Commercial Real Estate Needs CPR, Systemic Risk? (Joint Economic Committee)

Saturday, July 11, 2009

Commercial Real Estate Needs CPR, Systemic Risk? (Joint Economic Committee)

It shouldn't be a surprise that commercial real estate and CRE debt markets continue to de-lever and re-price during this recession. Toxic commercial real estate was levered up just like the housing market and the "other shoe" is falling as we speak as unemployment increases, cash flows dwindle, Rent/FFO declines, vacancies and delinquencies increase and properties underwater become hard to refinance. Banks exposed to this toxic CRE debt will see their capital position deteriorate further. This is why the Government (essentially the taxpayer) is trying to backstop bank stress and jump start the CMBS (CRE debt securities) market.

I've been watching this market for 2 years now and this cash crunch will MURDER sub-prime CRE debt originated at 100% LTV (loan-to-value) at the height of the CRE bubble. On a positive note Big REITs recently raised equity to pay down debt (Simon Properties, Vornado, Kimco, Acadia, Kite Realty). The commercial real estate market is still distressed and might need a TALF/PPIP backstop if realized CRE deflation poses a systemic threat. Of course that would mean rigging the market of natural price discovery.

The Joint Economic Committee held a hearing (Webcast: Commercial Real Estate: Do Rising Defaults Pose Systemic Threat?. Here are quotes from the hearing. Visit link above or click the photo to be redirected to the hearing.

James Helsel - RSR Realtors, National Association of Realtors (Click for full testimony)

"According to a recent International Council of Shopping Centers survey of shopping center owners — which represented a cross section of the industry that accounted for over 5,100 shopping centers and 12.6 percent of all shopping center space — 62.7 percent of respondents cited little or no confidence in refinancing company debt during 2009. In addition, 53.9 percent held that same opinion for 2010. A recent article in U.S. News & World Report entitled, ―America’s Most Endangered Malls‖ further highlighted the extent of the financial troubles facing distressed retail properties and included some startling data supporting the bleak outlook for America’s retail landscape. One statement from the article bears mentioning here – ―By some estimates, about 10 percent of America's malls could close within the next few years."

"While demand for space is essentially in a state of full retreat, we also see that vacancy rates are climbing across all property types and transaction activity for commercial properties is in a major slowdown. To highlight this critical situation, during the first quarter of 2009, nationwide only 607 major properties exchanged hands, for a total sales volume of $9.5 billion. The figure represents a 51 percent drop in investment activity compared with the fourth quarter 2008."

"In addition, commercial banks and the commercial mortgage-backed securities (CMBS) market represent approximately 70 percent of all outstanding commercial real estate loans. However, banks have tightened their credit standards and reduced commercial real estate loan volume while the CMBS market, which has been a key source of liquidity to the commercial sector, has ceased to function. In 2007, a record high of $230 billion of CMBS was issued. In 2008, this figure dropped to $12 billion and thus far in 2009, there has not been a single CMBS issuance. Hundreds of billions of dollars of commercial real estate loans from a variety of sources are expected to mature in 2009 and over $1 trillion by 2012. Under current conditions, there is clearly insufficient credit capacity to refinance this huge wave of loan maturities."

Richard Parkus - Head of CMBS and ABS Synthetics Research, Deutsche Bank (Click for full testimony)

"On the whole, I expect that total losses in CMBS will be approximately 9-12% of the outstanding CMBS loan universe, or about $65-$90 billion. For the 2005-2007 vintage loans, my estimate of total losses is somewhat higher, about 12-15%. For the 2007 vintage alone, I expect in excess of 20% losses. This compares with approximately 10% total losses for the worst performing vintage -- the 1986 vintage -- in the early 1990s."

"I expect that loss severities on defaulted construction loans could approach 80-90% in many cases. 90+ day delinquency rates are currently in the 12% range for construction loans in bank portfolios, but are somewhat higher for construction loans in regional bank portfolios. In fact, I am perplexed by the fact that construction loan delinquency rates are only 12% at this point. However, I believe that this can be explained by the fact that they are typically structured with interest reserves which are sufficient to cover interest payments until the expected completion of the project. Thus, construction loan delinquency rates are currently artificially low due to interest reserves, but will likely rise dramatically within the coming 6-12 months. In my view, losses on construction loans are likely to be in excess of 25%, possibly well in excess, which would imply losses of at least $140 billion. This, of course, would be disproportionately borne by regional and local banks."

Looking at the Bloomberg REIT Index Chart (BBREIT:IND). The index could be forming an inverted head and shoulders pattern. The right shoulder would test November 2008 support around 80. It closed at 93 on Friday. There is Government intervention risk here so watch out on the short side.

(Courtesy of Bloomberg)