Commercial Real Estate - Make Up Your Own Mind

Much has been written about the issues faced by Commercial Real Estate, the extent of losses the CMBS bonds will sustain, whether the TALF, PPIP and other government programs will help, and if the commercial real estate market is showing signs of bottoming or is going to keep declining a lot more. There are various views which all seem plausible. If you are not professionally involved in real estate, or if you do not already have a definite view, how do you go about developing your own opinion? This article is an attempt to help with that process.

The first step in the process is defining the problem being faced by the CRE market. It is a complex problem and yet the best description of it I have seen is a simple one sentence comment reportedly made by a panelist at a recent industry conference organized by CMSA:

“We have gone from a 6% Cap, 80% LTV world to a 8% Cap, 60% LTV world.”

That is another way of saying the CRE market faces a double-whammy of falling prices and reduced availability of debt, but the use of numbers in this short one sentence elegantly and succinctly captures the essence of the problem. A simple example will help explain.

Let’s take a commercial property, say an office. It is year 2006, property generates $600,000 in rental income per year, and cap rates are 6%. That results in value of $10 mm (600K/6%). In an 80 LTV world, Larry the Landlord buys the building for 10 mm, borrowing 8 mm (80% of 10 mm) for 5 years from a CMBS lender, and using 2 mm of his own money. Now fast forward to a time closer to loan maturity. In the new world, cap rates are 8%, so the new value is lower at 7.5 mm (600K/8%), and the new loan amount is 4.5 mm (60% of 7.5 mm). To refinance, Larry needs to pay off 8 mm, but can only get 4.5 mm in new loan. So, he needs to come up with 3.5 mm. If he has that money or can raise it from somewhere else, he can refinance the old loan and continue to own the property.

If Larry can not raise the additional amount, or if he does not think that it is economically worthwhile to do so, then the loan is foreclosed, and one option for the lender is to sell the property. Ideally, the property can be sold for 7.5 mm, the new value. In the worst case, there should be plenty of buyers at 4.5 mm (since one can buy the property no money down using the 4.5 mm debt available in the new world). The actual price will be somewhere between the two depending on how many buyers are there with cash available to buy, and what is their view of real estate prices in future.

By using the above numbers, we can quantify the range of expected losses in cases of sales:

	Decline or Loss	%Decline or Loss
Property Prices	2.5 to 5.5 mm	25% to 55%.
Borrower’s Equity	2 mm	100%
CMBS Debt	500K to 3.5 mm	6.25% to 43.75%

If you layer in other factors, for example, if you assume that building’s cash flow decreases by 15% due to higher vacancy or lower rental rates (or the actual rent is lower than the assumed rent in aggressive underwriting), the numbers become worse:

New cashflow is 510 K, which results in a new value of 6.375 mm, and a new loan of 3.825 mm. With a new buyer paying something between 3.825 mm and 6.375 mm in case of a sale, the range of losses is:

	Decline or Loss	%Decline or Loss
Property Prices	3.625 to 6.175 mm	36.25% to 61.75%.
Borrower’s Equity	2mm	100%
CMBS Debt	1.625 to 4.175 mm	20.31% to 52.19%

Broad ranges for sure, and you can quibble with the cap rates or LTVs, or the fact that this simple analysis ignores other expenses and complexities, but these are back-of-the-envelope numbers, and give you an idea. For CMBS deals, you also need an estimate on how many loans in a given deal will default. If you assume approximately 40% losses on defaulting loans, then defaults on 20% of loans in the pool will result in 8% losses on CMBS deals, which is somewhere in the middle of the range of losses being predicted by many of the market participants.

Loan extensions can postpone the problem, but not necessarily avoid it, unless the property prices go back to the old levels quickly, which no one expects.

Looking at the example above, one can clearly see the importance and impact of availability of debt. If debt up to 80 LTV were to become available again, that will narrow the ranges above significantly. Clearly, programs like TALF and PPIP that help increase availability of debt are helpful and important. But they do not solve all problems. They do not help with the decline in value. That pain has to be taken, even though many are trying to ignore it. The current low transaction volume environment reduces confidence in valuations, but eventually volume and clarity on new valuations will both increase.

Those who own commercial real estate property with a lot of debt and cannot carry it through the downturn will suffer losses they have not recognized yet. But those who have cash and can buy properties at cheap levels in distressed sales will benefit. As always, it will be important to analyze and understand not just the sector, but the individual investments being considered.

Comments

[titans:]

bottom line PROSHARES & other companies that are putting out these short ETS's on any sector are STEALING MONEY; ther're a disgrace to the industry & their scam has been uncovered by the WALL St. Journal Friday's edition........WHAT COMPANIES MAKE UP THE .DJUSRE index ???????????? MADOFF'S gone, now PROSHARES steps into his shoes !!!!!!!!!!!

Aug 03 12:32 PM

[Living4Divi...:]

MHFT and others -

Please tell me why Sam Zell would want to torpedo the CRE market? This is like Bill Gross torpedoing the bond market. Or Geithner saying "don't buy treasuries - they are over priced"

I am not sure about Zell's motives.


On Aug 03 09:16 AM Mad Hedge Fund Trader wrote:

> Stay away. Chicago magnate Sam Zell thinks the big foreclosures won’t
> hit commercial real estate until the institutional holders run out
> of money in 2-3 years. From 2000 to 2007, half of the commercial
> properties in the US were sold and releveraged, and even the weaker
> holders have enough cash flow and reserves to last until then. Having
> peaked at a higher top, single family homes are now crawling off
> a much lower bottom, giving a crucial boost to an economy based on
> consumer spending. I’d call this a future green shoot, if I didn’t
> know that the grizzled property pro was talking his own book. After
> completing a brilliant sale of a huge portfolio of properties to
> the Black Rock Group at the absolute peak of the market, Sam is now
> suffering from buyer’s remorse with a turbocharger, having rolled
> the money into the bed ridden and nearly comatose Chicago Tribune/Cubs
> combo. Sam’s favorite overseas foray is Brazil, where a large, growing,
> educated population backed by rich natural resources, falling interest
> rates, and a strong currency provide a great backdrop for property
> investment. China looks good too, but you have to speak Mandarin.
>

Aug 03 04:20 PM

[square to t...:]

Titans:

Sounds like your position in SRS is working as you expected. The problem with double-levered short ETF's is that their daily returns are very close (but not identical) to the inverse of the underlying index on a daily basis. However, their long term returns most likely WILL NOT be the double inverse of the the returns of the underlying index over the respective time period. This is a matter of mathematics. If you are going to accuse ProShares of stealing, have some proof or at least a strong argument for why that is the case.

If you are referring to the 7/6 wsj article, you obviously do not understand this. There are a lot of other articles out there that explain the disparity between expected and actual returns of the leveraged ETF's as well.

Disclosure: My one and only short position is in SRS (< 0.5% of my portfolio)

Aug 03 04:26 PM

[square to t...:]

Correction:
I obviouslyy intended to write that the investment is not working out you expected.

Aug 03 04:28 PM

[whidbey:]

Good example. I have clients who own a lot of real estate and they are scrambling to sell something so as to keep another piece. Others are planning prepackaged bankruptcies where the creditor banks and insurance companies take the RE and hire the current owner to run the place. The problem is: the Tenants. Most of them are in trouble and they couldn't pay anything like the economic value of the RE. For want of customers, the tenant fails who pulls down the landlord and maybe tumbles the bank or insurance (retirement plan) company. How many? will in one city in California we have about 40 buildings in strip malls and they are part of Calpers investments. I think there are plenty more out there.

Aug 03 05:24 PM

[Econ 101:]

Enter the Credit Union crisis...

On July 1 the state of California began issueing IOUs to contractors and employees to be redeemed on Octber 1. Banks wouldnt honor these so the State Employee Unions put preasure on the CUs to accept and hold these IOUs. There is to be a 3.7% premium on the IOUs for carrying the state for three months.

What happens to the CUs when CA cant redeem the IOUs on 1 October? Is this a stealth domino theory or what?

Come on Arnold, save the world!!

Aug 03 06:09 PM

[titans:]

i thought i made myself clear in my 10:14 am n.y. post which clearly shows i know what i'm talking about !!!!!!!! the wall st. journal article i'm referring to was this past fri. 7/31 page 1 where the writer basically comes out & says these short etf's are not out to be what ther're supposed to be & the etf's are being investigated.even Morningstar took a jab at these phony etf's these companies are putting out...finally the writer i mentioned from the street.com post his story fri 7/31 as well......eric oberg came right out and stated these companies are stealing money (quote), "that is money that has gone to "money heaven" ; meaning the money went into scammers pockets by the way the company figures out 3 to 1 ratios & 2 to 1 ratios.......NOW IF HIS INFO WAS INCORRECT, THE STREET.COM WOULD HAVE BEEN NOTIFIED THIS MORNING ABOUT A LAW SUIT FOR SLANDER....DON'T HOLD YOUR BREATH WAITING FOR ANY LAWSUIT IF YOU KNOW WHAT I MEAN.......THESE COMPANIES ARE PICKING UP WHERE BERNIE-BOY LEFT OFF; THEY ARE SC_M TOO & THEY KNOW IT !!!!!!!!!!!!!!!!!!!!!!...

Aug 03 07:31 PM

[gilco:]

I will let the pictures of CRE speak for themselves

gilco1.blogspot.com/

Aug 03 08:51 PM

[User 465743:]

Good article. But you are missing something. The lending at 60% is a fantasy. If you have a Class A office building in a major city, you may be 50%. If you have a hotel, a strip mall, a big box retail center, an asset located in a small town, etc, forget it. There is no financing. The banks are not lending the money that the Feds gave them. The only money available, really is money for apartments from HUD, Fannie Mae or Freddie Mac. Securitization expanded the credit markets so that assets that previously did not get financed were financed. Almost 60% of the loans out there, at least, were securitized in nature. So, maybe TALF will work, but I don't see the same focus on the dangers as I did when AIG was going bust. They focused on housing first, because it is politically correct. But they are missing the boat on commercial in terms of urgency and this will bring on a double dip. Commercial real estate doesn't work without debt. And the banks are not helping and the Feds are not helping. If there is no debt, there is no market and values are suspect. The jobs multiplier for commercial real estate is huge. Big players are taking advantage of low Libor rates and sitting on assets. Debt service is being paid but their values are in the tank. Zell is right. Eventually assets have to be refinanced and it will be a bloodbath. Write your Congressman, because they aren't focused on this and are clueless.

Aug 03 09:09 PM

[Malay Bansal:]

As it happens, there was a news report today that a group of 41 members of the House of Representatives from both political parties asked Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke to extend the Term Asset-Backed Securities Loan Facility through 2010 because of concerns on commercial real estate.


On Aug 03 10:42 AM twotraps wrote:

> This is not my area of expetise, just watching and trying to learn
> at this point. So, what can really happen? Will the govt bail out
> some property firms? I realize there could be a negative spiral
> of events including banks/brokerage firms...but unless they convince
> congress that the very foundation of the financial system would be
> in question, I can't see a bailout. I would rather find a way to
> invest in this potentialy major repricing.

Aug 03 09:40 PM

[Malay Bansal:]

Great way of making a point. Liked it very much.


On Aug 03 08:51 PM gilco wrote:

> I will let the pictures of CRE speak for themselves
>
> gilco1.blogspot.com/

Aug 03 10:04 PM

[Malay Bansal:]

MichaelJ007 and User 46753 make good points about dangers of a downward spiral, and that not every property will get 60% financing. I avoided some details to keep things simple.

One point that I wanted to make was that given any particular level of decline in real estate prices, not everything will be impacted by the same amount - the 3 rows in the tables have different amount of losses. So, will be important to understand each investment.

Despite the expectation of losses, commercial real estate has some positives too. Perhaps, that will be a topic I will do a future article on.

Aug 03 10:17 PM

[REITBull:]

"Almost 60% of the loans out there, at least, were securitized in nature."

User,

I have to disagree with you on this. At the end of Q1 only 21.4% of CRE loans were securitized (MBA). New loans are getting done at 60% LTV for class A, infill markets. I wouldn't take Sam Zell's comments at face value either. Remember that he called a bottom in Residential real estate in Spring 2008.


On Aug 03 09:09 PM User 465743 wrote:

> Good article. But you are missing something. The lending at 60% is
> a fantasy. If you have a Class A office building in a major city,
> you may be 50%. If you have a hotel, a strip mall, a big box retail
> center, an asset located in a small town, etc, forget it. There is
> no financing. The banks are not lending the money that the Feds gave
> them. The only money available, really is money for apartments from
> HUD, Fannie Mae or Freddie Mac. Securitization expanded the credit
> markets so that assets that previously did not get financed were
> financed. Almost 60% of the loans out there, at least, were securitized
> in nature. So, maybe TALF will work, but I don't see the same focus
> on the dangers as I did when AIG was going bust. They focused on
> housing first, because it is politically correct. But they are missing
> the boat on commercial in terms of urgency and this will bring on
> a double dip. Commercial real estate doesn't work without debt. And
> the banks are not helping and the Feds are not helping. If there
> is no debt, there is no market and values are suspect. The jobs multiplier
> for commercial real estate is huge. Big players are taking advantage
> of low Libor rates and sitting on assets. Debt service is being paid
> but their values are in the tank. Zell is right. Eventually assets
> have to be refinanced and it will be a bloodbath. Write your Congressman,
> because they aren't focused on this and are clueless.

Aug 04 09:20 AM

[Alok Swain:]

Good Article

Aug 04 10:23 AM

[Absolute One:]

Thats a nice quote Malay. I've heard it a time or two before. I just so happen to be a commercial real estate appraiser and I happen to do a lot of retail. While I keep hearing these rumors of 8% OARs and 60% LTVs, unfortunately I'm not seeing any actual transactions. It seems most of my colleagues are having the same issue. Granted, many of my clients (lenders) claim to be lending, but all I keep hearing from my broker friends is about their deals falling through. So I'm just interested in where these cap rates and LTVs are coming from. If you wouldn't mind, would you please post a few of these individual deals? I could sure use the comps....

Aug 07 10:45 PM

[titans:]

whoever keeps putting down arrows againts my comments againts proshares short etf's real estate plays need to admit they have something to do with the stealing company !!!!! if you might look past your nose, you'll see in friday's edition of the wall st. journal that law firm LABATON SUCHAROW on this past wednesday filed a CLASS ACTION LAW SUIT against this stealing company (which they are).call them @ 21 907-0700 & give them info on pro shares like i will how ther're stealing your money as well.....this company starting to sound like mick vic....ceo sapir commented that complaintare wholly without merit (sounds like a wanna be lawyer: but he's just a thief).we plan to defend against this suit vigorously.that's what vic said until his boys turned on him & he was standing there alone.from once saying i did nothing wrong to those dogs,i'll prove I'm not guilty to standing before the judge months later telling the truth that he's sc_m !!!!! WELL MY CRYSTAL BALL IS TELLING ME THIS CASE WILL PLAY OUT ALMOST THE SAME WAY..VIC DID HIS TIME & WAS A MAN & FINALLY ADMITTED GUILT.THIS STEALING FIRM (POR SHARES) WILL NEVER ADMIT THEIR GUILT (LITTLE BOYS) & WILL PAY THE SETTLEMENT , BUT THE MAGIC WORDS THAT WILL FOLLOW FROM LITTLE BOY SAPIR WILL BE WE DID NOTHING WRONG & WE'RE NOT ADMITTING ANY WRONGDOING (MORE LITTLE BOY TALK)..hey i can talk lawyer too sapir, my wife is a lawyer, so i here her around the house.YOU STOLE MY MONEY CROOK, I WILL DO EVERYTHING IN MY POWER TO HELP THIS LAW FIRM & BRING TO THEIR ATTENTION WHAT THE REAL HOAX IS;WITH THIS .DJUSRE INDEX.WHAT IDIOT (MAYBE SAM'S CLUB IS PUSHING THIS INDEX UP ???? ) IN THEIR RIGHT MIND WOULD PUT MONEY INTO 95 % OF THE STOCKS THAT MAKE UP THAT INDEX ???? ALMOST ALL THESE COMPANIES ARE IN REAL TROUBLE & CLOSE TO IT & 2010/2011/2012 WILL SINK ALOT MORE LIKE "GGP".since i know it not wise to invest in these troubled companies, who's the dummy with alot of money that pushing up this index & sending these short re's down more than the 2 to 1 or 3 to 1 ratio.then i got some earlier moron saying that's the math.THIS IDIOT MUST OF WENT TO THE SCHOOL OF HARD KNOCKS (to many punches to the head).....now when the next person puts a down arrow against my story, be a big boy and admit you have something to do with the crook company....remember what my crystal ball said will be coming from the sapir camp grounds before 2010 ends.when they make that comment, lets see if you finally use your brains & wake up & realize this company steals.......STAY TUNED AS THIS GOES TO COURT & THE ROBBED STAND BY THE LAW FIRMS SIDE ASSISTING THEM ALL THE WAY BRINGING DOWN THE CROOKS.IT WOULD BE NICE IF SOME OF THESE BOYS COULD GET SIDE BY SIDE CELLS WITH BERNIE-BOY !!!!!!!!

Aug 08 03:20 AM

[titans:]

saturday came the announcement that "another" law firm is bringing a class-action law suit againts 'pro shares'; can anyone say; GUILTY !!!!!!!!!! YOU BUNCH OF CROOKS, I HOPE YOU LIKE IT IN HELL....................

Aug 10 12:03 AM

[Malay Bansal:]

The 8% and 60% numbers are averages or general consensus on where deals are expected to happen. They will obviously vary with the property location and details. Transaction volume has been low because people do not want to take a loss with the lower volume unless they are for some reason forced to.


On Aug 07 10:45 PM Absolute One wrote:

> Thats a nice quote Malay. I've heard it a time or two before. I
> just so happen to be a commercial real estate appraiser and I happen
> to do a lot of retail. While I keep hearing these rumors of 8% OARs
> and 60% LTVs, unfortunately I'm not seeing any actual transactions.
> It seems most of my colleagues are having the same issue. Granted,
> many of my clients (lenders) claim to be lending, but all I keep
> hearing from my broker friends is about their deals falling through.
> So I'm just interested in where these cap rates and LTVs are coming
> from. If you wouldn't mind, would you please post a few of these
> individual deals? I could sure use the comps....

Aug 15 12:49 PM

[Malay Bansal:]

Absolute One,

One source of data is the American Council of Life Insurers survey of mortgages done by ACLI members. The 2009 Q2 survey had an average Cap Rate of 8.5, LTV of 57.9, Interest rate of 7.49, and DSCR of 1.65.

I saw the data in a research report so I do not have a link for the data, but you could probably google it.


On Aug 07 10:45 PM Absolute One wrote:

> Thats a nice quote Malay. I've heard it a time or two before. I
> just so happen to be a commercial real estate appraiser and I happen
> to do a lot of retail. While I keep hearing these rumors of 8% OARs
> and 60% LTVs, unfortunately I'm not seeing any actual transactions.
> It seems most of my colleagues are having the same issue. Granted,
> many of my clients (lenders) claim to be lending, but all I keep
> hearing from my broker friends is about their deals falling through.
> So I'm just interested in where these cap rates and LTVs are coming
> from. If you wouldn't mind, would you please post a few of these
> individual deals? I could sure use the comps....

Aug 23 02:53 PM

[Malay Bansal:]

Absolute One,

One source of data is the American Council of Life Insurers survey of mortgages done by ACLI members. The 2009 Q2 survey had an average Cap Rate of 8.5, LTV of 57.9, Interest rate of 7.49, and DSCR of 1.65.

I saw the data in a research report so I do not have a link for the data, but you could probably google it.


On Aug 07 10:45 PM Absolute One wrote:

> Thats a nice quote Malay. I've heard it a time or two before. I
> just so happen to be a commercial real estate appraiser and I happen
> to do a lot of retail. While I keep hearing these rumors of 8% OARs
> and 60% LTVs, unfortunately I'm not seeing any actual transactions.
> It seems most of my colleagues are having the same issue. Granted,
> many of my clients (lenders) claim to be lending, but all I keep
> hearing from my broker friends is about their deals falling through.
> So I'm just interested in where these cap rates and LTVs are coming
> from. If you wouldn't mind, would you please post a few of these
> individual deals? I could sure use the comps....

Aug 23 02:54 PM