Commercial Real Estate - The Next Train Wreck?

Posted by jeff

Thu Jan 24th, 2008 11:01 AM

In my recent piece "How Bad is The Bad Debt Situation" I looked at some data on banks' delinquent loans and charge-offs, from a historical perspective. There are a lot of concerns swirling regarding credit card debt, auto loans and commercial real estate loans. My conclusion was that residential loan delinquencies were quickly mounting to historically high levels, and charge-offs were already there, but that there was a lot of room for other bad debt to rise without reaching levels of the early 1990s credit crunch. Today I want to focus on commercial real estate loans for a couple of reasons.

First, several rather spectacular large commercial market blow-ups have grabbed the spotlight in recent weeks and soured sentiment on the commercial real estate market. A major Australian mall developer Centro, which has made large acquisitions in the U.S., has been unable to refinance $3.4 billion in short-term debt. Bruce Eichner a Las Vegas casino developer defaulted on a $750 million loan from Deutsche Bank due to refinacing problems, and New York's own Harry Macklowe faces a February deadline to refinance $7 billion of debt for several commercial property acquisitions for which he reportedly put up just $50 million in equity. In the U.K. individual investors are desperately redeeming shares of that nation's version of REITs, causing turmoil in the market.

Second, thus far this earnings reporting season several U.S. banks have reported rising commercial real estate losses. Third, commercial real estate is a major New York City industry (according to the NYS Bureau of Labor Statistics there are 200,000 plus jobs in real estate rental and leasing and construction) and a major tax generator. According to an article on the slowing New York City commercial real estate market from the New York Observer, the city's Independent Budget Office saw combined revenue from tax and property transfer taxes jump 255% between 2000 and 2005. According to a recent New York Times article, "George Sweeting, deputy director of the city’s Independent Budget Office, said the slowing real estate market would cost the city about $100 million in revenue."

Lastly, Wall Street firms like Merrill Lynch have significant exposure here and potential risk going forward. "In fact, bond rater Moody's Investor Service cited Merrill's $18B of commercial mortgage exposure as one reason it is maintaining its negative outlook on the Wall Street titan's creditworthiness even though Merrill has raised billions in fresh capital. Big additional losses could hit not just Merrill but also Citi, which has $20B in commercial real estate loans on its books and J.P. Morgan Chase, which has $16 billion in commercial mortgage-backed securities," according to a recent Crain's article.

So let's take a closer look at the losses being reported by banks and at the outlook for commercial real estate, particularly in NYC. The losses on the commercial real estate side are both charge-offs of whole loans and writedowns of CMBS (Commercial Mortgage Backed Securities). As I noted in my prior piece, there is a major distinction between losses from whole loans held by a bank that go bad, and write-downs of securities collateralized by loans, which are marked-to-market. The marking-to-market simply means the value of a tradeable security declined (or the value of an illiquid security is thought to have declined in line with the values of comparable securities that trade more frequently). There is no actual loss here until the security is sold at a loss or the underlying loans default, lowering the return on, and of, capital. Now there was a false assumption running around Wall Street in the fall that the eventual losses on many of the sub-prime related securities would not actually total up to the write-downs of market value being taken by the banks. Then the second round of writedowns came....essentially demonstrating that the banks thought their first haircut of securities values was actually too conservative and/or that even more securities were facing loss issues. No one knows what the ultimate losses will be and if some of the writedowns will be reversed. In the case of CMBS, we are in the first round of securities value reductions, where the banks are largely just owning up to the fact that spreads between treasuries and the CMBS securities have widened, which is a polite way of saying the value of CMBS's have declined, not necessarily because their interest and principal paying abilities have declined yet, but because investors are fearful of this and are dumping them. In some cases the banks hold offsetting credit default swaps, which have risen in value and protected them against net market losses.

As I perused conference call presentation materials and transcripts on banks and financial services firms that recently reported earnings I had a couple of key takeaways. The CMBS losses were not specified by market area or property type and seemed to be largely driven by pure mark-to-market. The whole loan losses and provisions were almost universally said to be residential housing related, whether it be single family or multi-family planned unit developments, real losses are still focused in the residential sector. Some regional banks, like Huntington Banchshares, which has exposure to the upper Midwest, characterized business conditions as depression-like in some markets (not really new news for Michigan), but I didn't see anyone talking about office occupancy declines, industrial facility closures etc.

As far as New York City goes, SL Green, a REIT that is a large owner of New York City office space, had several interesting things to say on its conference call. First, the firm reminded listeners that "since June 2007,we have been sounding cautionary signals on our earnings calls regarding what we believe would be a gradual slowing in the leasing market as a result of the anticipated pullback and space requirements from the financial services sector." However, while the slowdown in demand from financial firms has indeed come to pass, growth from other areas has made up for it so far. The company also said that it has not yet seen the offers of concessions by landlords that usually pre-sages rent declines appearing yet. In contrasting the firm's outlook versus the last recession, the management made some very good points including that "At each point in time today versus January '02, we were approximately nine months into an economic downturn that eventually became a full fledged recession. However, you should note the following. First we are starting off in a much better position now than in 01' and 02'. We have a 6% total vacancy rate versus 9% then in midtwon and downtown." Additionally the management noted, that "the component of total availability represented by sublet space is almost negligible. In each case, it is only about 1% of the total vacancy, approximately a little over 1% is sublet space and for downtown it's actually 0.9% of the 7%." It is worth noting that traditionally sublet space is more likely to be blown out by a tenant who doesn't need it at much lower rates. The final statistic of note with regard to New York office space was the firm's view that "New construction is much more scarce than it was back in '01,'02, '03 when there was about 10 million square feet of space delivered to the market. Today it is only 6.5 million square feet slated for completion in 08' and 09'."

At this point in time the commercial real estate market is being impacted by the credit squeeze and crisis of confidence moreso than by declining rents or fundamentals suggesting a significant fall in rents. No doubt the slowing economy will have a significant impact going forward, which is why Fitch Ratings recently said it expected delinquencies on commercial mortgage backed securities to triple this year - note that this would put defaults closer to the average annual level of 79 basis points. However, there are three cardinal sins in real estate: over-paying (which the market has already opined on through the CMBS market), over-leveraging (which is apparent from the short-term debt roll-over issues for guys like Harry Macklowe, and over-building. It seems like the last sin may have been the only one not commited in the commercial real estate space, particularly in New York City and it may be a saving grace. According to their recent 2008 Real Estate Capital Markets Industry Outlook: Top Ten Issues Deloitte L.L.P. believes that the lack of over-building nationwide suggests a slowdown, not a crash in the commercial market. Another recent survey report by the Urban Land Institute and PricewaterhouseCoopers notes "Respondents believe the correction in the commercial market will not be as severe as in the residential real estate market. Commercial real estate supply and demand is relatively strong, development is in check and the fundamentals are still healthy, according to respondents". The report also ranks New York as "the hottest commercial real estate market in the country".

Let's hope the fed's rate cuts firm up confidence in the financial system so that we survive long enough to see if economic weakness causes as much pain in commercial real estate as the headlines would currently have us believe.

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