Quelle Surprise! Commercial Real Estate Loans Looking Wobbly

A story in the New York Times warns, “Some Fear Commercial Property Loans Will Be Next Stage in Downturn.”

This is news? I’m in a lazy mood, so I will merely search old posts.

Fitch warned in April 2007 (yes, the year is no typo) of the lousy quality of commercial real estate loans and predicted higher defaults. We noted:

The same overly aggressive lending practices in operation in the subprime market, such as 0% down, overly optimistic forecasts, and loan structures that make sense only if one assumes a refinancing in the not-too-distant future, are also prevalent in commercial real estate. But because most commercial real estate markets are still strong and occupancy rates are high, the risks have not yet come home to roost

Fitch issued another warning in July 2007.
CMBS spreads widened markedly in July 2007 and August 2007

In September, investors start anticipating a 15% fall in commercial real estate prices for 2008 and get leery of completing deals

In November, Nouriel Robini describes the commercial real estate market as “totally frozen,” point to rising delinquency rates, and predicts a “coming meltdown.” Imagery a bit mixed, but the message is clear.

A couple of weeks later, the MIT Center for Real Estate reports that commercial real estate prices are falling

Showing that the often colorful Roubini wasn’t exaggerating, a Bloomberg story at the end of November said:

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

That should prove the point, particularly since this blog isn’t real estate focused. No doubt you’d find at least five times as many posts along those lines at Calculated Risk.

Now, kvetching over, the New York Times article can more accurately be read as an update on worsening conditions in a market that has already taken some knocks. This development was foretold at a panel sponsored by RGE Monitor in New York in May. One theme (Chris Whalen of Institutional Risk Analytics and Roubini in particular made much of this one) was that the next leg of the banking crisis would hit when regional and local banks started taking writedowns. That would create a feedback loop, since those banks have a much higher proportion of their balance sheets in real estate (not just residential but also commercial, particularly construction lending).

And we have so far neglected to mention the most obvious reason for flagging conditions in commercial real estate: a weak, probably deteriorating economy. Office space rentals are a function of employment. Weakening consumer spending hurts retailers; the number of shuttered stores and restaurants rises in a downturn. And as the Times implies, those overly-optimistic, end of cycle deals are coming apart.

From the New York Times;

A default by the complex, the rent-regulated Riverton Apartments, a 12-building residential development constructed after World War II, would be New York’s largest in the current housing crisis. For Wall Street banks, which hold about $100 billion of commercial mortgage-backed securities, the prospect has fanned new worries that a deterioration of the overall commercial property market could prompt more write-downs in the coming quarter, on top of losses already expected from their distressed mortgage securities holdings….

At the end of the second quarter, Deutsche Bank held $25.1 billion worth of commercial loans. Morgan Stanley held $22.1 billion and Citigroup had $19.1 billion.

Lehman Brothers, which has the largest exposure to this type of security, is shopping about $40 billion worth of commercial real estate assets, as well as its entire commercial real estate business. A large part of its portfolio is a high-risk loan known as bridge equity made with Archstone, a metropolitan apartment developer, and most of the rest are floating-rate loans, which are riskier, according to a person who reviewed the offering.

Banks are scrambling to dispose of these loans, typically made to hotels, office developers and retail strips, before problems arrive.

Yves here. A little late, no?

Broader real estate indexes are already showing signs of trouble. Moody’s/REAL Commercial Property Price Index has dropped nearly 12 percent since its peak last October. A more conservative index by the National Council of Real Estate Investment Fiduciaries shows growth slowing to one-half of a percent in the second quarter, from upward of 4 percent a quarter….

Now, the prospect of an immense default on a commercial residential property in New York — which has not suffered as much as troubled markets like Florida — has lent new momentum to concerns over the stability of commercial real estate loans….

A recent report by Lehman Brothers showed that aggressive underwriting is what probably has brought Riverton to the brink of default, not a fundamental deterioration in the overall market. But that report noted that there are other commercial properties that received similar optimistic underwriting, known as a pro forma loan.

Ratings agencies have only downgraded a few commercial real estate securities. At Moody’s, the list includes loans given to the Ritz-Carlton in New Orleans, a casino in Atlantic City and a land development deal in Miami.

Still, many analysts say a lengthy downturn in the economy would probably lead many commercial property owners to struggle with their mortgage bills. And pricing in commercial real estate is starting to reflect a tightening in commercial lending, they said.

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  1. Anonymous

    OT? I wonder what happened to this siyuation?

    Re: Zillow.com’s long-awaited mortgage lending service offers anonymous customized loan quotes to consumers, affording loan originators the opportunity to compete transparently for free mortgage leads

    Consumers using Zillow’s new Mortgage Marketplace will be able to anonymously solicit bids for loans from participating lenders. The consumer will fill out a detailed form disclosing all pertinent financial details.

    The form will be submitted anonymously to participating lenders, who will, in their turn, produce quasi-pro-forma loan quotes, submitting them, through Zillow, to the consumer. The consumer will then have the choice to make direct contact with particular lenders to decide whom to do business with.

  2. Anonymous

    This goes a step further:


    You’ve placed this great real estate deal under contract with the seller. You’ve used either a purchase agreement or an option so that you have the right to buy the property at a pre-agreed price, for a specified duration of time (either the inspection period or option period depending on the type of paperwork you’ve used). You have the right to assign your rights in your agreement to another investor for a fee. This will be your wholesale fee.

    After you gained control of the deal, you started to market it actively to your buyers list. Additionally, you are marketing it using yard signs (if you’ve received permission to do so), CraigsList, direct mail to Absentee Owners, a classified ad in the newspaper and perhaps even flyers to neighbors.

    Do I smell a new scam for flippers?

  3. RK

    The Riverton story is not about the value of commercial property. It is about the morons at Wachovia, who knew bupkis about the rent regulation
    system, and the prospects for de-regulation, in NYC.
    I’ve been a residential Manhattan landlord for 25 years
    in NYC, and the natural roll-over rate for regulated
    apts is 6% per annum or less, especially when the rents are well below market. If you ever get bored, go
    spend a day in housing court.

  4. mxq

    Thanks for posting this, yves. CMBS spreads have indeed exploded — markit shows, for instance, BBB spreads are 20%+.

    That said, i think Roubini is a bit mileading when he tells us deliquencies are on the rise.

    Fitch releases cmbs delinquency reports monthly. This month, delinquencies went from 0.41 in June to 0.43 in july.

    Yes, they did rise, but the magnitude is minute. To put that into context, Sub-prime resi default rates are in the 40+% range (thousands of basis points).

    Of course, that is not to say CRE is rolling through this mess with no problems – depreciation is already occuring at an accelerated rate and there were plenty of hideous loans underwritten…but given the structure and dynamic of CRE vs. RESI, and also taking into account that deliquency rates are at historical lows (2007 vintage shows 0.19% deqlinq. rate), I am skeptical about believing that cmbs stress is more about fundamentals than it is about lack of market liquidity.

  5. Yves Smith


    Very good points. The past comments on RE no doubt conflate some points, and I probably should have teased them out.

    1. A lot of late-cycle deals were done on very aggressive terms. Everything will have to work out for them to be viable. That probably means a restructuring at some point (ie, the original deal assumed a sale at a gain in 2-3 years, which with cap rates rising, ain’t happening). That is a problem independent of the default rate. Riverton fits this model. In this case, it assumed increases in case flow that haven’t happened

    2. The CMBS stats presumably are the best (or at least biggest) deals, presumably lots of office buildings, big malls, the very biggest apartment deals. Given the existence of Fannie and Freddie, I assume that a higher percentage of commercial real estate stays on the books of banks (office space in third tier cities, strip malls, etc). I suspect it’s harder to generalize about them but they tend to be more dependent on small businesses. I suspect they will fare worse than the big deals since the small fry will have even more trouble getting credit to tide them over if they get pinched than the big dogs

    3. Roubini tends to mix construction lending in with his discussion of the commercial real estate situation, when most treat it as a separate category. However, his general point holds: construction finance is a very big product for mid-tier and smaller banks. I don’t know what the size cutoff is, but one guy told me that 29% of the regional and smaller banks have construction loans in excess of their net worth. Some of these banks will take big hits, which will make them much more stringent on refis and maturing commercial loans.

  6. Jim Mc

    Actually CMBS lenders were major players on smaller commercial loans. A typical CMBS lender would go as low as a $5 million transaction. Some (such as Lehman) had units specifically dedicated to small loans.

  7. Pamela

    Yves…good point re: the CRE breakdown in terms of constrx/devlpmnt and commercial…DB had a chart (its slightly dated, it was through ~3q 07) that illustrated the huge growth in C&D loans during the past few years.

    It seems this portion of CRE failed to learn a lesson from the CRE collapse of the early 90's.

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