses that will opt to not pay their rent. That’s not a dumb move since it’s not like a landlord can go through the eviction process with the hopes of quickly securing another tenant. Many landlords will find themselves with no income on properties that have ongoing cash demands. These are the weakest players and it won’t take them long to be forced into liquidation. This will start to happen in months, not years, although the properties could sit empty for years as tangled and interwoven claims are worked out.

The greatest drama is playing out with those properties unfortunate enough to have their loan expire during the next twelve months. We will undoubtedly find some creative ways to “extend and pretend,” and it’s almost certain that the federal government will try to bail out this system by lowering rates, extending payback terms, and guaranteeing loans. Even so, there is going to be a reckoning based on the reality that market participants — the tenants in those buildings — will not be able to afford pre-crash rates of rent.

Remember, if the rent drops, the value of the property drops. Even with a long feedback loop, that’s the constraint that can’t be avoided. Lower rents destroys the commercial real estate market along with your pension fund (as I wrote a year ago) and a whole bunch of other supposedly safe investments that were chasing higher returns. This is going to be painful, and I suspect we’ll do everything we can to blow more bubbles and try to avoid this pain.

Yet, our small businesses need lower rents. Our commercial property owners need more flexibility in how they respond to local needs. This adjustment is acutely painful, no doubt, but let’s understand that it is fixing a chronic problem that has also grown deeply painful for a broad spectrum of society.

We desperately need to get off this roller coaster, to stop inflating and then reinflating a series of financial bubbles. The reckoning we sought to avoid has arrived. Our conversation needs to shift from preventing damage to setting ourselves up for the quickest recovery. How do we use our limited resources to seed the next generation of small businesses and entrepreneurs? How do we help them get back on their feet the quickest?

We can spend billions bailing out commercial real estate investments that have lost all touch with reality, or we can spend a small fraction of that keeping our local businesses on life support, allowing them to emerge after this financial disaster (of our own making) in position to thrive in a marketplace cleared of the unfair subsidies and advantages long given their corporate competition. That’s how we respond to local needs. That’s how we salvage something from this mess.

The urgent lead to localize is upon us. It’s only going to get crazier unless we shore up the foundation of our economy. We need to start building strong and resilient places. We need strong towns.

(Top image from MoneyBlogNewz.)