Commercial Real Estate Weakness / Spreads Widening

Noah,

It's just scary how this implosion is following the asset cycles script so closely. Every time I think....okay the next thing that will happen over the next few months is XYZ. I wake up the next morning and see that it's already happening....your new data points on CMBS and commercial real estate prices are just the latest example. This whole thing is going south at a break neck pace.

I think we discussed this last week. Speculation on the CMBX index is possibly skewing the perception of the market. I agree that CRE became overpriced, and that is reflected in cap rate compression that continued into the 2Q. The lending rates from I-banks are based on the CMBX index due to hedging which can be impacted by the speculation further. The first CMBS transaction of 2008 after an almost 2 month dryspell) will price next week and could cause spreads to catapult back in if it prices favorably - primarily because it would give the market an indication of where new issue paper is actually trading. Insurance companies that are cashing in on the high wall street spreads are giving much lower rates, but restricting leverage forcing buyers to put up more equity - which drives down prices. Fortunately for the sellers, most bought at a time when the prices were depressed - CRE has not experienced the same length boom in appreciation, only since about 2003 has it really headed upward at a steady pace, and until 2006 that trend was driven by fundamentals.

Cap rate increases over time will cause 2006 and 2007 vintage acquisitions to reduce in value, but they aren't indicative of defaults and foreclosures the way asset values impact residential real estate, at least not in the near term. A stabilized property acquired with a low cap rate and a very low interest rate in Feb 2007, barring a major disruption in rents and vacancies, will have the free cash flow to cover debt service well into it's loan term, typically 10 years, and avoid a high interest rate refi in the next few years.

Current spreads reflect a myriad of factors including derivative speculation, light volume in secondary trading (and the vintage of those trades), current sellers reluctance to accept 2008 pricing when they just saw 2007 happen, stricter lending standards (lower leverage, higher coverage), less interest only restricting initial yields on acquisitions, more conservative loan structure, higher subordination levels from the rating agencies, and a reluctance to believe 2007 full year cash flows are sustainable. That will drive prices down, but the impact is far smaller than in residential real estate.

In 1989, there was speculative overbuilding that didn't happen so significantly in this cycle that took years to clear. There will be defaults and foreclosures, but for the most part lenders will be OK. The CMBS market can still execute so loans warehoused have value, and the floating rate debt can be converted to a long-term asset with viable risk associated. The writedowns will come primarily from CDOs that can't trade because they have the CDO label on it, and bonds that just aren't yielding market coupons.

As the fitch report also said, tripling the default rate from 2007 would still end up less than 1% overall, and that is a sustainable level in the market that would not subject CMBS to anywhere near the level of pain experienced in subprime.

The concern (and what we should be watching) should be whether fundamentals really turn south, not the CMBX index or general secondary CMBS trading in order to get a idea about where CRE is headed.

I agree with your analysis in many respects, however I still hear lots of talk about optimistic pro formas underlying many 5 year interest only loans, etc where technical defaults may emerge with any downturn. So while there was not over-building in Manhattan there was still some serious sloppiness that will be punished. Meanwhile Chicago, Atlanta, London and other markets domestically and overseas have some honkin pipelines coming as well as the sloppy lending. Unfortunately the losses re-circulate to Wall Street which hurts the NYC office market, but also cascades into all areas of lending causing a big slowdown in the velocity of money, which hurts the economy overall and which rate cutting isn't going to fix real quick. Read my piece tommorow on the horror show emerging in bank regulation....worldwide. Things still seem dicey to me despite your many good points above.

Wow Mike, and thanks for the detailed lesson! Great stuff.

However, don't you think even a collapse of some of the CDO's held, will be perceived as much worse given the current environment even if as you say, it is no where near as large as subprime?

Also, if commercial really is such a different animal, what about other debt classes in the RMBS markets? Alt-a, prime, option arms, heloc's, etc...how BIG is this potential impact should problems arise in the higher quality debt classes?

What is subprime compared to the rest of this market?

Hey Noah,

3 points on this. Apologies if they have been made already.

1. Commercial mortgages, unlike residential are generally non-recourse loans - if you have a company with 5 warehouses and one of the warehouses isn’t doing so well you just walk away from it and let the lender take it back - they can’t come after the company balance sheet to make up any loss. Why is this important? - in a recession you should expect to see CMBS fare a lot worse regardless of what has happened with residential sub-prime. Add to that the current environment and all the credit pain we have seen in recent months and you get the spreads we have today. I agree with Mike - "Current spreads reflect a myriad of factors" - I wouldn’t try to pull any default probabilities out of them - they are what they are and reality could be better or worse.

2. Talking to some guys who do large individual deals in commercial real estate they say they see a big split in the market. Apparently this is nothing new in times like this. One part of the market is the crap that has always been questionable and only ever got developed because everyone was looking to develop something – they tend to be in terrible locations and lame businesses. From point 1 above you can see that analyzing the business is as important as analyzing the real estate when it comes to commercial real estate deals. They expect these properties to hit rock bottom in the ‘first wave’ and some may never bounce back. Then there are the not so bad properties/businesses that are getting pulled down with the whole environment. These are the kinds of properties that become good value.

3. You mentioned “Alt-a, prime, option arms, heloc's, etc”. It’s easy to underestimate the correlation across these asset classes. The same guys buying RMBS have been buying CMBS securities – if they get burned in one they sell out of the other as risk limits come down. We saw this when the ABX blew out back in October-ish – the IG and HY corporate credit indices blew out too. Nobody was talking about a recession then – and how can there be a link between some dudes house in Stockton, CA and IBM default risk? There isn’t any fundamental link but if it’s the same handful of big players in all assets you see them all nose dive together driven by a fundamental problem in one. I’m not suggesting that there aren’t real problems in the others too - there are, but the concentration of ownership makes it much more pronounced.

I wouldn’t read too much into the levels we’re seeing and the change from today versus yesterday. This goes for the equity market too. If it’s 10% higher today and today’s price tells you something about the state of the world what did yesterdays price tell you about it?

Lots of uncertainty out there – not a lot of liquidity (in MBS) – hard for price discovery mechanisms to work properly in an environment like that.

Lots of pain to come – that’s for sure.

JC - Points 2 and 3 are great, i agree completely. Regarding point 1, I would caution that you need to look at single tenant vs multitenant commercial properties. In most cases, single tenant properties are risky, even in the best times, and that is where the business analysis matters the most. Solid branded grocery store anchored retail is probably the least risky - people need to get food even in a recession. In very few cases will you see entire shopping centers or office parks vacate during a moderate recession (we can discuss the expected severity of the recession at another time). Apartments will also tend to hold up well, especially as people lose their houses and need to rent. Apartment complexes, Retail, and office (in that order) are the highest concentration of CMBS deals - about 75% by balance. Hotels (in recent years), industrial, self storage and manufactured housing typically make up the rest. By most account hotels would fare the worst in a recession, and warehouses would fare the best (if you can't sell you're product, you need to store it), and self storage is pretty stable depending on the location. If you look at manufactured housing, you'd think it would be worse-off, but it's actually one of the least risky asset types.

Borrowers are on non-recourse loans, but they also tend to be more sophisticated than residential borrowers. The borrowers aren't going to hand back CRE unless they have no other option (doing so will force them out of the lending market for about 10 years). High leverage is one thing - the servicer might want the property back to sell at the debt amount (ie - No loss). Poor fundamentals are quite another - that's where losses happen.

Noah - CRE CDOs are structured differently from subprime. Most suprime CDOs were repackaged BBB or lesser rated bonds combined along the (poor) reasoning that the deals aren't correlated. CRE CDOs are typically a mix of IG bonds and whole loans, b-notes of loans, or loans that don't match with the CMBS market. The risk is typically more spread out.

I think that even if problems arise up the credit curve in RMBS, you're still talking about assets without cashflow, the loan is really just a personal loan based on the person's ability to repay it (income) with a % of the house's value put up as collateral. The commercial loan is a loan sized based on the collateral's market adjusted cash flow value entirely. The borrower is only considered as far their credit worthiness or lack thereof. I would say that it would make more sense for defaults in commercial to precede defaults in residential (companies hold up commercial, companies go bk, they aren't paying rent, CRE defaults and a couple months later the people who lost their jobs default). I don't think residential defaults would impact the fundamentals of commercial. I think the 5 year IO loans will come into question, but for the most part, those mature in 2011 and 2012, when this market is likely to have either turned a corner, real estate finance will have a different paradigm. Good assets can still get relatively cheap financing from more conservative insurance companies - a testament to the lower risk. CMBS shops suffer from being forced to price based on the broken capital markets, another way of saying investors are either unfunded (the European vehicles that went belly up) or scarred (owned subprime or look at fixed income as a generic asset.

RE: the last question, i'll put this in perspective. There is approximately $1 trillion in subprime outstanding from 2005-2007. There is about $550B of CMBS outstanding from those years. All other RMBS is much larger. In terms of CDOs, i don't have exact numbers but CRE CDOs in total approach $100B, and the loss severity on those securities, when everything is said and done, probably won't be 100% like it will be on subprime CDOs.

thanks Mike! I hope to hear your input alot moving forward on the site!!

All -

I am trying to clear up the confusion I have surrounding the CMBX index. I understand this index to effectively be CDS for the CRE market.

However, if you go short a particular vintage and tranche - let's say triple A's - and they are trading at 230 over swaps at that time are you effectively just betting that spreads will widen? This makes sense to me and can be used as an effective hedging instrument if you are long in the cash market.

However what I don't understand is how this ties into traditional CDS where you can make a bet on the likelihood of default of an issuer. How do current spreads of say 220-230 over swaps imply a certain default rate?