Commercial Real Estate: From 'Best' to 'Worst of Times' in Seven Months Flat

The most recent Existing Home Sales figures (+5.1% in February) have given some reason to feel optimistic about the residential real estate picture but yesterday’s foreclosure auction of the John Hancock Tower, the tallest building in New England, for about half of its last sale value three years ago, might bring back the somber hues and this time, instead of painting with brushes, they could be using rollers.

Commercial property has taken quite a turn recently. Richard Parkhus, head of commercial mortgage securities research at Deutsche Bank described how “In just seven months, we’ve gone from the best of times to the worst of times.”

While that may be true hind sight is always 20/20 and there’s no telling that today’s “worst of times” might not be the “best of times” when we look back seven months from now. Comparing where we are currently to some of the other “worst of times” might help provide a better perspective. (At this point I feel like I should add one of those warnings that appear before some TV shows: “The following program contains graphic . . . “)

The Real Estate Roundtable estimates that commercial real estate in the U.S. is worth $6.5TN, about three times the size of the market in the early 1990s. The leverage applied is about 50%, as about $3.1TN $6.5TN is financed by debt.

Another way to look at this is in relation to Tier 1 capital. During the 1990s less than 2% of the country’s banks and savings & loans had commercial real estate exposure exceeding 5 times their Tier 1 capital. At the end of 2008 this number was 12% or about 800 financial institutions.

General Growth Properties (GGP) could stand as the poster child for the current commercial real estate environment as although they have stopped paying debt service on two of their key properties the lenders have not forced GGP into bankruptcy as they believe there is more to be gained by riding out the storm with a company whose tenants are happy with the way the Malls where they lease are maintained.

The potential for additional GGP’s exists as well as there are $154BN of securitized commercial mortgages coming due between now and 2012 according to Deutsche Bank, of which 2/3rds will not qualify for refinancing due to a decline in property values of anywhere between 35% and 45% from their 2007 peak.

Deutsche estimates that default rates on the $700BN of commercial mortgage backed securites that now exist could hit 30% and the loss rates, a key component of how much lenders recover, could exceed the 10% peak seen in the 1990s.

All of this has not been lost on the REIT market as volatility in some shares has the day traders from the tech boom itching to get back in the game. During the 1st quarter of this there were 4 days where REIT stocks had intra-day swings greater than 10%. That is an improvement from 4Q08 when the number of days was 15 but still well above the figure for the first nine months of 2008 when there was just one.

On March 23rd for example the S&P rose 7% but ProLogis (PLD) went up 28%. This past Monday, March 30th the S&P fell 3% and PLD dropped 12%.

In total the Dow Jones Equity All REIT Total Return Index, comprised of 113 stocks, posted a negative return of 32% in the first quarter - better than the -39% realized in 4Q08. The index is down 68% from its February 2007 peak.

The foreclosure sale of the John Hancock Tower has proved that the commercial real estate sector is not immune from the current economic down turn. “The real danger is a repeat of what happened on the residential side: A complete choking up, foreclosure disasters and increased stress on the banking system,” as Jeffrey DeBoer, CEO of the Real Estate Roundtable, so eloquently put it.

Comments

[Mad Hedge F...:]

This has been building for years. George Soros says that it is “inevitable” that commercial real estate falls another 30%. Rents are falling, tenant bankruptcies are rising, there is tons of debt to be refinanced for which there is no market, so cap rates are rocketing and “ghost mall” has joined the recessionary lexicon. This all adds up to lower prices. Some credit default swaps are trading at levels suggesting that a major REIT bankruptcy is imminent. I know George is sometimes prone to extreme statements, but this time he may be on to something. If you want a short play, or if you have an existing long position in commercial real estate which you can’t get out of and want to hedge, try a short position in the (IYR), although it has already dropped from $85 to $21. You can also play one of the sicker REIT names like Brookfield Properties (BPO).

Apr 02 07:52 AM

[Dabqs:]

Mad Hedgie,

It may be wise to watch what Soros is DOING with his dollars, instead of what he is SAYING. He has recently began building a position in CBL, a well known retail REIT.

I have observed that truly great investors buy when others are petrified with fear, and while the media is beating the drum of negative news toward a sector.

Have you given some thought to this possibility?

Dabqs

Apr 02 11:59 PM

[Joe Adamaitis:]

I would only add as I have said since early 07, that there are many commercial loans out there that were sold using the same type of sub-prime products as were used i n residential and which are probably included in your calcualtion of those coming due in 2012.

No Doc and Stated commercial loans were the rave from 2005-2007. However, If these loans which were made by non-banks and sold to hedge funds etc., and are not in that calculation. there may be a much bigger bang than one thinks.

Further, I tend to tie commercial real estate loans and leasing to the commercial equipment leasing sector which is also tied to unemployment. If the commerical real estate sector truly cracks to such dire proportions and the unemployment continues to rise, then naturally the need for the leased equipment is drasticlally reduced. Lastly, if the funding continues to dry up for both sectors then the combination of these two (commercial real estate leasing/funding and equipment leasing) could have a drastic effect on the overall financial recovery of the country. Just another piece of the pie shall we say.

Apr 03 08:37 AM

[cynewulf:]

Lets go to the mall.

Apr 03 09:32 AM

[tylakewalker:]

You cannot have a meaningful discussion about "commercial real estate" unless you break it down to the smaller subsets. A REIT in shopping malls is facing different market forces than a REIT in multifamily or health care properties. Quit overgeneralizing to such an extreme.

Apr 16 10:05 AM

[ps55:]

It seems obvious (to me at least) that the further fall of commercial real estate is an inevitability, and one that will bring the next down leg in global markets. Stocks will fall again, before any meaningful recovery...and the same people that are touting a recovery in the media are the ones talking about this bust in commercial real estate..interesting. Discuss the market and trading plays at marketfriends.com

Apr 16 11:35 AM

[Chris B:]

I have no real desire to get into office, industrial, retail, or residential real estate.

1) The sector is overbuilt for an economy that is slowly reverting back towards the long-term consumer savings rate of 10%. There are too many retail stores, restaurants, marginal businesses, and luxury apartments to be supported by the high-savings economy of the future. Worse, this supply is impossible to remove from the market, unless an earthquake or something occurs. Bottom line: take everything built since 2003 or so, subtract 10%, then add back 2% population growth. That's the scope of the overcapacity.

2) Most REIT's used short term financing on their properties and are dependent on refinancing in the future. In fact, refinancing cash-outs were actually a source of "income" during the go-go years and much of their leverage is based on property values at the peak. As the article points out, refinancing becomes impossible when the value has dropped below the loan amount.

3) Competitors can easily enter these markets, buy up distressed or foreclosed properties, and, thanks to low mortage rates, finance them at cheaper fixed costs than the existing publicly-traded REIT's. Thus they can undercut the established players on price.

----------------------...
Healthcare real estate however, lacks many of these downsides and may represent an opportunity.

1) Demographic graying means demand will expand, not contract.

2) Healthcare is not generally a discretionary purchase compared to fashion merchandise, fancier apartments, manufactured trinkets and luxury items, or other services.

3) Healthcare properties have custom designs and fixtures (e.g. oxygen plumbing, different building codes) and are not easily substitutable.

4) More reliable revenue streams mean they are more likely to be able to obtain financing.

Example: finance.yahoo.com/news...

5) Finally, political changes are unlikely to harm the REIT's that rent out medical offices, hospitals, and nursing homes. Those arrangements will remain in place even if some sort of national health insurance plan is enacted. In fact, revenues for the renters may even become more reliable under such a plan (fewer write-offs).

Apr 16 12:52 PM

[MGA_1:]

Next up:
* Commercial real estate
* Alt-A/Option Arms
Coming to an economy near you. Starting this summer !

Apr 16 03:11 PM

[Mad Hedge F...:]

It's amazing they lasted as long as they did. George Soros says that it is “inevitable” that commercial real estate falls another 30%. Rents are falling, tenant bankruptcies are rising, there is tons of debt to be refinanced for which there is no market, so cap rates are rocketing and “ghost mall” has joined the recessionary lexicon. This all adds up to lower prices. Some credit default swaps are trading at levels suggesting that a major REIT bankruptcy is imminent. I know George is sometimes prone to extreme statements, but this time he may be on to something. If you want a short play, or if you have an existing long position in commercial real estate which you can’t get out of and want to hedge, try a short position in the (IYR), although it has already dropped from $85 to $21. You can also play one of the sicker REIT names like Brookfield Properties (BPO).

Apr 16 03:44 PM

[RiskReturnO...:]

How about puts on the IYR? Seems like cheaper to buy the $27-$29 strike puts with IYR trading around $31 ... do you see any events that could trigger a down move? Just trying to minimize premium ... May is not too expensive.


On Apr 16 03:44 PM Mad Hedge Fund Trader wrote:

> It's amazing they lasted as long as they did. George Soros says that
> it is “inevitable” that commercial real estate falls another 30%.
> Rents are falling, tenant bankruptcies are rising, there is tons
> of debt to be refinanced for which there is no market, so cap rates
> are rocketing and “ghost mall” has joined the recessionary lexicon.
> This all adds up to lower prices. Some credit default swaps are trading
> at levels suggesting that a major REIT bankruptcy is imminent. I
> know George is sometimes prone to extreme statements, but this time
> he may be on to something. If you want a short play, or if you have
> an existing long position in commercial real estate which you can’t
> get out of and want to hedge, try a short position in the (seekingalpha.com/symbo...),
> although it has already dropped from $85 to $21. You can also play
> one of the sicker REIT names like Brookfield Properties (seekingalpha.com/symbo...).
>

Apr 16 08:43 PM