Tuesday, April 7, 2009

CRE Will Lead The Next Round Of Panic

While there are countless potential catalysts that could be considered "the elephant in the room," pension funds and commercial real estate are two growing problems that haven't really seeped into the collective consciousness of investors.


I've talked about pension funds recently (The Next Shoe To Drop.) And the Washington Post recently published an article forecasting the Social Security surplus to run out next year - 10 years ahead of what the models had forecasted. Oops. But last week we got some long expected news on the CRE front. Boston's John Hancock Tower was sold at an auction for $660 Million - half of what it was purchased for two years earlier. The structure of the debt behind this property was extremely complicated, so it could be said that the actual purchase price of the property was lower for these specific purchasers than it would have been for a third party. Regardless, the sale sets a precedent for Class A office properties.

This particular property happened to be financed by two of our best and brightest - Lehman Brothers and Royal Bank of Scotland (Greenwich Capital). It was issued as a standard mortgage with layers of mezzanine financing on top of that. Each tranche was held at various levels of seniority by various investors who held them as part of securitized mortgages via holding companies or holding companies of holding companies, etc. You get the point. Inconceivably complicated to the layman. Some of the holders of debt received nothing, while others were nearly made whole.

To be sure, this property was likely one of the more ridiculous of the financing structures among large office buildings. That is why it is one of the first to be foreclosed and subsequently auctioned off. Very much like the most outrageous of the subprime home loans were the first to be foreclosed. What it will do, however, is influence the collateral values behind 1000's of other loans on comparable properties.

Deutsche Bank is out with a report on the US CRE market. They estimate that the total decline could be "between 35-45% and possibly more." Here is a chart of prices from their report in comparison with residential prices:

To date, the commercial property market has fallen 16.4%. As you can see, the rate of decline has been far faster than that of residential. The commercial peak was about 1 year ago. Residential prices had only fallen 5% after the first year. Delinquencies are skyrocketing and scheduled maturities on the debt is slated to rise continually over the next decade.

However, the overall impact of a CRE meltdown is going to have a far different effect as did the residential collapse. I'm sure many of my readers recall the early 90's recession, whose leading cause was an oversupply in commercial real estate (I only know what I've read - I was busy collecting hockey cards back then...) Calculated Risk has been harping on this for years now: Small banks and thrifts are far more leveraged to Commercial Real Estate and Construction and Development loans than are the major financial institutions. Because of the sweet deals lenders like Countrywide and IndyMac could get in securitizing consumer and residential mortgages for sale to Fannie/Freddie, AIG, etc, the smaller banks could not compete in those markets. So they were "forced" into the commercial side.

CRE has always been the domain of the little fish. For this reason, total bank failures in the 80's/early 90's was far higher than even now. See chart below:

As these CRE delinquencies rise, we can expect to see the failure of many more small banks and thrifts. Whether the number of these failures will surpass those of the last bout of failures, I do not know. But I will go out on a limb to say that the overall size of the institutions and thus damage to the FDIC will be far greater.

I would not underestimate the contraction in CRE. Even though the overall size of the CRE market is smaller than that of the residential market, the debt is far more concentrated. A single default could be enough to put numerous financiers in jeopardy. Today, we learn that S&P is going to start downgrading large swathes of CRE debt. From the WSJ:

Standard & Poor's Ratings Services said much of its ratings on commercial mortgage-back securities "may no longer be appropriate" in light of new estimates on defaults and loan losses.

The ratings agency, which in February said downgrades would increase this year in light of higher delinquencies and expectations for an increasing number of large loan defaults, said Monday "large-scale" placement of CMBS on watch for downgrade should begin in the coming days.

S&P expects to issue the same warning on transactions involving collateralized debt obligations involving commercial real estate and re-real estate mortgage investment conduits.

(emphasis mine)

This is going to push up refinancing rates even higher, making much of it uneconomic to even bother. Below is a chart of 'A' rated Commercial Mortgage Backed Securities compared to treasuries. Even the quality paper is falling off a cliff. Further downgrades will be the final nail in the coffin.

The story is all too familiar. Builders were unable to foresee the drop in demand. The overall market ended up way overbuilt. Consumers have cut back their spending. Retail bankruptcies (like Circuit City, Linens & Things, Mervyns, etc) are pushing total vacant space higher and rents lower. And overleveraged mall owners don't have the cashflow to pay off their loans. One of my favourite shorts over the last 2 years had been General Growth Properties. They operate 200 shopping malls with a terrible business model. They are now in bankruptcy limbo. How many of those properties will be auctioned off similar to the Hancock Tower? What impact will that have on the values of other properties? What impact will empty "white elephants" have on residential values in the area? How is any of this inflationary?

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Jittery said...

GGP bull here, you must have done well shorting GGP over the years but yesterday and today have got to be scary for you, any theories on the recent volume spike?

Also, since CRE values have fallen so far already, why don't you think current values are reasonable?

EconStudent said...

US REIT index has fallen 80% since 2006 (Vanguard REIT ETF). I am wondering if right now is a good time to be a contrarian and buy Vanguard REIT ETF for example.

Matt Stiles said...


I've been out of GGP for many months now. I got out too early on the way down - as it was going through $10 IIRC. But my position was via distant OTM puts purchased with the stock near $40. I did quite well. I haven't looked at it in a while.


REITs are particularly overleveraged. Much like GGP (although they're not all that bad). I wouldn't want to be dabbling in anything that has that much leverage unless I was expecting to lose most of it.

If I wanted to get in on commercial property, I would rather wait for the economy to show definitive sings of recovery and buy an income producing property. CRE typically lags the overall economy by 18-24 months. So it should provide ample opportunity for the astute.

If you really wanted in now, you would be better off to look at some of the debt of the major operators and find one you're pretty sure will survive. Much of it can be bought at a fraction of NAV with decent yields to maturity. If they make it that far (or get gov't financing - never rule it out), you'll be paid handsomely.


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