Commercial Real Estate: Is the Other Shoe About to Drop?

Here’s a couple of interesting data points that kind of got buried in all of the news of the day.

First from Market Watch, you can almost hear General Growth Properties death rattle as you read this one:

Shares of real estate investment trusts, which have been pummeled so far in 2009, were down again Monday on fresh liquidity worries after mall giant General Growth Properties Inc. said it is in default under multiple loans.

GGP in a regulatory filing late Friday said it is currently in default under certain of its loans. The stock was down about 9% to 42 cents at last check Monday.

“The firm reported that — despite these defaults — none of its lenders have yet taken steps that would require it to immediately file for bankruptcy protection,” Morningstar analyst Todd Lukasik wrote in a research note Monday on General Growth’s filing.

“Still, it appears to be just a matter of time before this firm is forced into bankruptcy, as the head winds of reduced consumer spending, excessive leverage, and unreceptive credit markets are too much to bear, in our opinion,” the analyst said.

General Growth is scheduled to release quarterly results after Monday’s closing bell. The company’s descent has stood out even in the decimated REIT sector, where the stocks have been thumped by the recession, declining property values and rents, and turmoil in the debt markets.

Second, from Reuters, here’s what’s keeping one Fed regional president awake at night:

U.S. commercial real estate problems could derail the country’s economic recovery later this year, a top Federal Reserve official said on Monday.”Many banks are pretty heavily exposed to commercial real estate. It is also a big part of the securitization market. So commercial real estate is one that concerns me,” said Federal Reserve Bank of Atlanta President Dennis Lockhart.

Lockhart, a voting member of the Fed’s policy-setting committee this year, said that around $400 billion of commercial real estate refinancing was hanging over the market and he was monitoring its progress with care.

“If you think of 2007 and 2008, in a negative sense, as the year of…residential real estate issues, it is possible to think of 2009 as the year of commercial real estate. That is the one domestic factor that keeps me up at night,” he told the Association for Financial Professionals after a speech.

Not too hard to connect the dots here is it? This one has been brewing for some time and is now about to boil over. I don’t think it’s on a par with the residential mortgage problem but it is big and it is going to have a different set of impacts.

Commercial real estate had a bubble all its own and underwriting that was just as shoddy as its residential mortgage cousin. It has been longer in coming to a head simply because of the structure of most commercial real estate loans. They maintain an interest reserve, a sort of slush fund from which the borrower gets to borrow money from the lender to make the interest payments. That bucket is running dry and the day of reckoning is just around the corner.

As this bubble bursts it works down the banking chain. Here is where the regional and community banks were big players and here is where they start to suffer. These institutions aren’t too big to fail but they may overwhelm the FDIC as it exacts its rough justice. If the problems are widespread then it might become more problematic for the FDIC to seize and roll banks to competitors.

Some have said that it won’t be as bad as the early 1990’s because the commercial property market isn’t as over built as it was at that point in time. That may or may not be true. It certainly isn’t the case with retail property. We know the disaster looming there. Industrial property may be in more dire straits than we think. Regionally, it could really suffer with the rationalization of the auto industry. Office has been touted as not being that bad. Maybe yes, maybe no. It depends on how quickly we come out of this economic mess and what the nature of the new status quo.

This problem isn’t related solely to the U.S. Just like the early days of the residential mortgage problem look it to spread overseas and infect others. Just one more point of stress on a system that might not be able to stand it.

Comments

[nana1]

You are wrong about underwriting standard of commercial loans. I am mortgage broker-commercial loan.
Most people or these TV speaker and writers know nothing about commercial loans.
Commercial Loans underwriting is different than residential.
Lender does not care so much what is the value of property as long as net rental income ( this is Groos income100% - 40% expenses including vacancies = 60% -net rental income) will pay for mortgage payment ( principle and interest) in the ratio 1.25-1.45, depending on property. Other words net rental income must be higher at least 25% or more to pay for monthly mortgage payment.
If you do not know how to underwrite commercial mortgage , please close you mouth and go to school to learn.
Idiots are present and there could be some private or private company that will fail . Most our public corporations in Real Estate survived and they are healty.
Please go to school and learn basic algebra and %.

2009 Feb 24 02:24 PM

[jstratt]

Commercial Real Estate definitely had a bubble. I read the article looking for facts to help define the scope of issues coming. When I drive to work I see the effect of a huge overbuilding of hotels and lodging.

It is hard to imagine retail not taking a sizable hit. Just way too much space built. Not only that my eyes see such massive scale in businesses built over the past decade. When I look at Cabelas, Borders, Michaels, Discount Golf outfits, Clothing stores... I dont see stores that utilize space effectively or efficiently. In strong times excesses are overlooked but in weak times they strangle you.

Office space is also overbuilt. It is harder to get an eyeball perspective however. I need occupancy rate facts and rates of decline to get a true understanding about offices.

If we have anything like the 1990s correction which is at least possible, it will be a great investor opportunity. I know of several buildings that have increased 4-5 times in value from the purchase in early 1990s to now.

Finally I dont think Commercial RE had the level of fraud that Residential RE did. That said the money was easily available for anyone who could project fast rising rents in their analysis. None of those analyses projected losing anchor tenants in this economy.

2009 Feb 24 06:42 PM

[Tom Lindmark]

jstratt,

Vacancies and related statistics like sublease space have to be viewed on a local basis. National statistics are close to meaningless. I agree that there will be some bargains. How the commercial properties are sold by the bank or the government will determine how deep the bargain.

The underwriting problem with CRE was that investors overpaid and lenders justified the debt by accepting proforma rent projections that never had a chance of being realized. Too much leverage was employed and the going-in operating cash short fall was carried by interest reserves. Operating cash flow has no chance of ever achieving projected levels so you just wait for the interest reserve to run out and then it's hand back the keys time.

2009 Feb 24 08:10 PM

[bigmoney]

I live in a sunbelt city and the rate of strip-mall growth over the past 10 years has been astonishing. Farmland and open space on the edge of town gets converted to nail salons, tanning salons, gyms, knick-knack retail, big box retail, and restaurants virtually overnight.

2009 Feb 24 10:31 PM

[{5U}]

It certainly does not help that CMBS were bundled into CDOs. AAA tranches of CDOs are trading like junk.




On Feb 24 08:10 PM Tom Lindmark wrote:

> jstratt,
>
> Vacancies and related statistics like sublease space have to be viewed
> on a local basis. National statistics are close to meaningless. I
> agree that there will be some bargains. How the commercial properties
> are sold by the bank or the government will determine how deep the
> bargain.
>
> The underwriting problem with CRE was that investors overpaid and
> lenders justified the debt by accepting proforma rent projections
> that never had a chance of being realized. Too much leverage was
> employed and the going-in operating cash short fall was carried by
> interest reserves. Operating cash flow has no chance of ever achieving
> projected levels so you just wait for the interest reserve to run
> out and then it's hand back the keys time.

2009 Feb 25 12:28 AM

[toobad41]

Due diligence on this topic or any other topic cannot be obtained by reading reporters from Market Watch or Reuters. Talk is cheap and this is cheap talk.

2009 Feb 25 09:31 AM

[Repsonsible Citizen]

Protect Yourself and your family , Buy Guns , Gold and lots of AMMO , good luck :)

2009 Feb 25 12:36 PM