"The Commercial Real Estate Market is Imploding"

The rating agency Fitch for some time has warned of lax lending practices in the commercial real estate market. Bloomberg reports today that prices of derivatives protecting investors against default of the highest-rated commercial real estate securities have appreciated sharply in the last month, signaling the expectation of defaults ” rising to the highest level since the Great Depression.” Not surprisingly, sales of newly-issued commercial real estate debt have also slowed to a trickle and that in turn has led to a near-halt in commercial real estate transactions.

Commercial real estate brokers claim the grim views are overdone, that tenants are “rock-solid,” and defaults are well below the ten-year average. But the Fitch reports earlier indicated that some deals were being done on terms that. like subprime, required a refinancing and price appreciation to work. Since the underlying market is now in a downturn, some deals will go bad. Similarly, vacancy rates are already at 7.6% in Manhattan, and Wall Street layoffs have only begun. Whether the damage will be as bad as the derivatives prices suggest remains to be seen.

Nouriel Roubini forecast that losses in commercial real estate could reach the $100 to $150 billion level. The derivatives market appears to agree with his view.

From Bloomberg:

In the bond market, commercial property investors are about as creditworthy as U.S. homeowners with subprime mortgages….

The cost of derivatives protecting investors from defaults on the highest-rated bonds backed by properties more than doubled in the past month, according to Markit Group Ltd. Prices suggest traders anticipate defaults rising to the highest level since the Great Depression, according to analysts at RBS Greenwich Capital in Greenwich, Connecticut.

The seven-year rally in offices and retail properties ended in September when prices fell an average of 1.2 percent, according to Moody’s Investors Service. Banks worldwide are holding $54 billion of unsold commercial mortgages, according to data compiled by New York-based Citigroup Inc. that includes fixed and floating-rate debt.

Lenders are struggling to sell loans to investors after losses on debt backed by subprime mortgages to people with poor credit caused financial markets to seize up in July and August. Bonds with AAA ratings secured by properties ranging from the Sears Tower in Chicago to trailer parks in Delaware yield about 203 basis points more than similar maturity Treasuries, up from 92 basis points on Oct. 12, according to Morgan Stanley indexes.

The benchmark CMBX-NA-AAA index of derivatives tied to the safest commercial mortgage securities rose to 102 basis points from 44 a month ago. It costs $102,000 a year to protect $10 million of bonds backed by property loans against default, up from $44,000 a month ago. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.

Sales of debt secured by commercial mortgages tumbled 80 percent to $3.9 billion in October from a year earlier, data compiled by Bloomberg show. New securities backed by loans on buildings will fall 50 percent in 2008 from $220 billion this year, Moody’s said Nov. 2.

Real estate deals are coming apart at the fastest pace since September 2001, when the U.S. economy was shrinking, because banks are tightening standards for loans, said Robert White, president of Real Capital Analytics, a New York-based research firm.

About $15 billion of commercial property transactions of $10 million or more are under contract in the U.S., compared with about $70 billion at mid-year, White said. That’s unusual because the number usually rises at year-end, he said.

More than 75 have been withdrawn because banks aren’t lending, and that estimate is “probably conservative, because not all deals that blew up were well-publicized,” White said.

“The commercial real estate market is imploding,” said James Ortega, who manages $150 million at Saenz Hofmann Fund Advisory in Sao Paulo. Ortega has set trades to profit from a decline in property companies’ shares. “We’re about to experience a very significant correction.”

Mortgage brokers say traders are overreacting. Defaults are running at 0.4 percent in the U.S., below the average of about 1 percent over the past 10 years, according to Moody’s. That’s a fraction of the 15.2 percent of subprime home loans that are at least 60 days in arrears, an index by the New York-based ratings company shows.

“I always think Wall Street does panic better than anybody I know,” said John Levy, president of Richmond, Virginia-based commercial mortgage broker John B. Levy & Co.

The decline in prices of the safest types of commercial mortgage-backed securities mostly reflects a slump in credit markets, not expectations of defaults on loans backing the securities, said Michael Sun, an analyst at Wachovia Corp.’s Tattersall Advisory Group in Charlotte, North Carolina, which manages about $5 billion of commercial mortgage securities.

“They are, credit-wise, a no-brainer,” Sun said. “Nobody disagrees they are rock-solid credits.”

For the highest-ranking commercial-mortgage securities to stop paying, defaults on the underlying loans would have to soar to 81 percent, according to RBS Greenwich analyst Lisa Pendergast, based on assumed 40 percent losses on foreclosures. Investors are unwilling to buy the notes because of concern that “capital challenged” banks and investment funds may be forced to sell the securities, pushing prices lower before any recovery, she said.

“The market is priced as if it might melt down, yet real cash investors absolutely don’t expect that to happen,” Citigroup analyst Darrell Wheeler in New York said in an interview today. Dwindling sales of mortgage securities should help the market rally, he said.

In Manhattan, the world’s largest office market, the vacancy rate rose to 7.6 percent in October, the highest in a year, property brokerage Colliers ABR said. Rents increased 1.4 percent on average to $64.08 a square foot from September, the second-smallest month-to-month increase since June 2006.

The Bloomberg Real Estate Investment Trust Index measuring the stocks of 126 publicly traded property companies dropped 30 percent from its peak in February.

Developers such as billionaire Harry Macklowe, whose properties include the General Motors Building on New York’s Fifth Avenue, have struggled to finance deals.

William Macklowe, Harry’s son and president of Macklowe Properties Inc., said in a September interview the firm may have to sell some real estate to pay back $3.4 billion of short-term debt used to buy seven buildings in New York. He didn’t return calls this week.

Record-low interest rates in the past five years encouraged banks to loosen underwriting standards and caused prices to rise as much as 35 percent a year.

Banks provided loans that allowed borrowers to pay only interest, not principal, and lenders offered financing that exceeded property values, according to Moody’s. The average loan-to-value ratio reached a record high of 117.5 in the third quarter for mortgages that were turned into bonds, from 90 in 2003, said Moody’s, which bases its calculations on its own estimates of rental value.

Those are some of the same practices hurting the $10.7 trillion residential mortgage market, according to an annual survey in October by accounting firm PricewaterhouseCoopers and the Urban Land Institute in Washington.

An index of credit-default swaps on 20 residential mortgage securities with BBB- ratings, known as the ABX-HE-BBB- 07-1 index, fell to 16.84 this week from 97 in January. Credit- default swaps are used by investors to speculate on the risk of a borrower failing to meet obligations. The index falls as concerns about credit quality increase.

Bondholders helped feed demand for loans by purchasing a record $273 billion of securities backed by commercial mortgages this year, up from $95 billion in 2004, based on data compiled by Trepp LLC, a New York-based research firm.

Demand has dried up since July, when securities linked to subprime home mortgages contaminated credit markets and caused financial institutions to report losses or writedowns of more than $66 billion.

Banks also have about $283 billion of debt they provided to help finance leveraged buyouts in the U.S. and Europe that hasn’t been sold, according to research by Charlotte, North Carolina-based Bank of America Corp.

Banks are preparing to sell $15.5 billion of commercial mortgage-backed bonds, according to Citigroup, the largest U.S. financial company by assets. That compares with an average $27 billion a month through October, based on Trepp’s data. Howard Esaki, head of global commercial mortgage securities research at Morgan Stanley in New York, said U.S. sales may fall 60 percent to 70 percent next year.

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  1. Anonymous

    The type of mortgage-backed securities the Fed bought are created when bundles of individual mortgages originated by commercial banks are guaranteed by quasi-governmental agencies such as the Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae), then split apart and sold to investors. Homeowners pay interest on these mortgages, interest payments flowing through to the final holders of MBS.

    While the purchases are only temporary — the cash must be returned by Monday — one wonders how long before the Fed grants itself the power to buy MBS permanently. Either way, the Fed’s response shows that it is worried about the growing mortgage crises and willing to do anything to buy its way out of it. Unfortunately, by buying up MBS and propping up the market the Fed will only cause more harm than it already has.

  2. Anonymous

    “They are, credit-wise, a no-brainer,” Sun said. “Nobody disagrees they are rock-solid credits.”


    “The market is priced as if it might melt down, yet real cash investors absolutely don’t expect that to happen,”

    What accounts for this difference in perception? Is it purely the fear that “it might get worse before it gets better, and even if it’s almost guaranteed to get better in the long term it would be a career-limiting move to buy anything that might fall further by next quarter”, or is there more to it?

    Andrew Clavell has a post about how the valuation of CRE funds sometimes mimics a barrier option, and that this drives down their valuation significantly.

    I don’t fully follow his argument, but if he’s right, would this account for the difference in perception between what derivative pricing says CRE is worth and what property developers think CRE is worth?

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