Wednesday, February 24, 2010

Business Financing & the Bursting of the Commercial Real Estate Bubble

A few weeks ago, I wrote about the economy in general and the commercial real estate market in particular.

Last week, The Washington Post had an article suggesting that the other shoe is about to drop when it comes to commercial real estate. The article makes for sober reading, suggesting that the commercial market is a bubble that is about to burst (although, unlike home foreclosures, it is likely that few, if any, commercial and retail tenants will find themselves out on the street because of a foreclosure).

A spate of commercial foreclosures is something we have seen before. During the S&L crisis of the early 90s, I recall one banker telling a client of mine that his project was going to be foreclosed upon and it would just be added to the pile of other properties that the bank had already acquired in that manner. The banker did not seem particularly troubled.

Just this week, we learned that bank lending dropped 7.5% during 2009, supposedly the largest annual decline since the 1940s. Is there a corollary between the dearth of lending activity and the upcoming bubble burst? In my opinion, there is; it’s not hard to imagine how the former will cause the latter. Most businesses need to be able to borrow money in order to operate and smooth out cash flow ups and downs. Debt is not necessarily an evil to be avoided and, in fact, if used wisely, is a good cash management tool. When a business needs new expensive equipment, why should it pay the full price up front when debt will allow it to amortize the cost over the effective life of the equipment? And in today’s economic climate, where customers age their receivables as long as possible, a business may need to dip into its operating line of credit to meet those obligations which cannot be aged – payroll, for example.

When banks stop lending, businesses find it hard to operate – let alone grow. And for a business that is marginally profitable, or for a business that is currently in an economic trough, the unavailability of credit can make it impossible for the business to continue. A business can, of course, ask its landlord for rent relief, but a too-understanding landlord may suddenly find itself unable to generate enough rent revenues to meet its debt service obligations or find that, even with rent relief, its business tenant cannot long survive; this, obviously, impairs the landlord’s rent revenues and its ability to meet debt service obligations. So, it is not hard to draw a straight line from the lack of business financing to the bursting of the commercial real estate bubble.

Back in 1990, I started a law firm with two colleagues. During our first year our revenues were, as one might expect for a start-up, acceptable, but not spectacular; nevertheless, we all did quite well economically because we offset the low revenue stream with a close eye on operating costs; what we didn’t make in revenues we enjoyed in savings.

While I don’t want to suggest that the road to survival is layoffs, there are many areas of discretionary spending that can be reduced if not eliminated. How many businesses have a budget that is continuously reviewed and updated? My guess is that there are very few that do. Contrary to popular sentiment, I think it’s currently prudent to sweat the small stuff.

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