CRE, CMBS Disaster Imminent? Not So Fast

Jun.15.09 | About: General Growth (GGP)

The general theory has been that commercial real estate [CRE] & commercial mortgage backed securities [CMBS] may be the next shoe to drop, as I speculated here in March. But some recent events force us to take a closer look.

Since March we have seen improvement in the AAA rated CMBS market, mostly due to the TALF being used there. Again, no comment on the "right or wrong" of this action, but it is undeniably helping this market.

Then we had none other than Sam Zell coming out and saying that all the talk of a REIT industry "meltdown" was overblown.

Most recently was the very important news that loan servicers were looking at extending maturities on debt from the customary 6-12 months to out as far as 5 years.

Now this from the WSJ:

With the commercial real-estate industry bracing itself for the onslaught of hundreds of billions of dollars in maturing loans, the Treasury is considering issuing rules that will make it easier for property developers and investors and their loan servicers to restructure debt, according to people familiar with the matter.

Tax rules make it difficult for borrowers who are current on their payments to hold restructuring talks with the servicers of commercial mortgages that were packaged and sold as bonds. This lack of flexibility was one of the reasons cited by the management of mall giant General Growth Properties Inc. for its Chapter 11 bankruptcy filing in April.

At present, developers and investors complain that only those who are delinquent can talk to servicers of these bonds, named commercial-mortgage-backed securities, or CMBS. But now the Treasury is considering issuing guidance that would allow servicers to start talking about ways to avoid defaults and foreclosures sooner, possibly at least two years ahead of the maturity date of a loan, these people said. The Treasury guidance, which could be released within weeks, would essentially enable loan-modification talks to take place without triggering tax consequences, these people say.

What does it mean? If we convert this to housing, you are having trouble with your loan. Under the current rules, the banks could not talk to you about altering your loan until you defaulted. Once you default on commercial loans, all sorts of cross defaults and debt covenants are triggers across other debt. This is bad.

When Treasury alters the current rules, loans can be altered BEFORE default. This is huge and in retrospect may have saved General Growth Properties (GGWPQ.PK) from Chapter 11, as it was not able to restructure loans until it defaulted which then drove into 11.

Back to the article:

... property owners and investors hoping to restructure troubled mortgages are hearing a tough message from CMBS servicers: We can't talk to you unless you first fall behind on payments. This is because when CMBS offerings are created, the underlying mortgages are legally held by tax-free trusts. The trusts can be forced to pay taxes if the underlying loans are modified before they become delinquent, according to current CMBS rules.

"It can be frustrating," says Monty Bennett, chief executive of Ashford Hospitality Trust Inc. The Dallas-based real-estate investment trust that owns 102 upscale hotels has tried to start negotiations with servicers for extensions of payment deadlines for CMBS loans coming due. They have had little success. "You're trying to be proactive and get a plan together to address [a loan maturity], but you can't get someone to talk to you

There are scores of operationally healthy REITs that will simply not be able to restructure debt as it comes due to stagnant credit markets and will suffer the same fate as GGWPQ.PK. By allowing refinancing (for lack of a better word) before default, many will be avoided.

Will there still be defaults and REIT collapses? Yes. But the key difference will be that those falling by the wayside will not be healthy organizations but the weak that deserve to fade away.

Yesterday I had an email exchange with reader Davidson on the subject and he said:

All the noise about Alt-A and Commercial Real Estate being the tsunami on the horizon tells me that this one will be solved as well. I can tell you that private equity funds of $billions have been established to capture value. Roth of Vornado (NYSE:VNO), Simon of Simon Prop (NYSE:SPG) have cash to buy up the best properties that may be thrown on the market. Some one may take a hit but these guys may be stumbling over themselves to buy this troubled stuff and in the end a solution will clear the inventory.

It would seem that the commercial real estate market has watched and learned something from what happened in housing. They are taking proactive steps to stave off a total meltdown. For instance REITs have already issued equity and cut dividends (issuing them in stock rather than cash) ahead of problems rather than well after as the banks did with housing. This means that going into any problem they are already capitalized to levels that will allow far more of them to remain healthy and actually expand operations as this develops.

Does it mean there is no more pain in store? There surely is. But, I think one has to revisit the "total collapse" meme and perhaps materially alter that. Now if the Treasury opts not to modify the current rule, (which does not make much sense by the way), then we may very well see considerable pain here. Based on recent actions though, I think it is safe to assume something is coming from them.

I am going to begin to look far closer at this sector and will report in as I find things..

Disclosure: Long GGWPQ.PK