Matt is so close and yet so far on the explanation for why commercial buildings sit vacant instead of lowering the rent.

The problem with lowering the rent is not sweetheart deals or some weird local monopoly idea. **The problem is the lowering the rent will *force the bank to foreclose.***

Instead of foreclosing, both the bank and the building owner would rather keep making interest payments and letting the building sit empty, "waiting for the market to improve." This is called "Extend and Pretend."

Why does this happen?

The value of a commercial building is calculated as a multiple of the rent, so lowering the rent lowers the value of the building, which generally leads to foreclosure.

This is fairly easy to understand with a simplified example:

Suppose an operator wants to buy a commercial building. He has a few million dollars to work with, but needs a loan. To get the loan he and the bank need to agree on the value of the building.

So, the operator forecasts the building will generate $1M per year in net rent (after expenses). The owner and the bank agree to a “capitalization rate” to determine the value. Let’s say they agree to 5%, meaning the building will generate in 5% of its value in net rent per year. So you take $1M / 0.05 and the value of the building is $20M.

The bank will only lend 80% of the value, so the owner puts $4M down to get the loan.

Commercial loans are not backed by the government the way residential mortgages are. You can’t get 30 year amortization terms. Instead, loans are typically 5-10 year terms with 20% down, often interest only, and **at the end of the term the owner must pay off the loan or refinance.**

So let's assume they go with a 4% interest-only loan with a 5 year term. They owe $16M, must pay $640k per year in interest, and the full $16M is due in 5 years. They don't expect to pay the $16M in 5 years, they expect to re-finance and get a new loan.

Now, three years into this project it turns out the building operator was wrong, there isn't enough demand at the building's high rent, so the building is 50% vacant: the building is only generating $500k per year in net income instead of $1M. The owner is paying $640k in interest, therefore losing $140k per year operating the building.

That sucks. Surely he should lower the rent, right?

**Imagine the owner lowers the rent by 30% to get the building full.**

Now the net rent is $700k, the owner pays $640k on the loan, and earns $60k per year. So he's better off, right?

**NO.** Because now the financial model upon which the owner and the bank made the loan on is *proven false.*

The building is now proven to generate $700k net rent, which means it is worth $700k/0.5 which is $14M. The owner owes $16M. — more than it is worth!

This means the bank is upside down on the loan, which will trigger foreclosure. The operator will have to pay the entire $16M to avoid that, which... they don't have. If they go to get a new loan, they can only get a loan for $11.2M (80% of the real value of $14M), which means they still need to come up with 4.8M cash to keep the building. Or, the operator can give up, and lose the $4M cash they invested up front.

Note that if the operator gives up *the bank is also in a bad situation*. They can only sell the building for $14M, so they will have to write off a $2M loss.

Both the bank and the building operator can avoid this for the low, low cost of pretending that the vacancy is temporary and the market will rebound any day now. All the operator has to do is lose $140k per year on the building. Effectively, the operator is paying $140k per year in order to *not lose* $4M in equity immediately. And it takes about 28 years for that $140k per year to add up to the 4M he has to lose, so there's a LOT of incentive to find the cash and buy time to protect the original downpayment.

This is crappy for everyone. But it's the way our entire commercial real estate market works, so, for us to change it you'd be talking about significantly overhauling the industry to use some other basis for determining the value of a building and what people can borrow to buy one, which... would be hard.

So -- again, there's no monopolist required and no sweetheart deals for friends etc etc. required to explain commercial vacancy, just cold hard spreadsheets.

You can read more about this, and how commercial real estate people think about it, here: loopnet.com/cre-explain…