Commercial Sector At High Risk
A: The natural evolution of this credit cycle would be to assume a few things. One, that what started out as subprime will soon spread to near prime and prime; this is already happening. Two, that what started out in residential will soon spread to commercial; the topic of this discussion. And three, that the credit cycle is coming in waves. Looking at the CMBX indices, it appears that investor sentiment on the commercial sector and subsequent commercial mortgage backed securities, is deteriorating quickly. It appears the next wave, whenever that may be, will be related to the commercial real estate sector.
First off, all of MARKIT's CMBX spreads have widened dramatically in the past 6 weeks. Take a look at the CMBX-NA-AAA index for a basic idea of the widening spreads (NOTE: A rising line graph is negative and is a sign of deteriorating investor sentiment for commercial mortgage backed securities):
Up is down. Click the link above and you can check in on all the classes of CMBX indexes that Markit offers; lower quality indexes show an even more dramatic deterioration. This is one reason why Lehman Brother's health is being questioned; as they have significant exposure to commercial real estate, mainly the buyout of Archstone-Smith for $22.2 Bln, near the peak of the housing boom.
CORRECTION (Aug 6th @ 11:42AM): Archstone Smith is residential firm. It was NOT this purchase that gave LEH their commercial exposure. LEH does have commercial exposure, but not from this transaction. This was simply an ill-timed transaction that contributed to the company's overall exposure to the housing market.
Calculated Risk pointed out 7 weeks ago:
This deal was announced in May 2007, but wasn't closed until October - after the credit crisis started. I bet Lehman and their partners wish they had paid the $1.5 billion break up fee! The Archstone-Smith acquisition was a negative cash flow deal from the start. To cover the interest on the $16 billion in debt financing, there was a $500 million interest reserve created.The problem here is very similar to when the Markit ABX indices started to shit the bed exactly one year ago! Last July, most people didn't have a clue of the severity of problems those cliff-diving ABX indexes were trying to tell us! Here, I'll remind you; In my July 2007 post, "Macro Check: Rates Holding" I stated:
This suggests that Archstone is burning through the interest reserve very quickly. Not mentioned in the WSJ article was that Fannie Mae and Freddie Mac acquired a total of $9 billion of the $16 billion in debt. Something to remember if this deal really goes south.
While it's not making the major headlines as it did a weeks ago, the subprime mess that led to a disruption in the MBS (mortgage backed securities) markets is not going away. This is leading to a level of uncertainty that the tradable markets hate most! It is leading to a rise in safe haven plays, like gold and other commodites, and is still yet to reveal itself on just how bad the problem is.Now the CMBX indexes are starting to really go off. If recent history is any guide, we will start to see big time rising defaults in the commercial sector. CR is all over this dynamic with 483 mentions to the coming CRE Bust which he states is now here! I have to give credit where its due.
Barry Ritholtz over at The Big Picture has a great post on this topic titled, "WTF is going on in the ABX markets":
"Its one thing when we see that the BBB bonds -- the junkiest sub-prime crap in the Residential Mortgage Backed Securities (RMBS) universe -- getting shellacked due to foreclosures."
"But today, we see that the AA and even the AAA are getting whacked. It looks like either a fund is getting liquidated across all asset qualities -- or someone is panicking."
The ABX index measures the risk of owning bonds backed by home-loans to people with poor credit. Just take a look at some of the charts he posts to get an idea of the sharp moves in these markets. Crazy.
Looking ahead, FinancialWeek had an article last month about the I-Banks exposures to deteriorating commercial mortgage backed securities and guess the two firms that topped the list? BEAR STEARNS & LEHMAN BROTHERS! According to the story: According to Fitch data, Lehman had $36 billion in commercial mortgage-backed securities in trading assets and commercial real estate loans held for sale, or 140% of tangible capital, as of the end of 2007. That was about equal to Bear Stearns' exposure of 143%, but once again much higher than Morgan Stanley's 44%, Goldman Sachs' 55% or Merrill Lynch's 80%.As you can see via the above-right chart, Lehman is right up there in the exposure to commercial real estate. The stock price (NYSE: LEH), currently down 6.75%, seems to show the 'no tolerance' trader mentality to over-exposed I-banks in this current environment. The bad news is, this has to happen as the cycle continues! The good news is, this has to happen for the cycle to end!
Here too, Lehman has reduced its exposure to less than $30 billion, but the stress in the commercial real estate market is only beginning, and more is clearly on the way.
Posted by Jeff
Thu Jul 31st, 2008 04:51 PM
Noah,
The commercial real estate part of the real estate crash is just getting started, but hey who didn't know it was coming. It has lagged the downturn in housing for 3 reasons. 1) People continued to go great guns lending to commercial development, but more so acquisitions of exiting properties until well after the residential housing market had rolled over and up until the sub prime implosion started to suggest the likelihood of recession. 2) In both development and acquisition lending interest reserves (the lender lends you the money to pay him his interest) were being extended (normal in construction lending where there is no source of cash flow to pay the bank until the project is done) stupidly for deals that needed significant rent growth to actually support their debt...or were just bought to resell to another buyer for an even more inflated price. 3) Supply and demand in commercial markets was pretty well balanced in most US markets and segments (apartments, office, industrial and retail) until recessionary conditions set in. Now interest reserves are running out and the merd is hitting the oscillating ventilateur. I Star Financial a publicly traded "hard money" lender, which offers high cost financing for developers to buy land and get approvals, before they bring in partner equity and get a construction loan raised their outlook for bad loans and provisioning needs substantially this morning....but the stock traded up because their liquidity position has actually been improving (they sold some huge timberland assets). But the street understands a lot of this already and has been baking it into stock prices...if not analyst estimates. The commercial downturn should be much less severe than the early 90s when tax driven building resulted in a mammoth over supply in most commercial markets and categories and delinquent loans went to 12% of total....they are just below 4% now. My guess is they get to 6% or so before it's all said and done. I will do an updated piece on Q2 bank delinquencies and charge offs soon.
Posted by Noah
Thu Jul 31st, 2008 05:11 PM
As always, great comment Jeff. But I have one question given the difference in credit markets this time around?
What about the exposure of the banks with credit markets as bad as they are and financials as beaten down as they are? Dont you think even a modest downturn in CRE sector could set us back another few steps, and beat down financials further and put back any recovery?
Maybe the hit is not as hard, but to a hurt company, it may feel a lot worse?
Posted by Noah
Fri Aug 1st, 2008 09:03 AM
Did you see the article in FT today?
Real estate sector fears huge increase in CMBS defaults:
http://www.ft.com/cms/s/d9576c40-5f61-11dd-91c0-000077b07658,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2Fd9576c40-5f61-11dd-91c0-000077b07658.html&_i_referer=http%3A%2F%2Fcalculatedrisk.blogspot.com%2F
"Defaults on commercial mortgage-backed securities issued at the height of the credit bubble will more than quadruple from their current levels under conditions in the US economy expected by the commercial real estate industry, according to a report from Fitch Ratings.
Borrowers would default on an average of 17.2 per cent of securitised commercial mortgages over 10 years if the US economy dips into a recession with 0.2 per cent contraction in growth, compared with current very low default rates of 4 per cent, a rise of 330 per cent"
Its the hit to banks balance sheets as the third credit wave and the potential for another big name to fail, that is what concerns me in this shaky environment
Posted by jeff
Fri Aug 1st, 2008 11:29 AM
Noah,
No doubt the Commercial Real Estate downturn will sting banks. Maybe I am being less concerned about it, because we identified this threat very early on....I can't believe banks don't know about this and are not already already risk adjusting the value of their holdings based on the slowing economy, lack of liquidity for refinancings and likelihood of higher default rates. The FT article is a great case of fanning the flames of bearishness, check what the assumptions are - "Such a scenario corresponds "to the negative predictions currently offered by commercial real estate experts", analysts at Fitch wrote. This would happen if the economy suffered a similar downturn to 1991, and assumes that the value of properties covered by the deals falls by 25 per cent, and cash flow from rents by 15 per cent." The only thing is the current environment is nothing like 1990 from a supply standpoint...we are not overbuilt in most commercial real estate segments or geographies. FYI REIT stocks are one of the only sectors with a positive return this year.....they got killed last year.....the discounting mechanism is at work.
Posted by Noah
Fri Aug 1st, 2008 11:36 AM
How would you view REIT's right now looking forward? Worst is behind us?
Posted by David
Fri Aug 1st, 2008 12:46 PM
What do you expect when a lot of commercial deals were underwritten to 5 caps and below? Get a bad tenant or two, like say a Bennigan's or Mervyn's, and kiss your equity goodbye.
Posted by jeff
Fri Aug 1st, 2008 01:52 PM
Noah,
I think the worst is certainly yet to come for commercial real estate, but it should happen in the next 6 - 9 mos. unless soaring oil prices/currency devaluation/hyper inflation causes a major recession from here. I am not in that camp as I think slowing growth outside the US will equilibrate a lot of the currency oil issues, it will still hurt US GDP and I expect a couple of quarters of negative GDP.....but not the end of the world. As a discounting mechanism it is possible that the stock market...including REITs will start to discount my outlook by bottoming soon. I don't expect any kind of great bull market, just a slow climb of a very long wall of worry....but hey I'm an optimist. I still haven't seen anything new you and I have not been predicting for 6 months plus....so I figure lots of smart guys on the street have been positioning relative to these problems for a while and will need new fresh unexpected bad news to really change their minds....that's also why I find it interesting that the Tisch's and other smarties are starting to buy housing debt.
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Posted by George Weis
Fri Aug 15th, 2008 12:14 PM
Colliers market report for July 2008 show marked improvement in vacancy rates for that month. Could it be the commercial market has found a bottom and will be improving over the next year?
As a tenant looking for space, rents are still flying up. Little is available. I think that Manhattan will basically be untouchable from now on.
Posted by George Weis
Fri Aug 15th, 2008 12:14 PM
Colliers market report for July 2008 show marked improvement in vacancy rates for that month. Could it be the commercial market has found a bottom and will be improving over the next year?
As a tenant looking for space, rents are still flying up. Little is available. I think that Manhattan will basically be untouchable from now on.
Posted by George Weis
Fri Aug 15th, 2008 12:15 PM
Colliers market report for July 2008 show marked improvement in vacancy rates for that month. Could it be the commercial market has found a bottom and will be improving over the next year?
As a tenant looking for space, rents are still flying up. Little is available. I think that Manhattan will basically be untouchable from now on.