Commercial Real Estate Weakness / Spreads Widening
A: I would like to talk about the bigger picture again, as I often do here, and discuss some of the problems that seem to be bubbling under the surface in the commercial sector. This is a wide angle lens discussion on this sector and not a spotlight on Manhattan commercial real estate. It's important to note that commercial real estate saw a similar boom that residential saw over the past 4-5 years, and that the debt used to finance many of these deals were securitized and dispersed just like subprime was. As the slowdown occurs, one has to wonder if this may be the next shoe to drop on the books of the financials holding commercial mortgage backed securities.
Yes, all this matters. First, lets take a look at what the CMBS indices have been doing over at Markit.com which shows us the continuing widening of credit spreads in the commercial sector. What does this mean? Well, even with the fed rate cuts, the lending environment for commercial real estate has dried up. Risk is being priced in and as a result, credit spreads are widening signaling unease in the credit markets for this type of paper. The chart on the right shows you the rising spreads: FOR CMBS INDICES, UP IS NEGATIVE.
This is not all. The MIT Center for Real Estate issues a quarterly report, TBI (transactions based index) of Institutional Commercial Property Investment Performance, to measure market movements and returns on investment based on transaction prices of properties sold from the NCREIF Index database. 
"Results for the 4th quarter of 2007 show a negative 5% capital return for the properties sold in the NCREIF database. This is the second consecutive negative quarterly price change in the all-property TBI, a cumulative fall of more than 7% since the peak in the 2nd quarter of 2007. The investment total return for all properties in the 4th quarter also registered a decline of 4.3 percent.According to the BostonHerald.com's article, "Commercial Real Estate Prices Tank":
Please note that the TBI is a statistical methodology that produces estimates of price movements and total returns based on transactions of properties sold from the NCREIF Index database."
Commercial real estate prices are tumbling across the country in a decline not seen since the devastating recession of the early 1990s, a new MIT report finds. The value of commercial real estate owned by major U.S. pension funds fell 5 percent in the fourth quarter, according to a commercial market index produced by the MIT Center for Real Estate. The drop was nearly twice the 2.5 percent decline seen in the third quarter. The ongoing credit crunch in the capital markets, which has made it difficult for real estate firms to both buy buildings and develop projects, is a key factor in the price declines, the MIT report finds.Jeff spoke about this last week. In his piece on JAN 29th, Jeff stated:
...the spread (or premium in yield) investors are demanding from 'AAA' Commercial Mortgage Backed Securities has risen significantly. We knew spreads had widened, forcing banks to write down the values of some of these CMBSs, but what really worries me is that the widening has continued even as the fed has slashed rates. Fed cuts rates and borrowing cost goes up, not the math we want to see.There is a point here. We know that forces outside Manhattan can affect us. If subprime defaults rise as national housing prices fall, the entire secondary market for securitized subprime MBS will dry up. This wreaks havoc to the financials, causes billions in losses, tightens underwriting standards, and makes lending rates rise as risk is re-priced. Well, what about OTHER DEBT CLASSES; i.e. Commercial mortgage backed securities?
Since cap rates (mutiples of net operating income) at which properties trade are directly correlated with borrowing rates (increased interest cost = increased cap rate) and increased cap rates equate to lower prices versus net operating income, assuming net operating incomes from commercial properties just stay flat, prices will fall. So even in a market with great dynamics like Manhattan, if borrowing costs rise, net operating incomes need to rise just to keep cap rates stable and keep prices from falling. Again, this equation isn't new news, but you really want to see borrowing costs stop rising.
I did some searching and I saw that Fitch yesterday placed 51 U.S. CMBS deals under analysis with the report concluding within the next 30 days. Here is the story:
What is the potential damage to banks books? According to today's WallStreetJournal story, about $180 Billion. When discussing Blackstone's coming sale of debt for which it used to finance the Hilton deal, concerns are mounting:"Following its monthly surveillance review, Fitch Ratings has identified 51 of its U.S. CMBS deals as 'Under Analysis', indicating that Fitch will be issuing a rating action within 30 days."
"A less-than-successful offering could send the market into a longtime funk, exposing banks to more write-downs at a time when they have recorded more than $100 billion of losses on residential-mortgage-related securities over the past few months. In a report issued Friday, analysts at Goldman Sachs Group Inc. estimated that banks could book $23 billion of commercial-real-estate-related losses this year alone, consisting mainly of write-downs on CMBS's and related securities.So, although this doesn't necessarily relate directly to Manhattan, do you feel this is something worth keeping an eye on? I certainly do!
All told, Goldman Sachs predicts that U.S. commercial-real-estate prices could fall as much as 26% though 2009, driving the total of related loan losses to more than $180 billion over time, of which global banks and brokers might bear over $80 billion."
Posted by Jeff
Wed Feb 6th, 2008 05:54 PM
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.
Posted by mike
Wed Feb 6th, 2008 06:38 PM
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.
Posted by jeff
Wed Feb 6th, 2008 07:16 PM
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.
Posted by Noah
Wed Feb 6th, 2008 08:19 PM
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?
Posted by JC
Thu Feb 7th, 2008 12:12 AM
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.
Posted by mike
Thu Feb 7th, 2008 10:10 AM
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.
Posted by Noah
Thu Feb 7th, 2008 10:22 AM
thanks Mike! I hope to hear your input alot moving forward on the site!!
Posted by Brian
Mon Feb 18th, 2008 11:45 AM
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?