Roubini Sounds Alarm About Commercial Real Estate

Nouriel Roubini, in his latest post, announces the “massive forthcoming losses” in commercial real estate. Note that the frothiness of commercial real estate has been reported for some time (Fitch first warned about it in April; Roubini made noise about it in July, when Fitch issued a second warning) but the financial media has chosen not to take notice.

While Roubini is correct to point out that commercial real estate is another train-wreck-in-the-making, it’s important to note that even by his own estimates, it’s a smaller problem than subprime. Total securitized real estate is $804 billion; Roubini estimates losses at $100 billion, perhaps $150 billion.

So the real question is where these securities would up, or more precisely, how exposed are commercial banks and investment bank? I hate to say it, but as much as hedge funds, insurance companies and pension funds will be hurt by the deterioration of these holdings, damage to them does not have serious knock-on effects, while further losses at intermediaries would. The Bank of England’s October Financial Stability Report found that roughly 15% of asset backed securities went into collateralized debt obligations. It is therefore probably reasonable to assume that at least that much of the CRE losses will actually show up in CDO losses.

In and of itself, the loss figures aren’t enough to constitute serious impairment. But given the growing residential mortgage defaults and foreclosures, burgeoning CDO problems, and increasing worry about the strength of the financial system, problems in the commercial real estate sector could have repercussions out of proportion to the size of the event.

From RGE Monitor:

While everyone’s attention is concentrated on subprime and other residential mortgages, as first reported by this blogger this past July the next shoe to drop – in the mortgage and credit crunch saga – will be commercial real estate (CRE); indeed investors’ worries and panic are now shifting towards CRE and its related securitized products (CMBS and CMBX).

Many of the same excesses that were observed in subprime – poor underwriting standards, loose and excessive lending to marginal projects – are also observed in CRE. For example, as reported by Fitch, since 2005 there has been a very sharp increase in interest rate only mortgages and mortgages with high loan to value ratios. Loans increased to 118 per cent of the value of commercial properties in the last quarter, as reported by Moody’s, suggesting widespread use of reckless negative ammortization mortgages. And while real investment in commercial real estate has been strong in recent months (growing at a SAAR rate above 10% while residential was collapsing at a negative 20% rate) there is now evidence that commercial real estate is also at a tipping point. Actually the bubble in CRE construction – like the bubble in residential construction – will soon turn into a painful bust…..

Once this slowdown in CRE investment does occur of three components of fixed investment (residential, non-residential structures, and software and equipment) could experience negative growth.
And indeed the boom in CRE investment – with excessive construction of commercial real estate is leading – like in the case of housing – to a glut of unsold or empty properties that is leading to a fall in prices. As reported by the FT: “Moody’s index of commercial real estate prices is expected to show that prices flattened or fell in September, after rising nearly 14 per cent in the 12 months to August. RBS Greenwich Capital predicts that US commercial property prices will fall 10-15 per cent next year.”

The coming meltdown of commercial real estate is also evident by the sharp widening in credit spreads for CRE mortgages and commercial mortgage backed securities (CMBS). One of the most clear signals of this extreme stressed in the non residential MBS (CMBS) market is given by the CMBX index that is reported by Markit. The data are scary: for BB tranches the spread is now over 1500bps; for BBB- the spread is 1,100; for BBB is 965; even for A is 540; and 326 for AA tranches. All these spreads have sharply widened compared to their spring 2007 levels. At these spreads the ability to finance any new CRE investment – apart from those already committed and financed – is practically null. After the pipeline of already financed projects is finished the market for financing and securitizing CRE – apart from the highest rates projects – is practically frozen. Indeed, the issuance of CMBS fell to $6.3 billion in October, down 84% from a record $38.5 billion in March that finance about half of commercial property purchases. So the CRE market now behaves similarly to the sub-prime market; it is totally frozen.

Indeed delinquency rates on CRE projects – while still modest – are sharply rising. According to the WSJ the current default rate is 7.88% for CMBS issued in the last 10 years and is set to significantly rise. And now lending standards are being tightened as the risks of CRE are emerging and the credit crunch in this market is escalating: the typical loan to value ratio is now down to 70% from 80% and higher loan margins are imposed on investors.

And since the total value of the stock of securitised commercial property loans was $804bn (at the end of the first quarter of 2007) the coming bust of CRE will lead to another round of massive losses for the banks who made these loans and the investors who bought these toxic mortgages. So expect another saga of collapsing construction, falling prices, rising default and deliquencies and massive losses for the mortgages and mortgage backed securities related to CRE. If CRE prices will fall – as expected by some – by at least 15%, the losses from CRE investments could easily be above $100 billion, possibly as high as $150 billion. Add those CRE related losses to the losses in the $300 to $500 billion range now estimated by RBS and Deutsche Bank for subprime and other residential mortgages. The financial markets massacre is just starting and a generalized liquidity and credit crunch will become full blown in the next few months.

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  1. ajw

    Doesn’t that analysis leave out the billions (trillions?) in equity value that a decline in CRE could also cause for institutions that own it?

  2. ajw

    Sorry, should have been clearer about that – I was referring to the CRE that is not securitized through loans…

  3. Peter Principle

    “it’s important to note that even by his own estimates, it’s a smaller problem than subprime. Total securitized real estate is $804 billion; Roubini estimates losses at $100 billion, perhaps $150 billion.”

    $150 billion? That’s just a bit shy of Citi’s remaining market cap. But we’re at the point where that’s now dismissed as a “smaller” problem?

    Strange days.

  4. Yves Smith

    Peter Principle,

    Ah, but keep in mind these losses are not all at Citi. We have poor chump banks and funds all over the world who own this paper!

    I remember talking several times with a former Fed economist, now head of a very successful hedge fund (and this guy is well into his 60s, so he has seen a lot of bad markets). He didn’t regard the prospect of what was then estimated to be $170 billion in subprime losses as a big deal. Its effect would have been to knock 1% off GDP growth.

    But $100 billion on top of say, $250 billion in subprime losses, plus CDO losses that could conceivably exceed subprime, well then you are talking real money.

  5. H

    “It is therefore probably reasonable to assume that at least that much of the CRE losses will actually show up in CDO losses”

    I have no hard data to back this up by, but CDO’s on CRE was a fairly new development and there were only a handful of deals done since the end of last year, so CRE losses via CDOs should be significantly below those of regular ABS (relative to total outstandings).

  6. Yves Smith


    Thanks for the clarification. Quite a few descriptions of CDOs have mentioned commercial real estate, so I didn’t want to be double counting losses (this site has been making noises about CDO losses). Your factoid, of course, makes the impact of the CRE losses greater.

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