Commercial Property's Cash Flow Issues Not Limited to Maguire Properties

The WSJ reported in this morning's paper that real estate investment trust Maguire Properties (MPG) has notified the holders of $1.06B worth of commercial debt that it faces "imminent default" on it's obligations.

Aside from the fact that Maguire's lenders are taking a bath on this one, this latest piece of news is a clear sign that commercial property is reaching a tipping point of sorts. Obviously, those REIT's whose assumptions were most favorable going into these deals are the ones getting burned right now. Maguire and many others examine a property from the front-end using a pro forma that includes future assumptions about market rents. Usually these assumptions end up as a linear, positive function; that is, rents are assumed to rise steadily and incrementally throughout the first 10 years of the building's life. The result is inevitably a model which indicates steadily higher levels of free cash flow, after paying for the building's management and dropping some maintenance dollars into the escrow of course. Obviously, the closer to the peak of the commercial real estate market a building was financed/modeled, the quicker it will approach the "danger zone". This is a term that I'm completely making up, but it refers to the point at which a commercial building's cash flow is insufficient to service its debt. This ends up being a function of the severity of declines in market rents, the viability/solvency of the individual lessee's, and the level of financing secured for the property relative to its value (LTV).

Once a property goes cash flow negative, the owner must weigh several factors, most importantly the likelihood of a rebound in the absolute level of rent supported by the local market, and in many cases the reputation of the entity which leveraged itself. I emphasize the use of the word entity in this case because most often an LLC or S-corp is responsible for the property's mortgage. These "shell" corporations can, in theory, default on their obligations without incurring liability for the "mother" company. Anyways, the REIT must make a judgment as to how long it will continue to feed the property before allowing it to fall into default. Maguire has apparently decided that this handful of So.Cal commercial properties will be a significant enough strain on cash flow that "punting" them is the best available option. Similar determinations are currently being made across the country with regards to income producing properties; this is what de-leveraging looks like.

Disclosure: No position in MPG

Comments

[Zmartmoney:]

The further the penalty is from the infraction, the more quickly the affair is dumped on whoever had the bad timing to get near it. There is about to be a lot of damage done across the country as these properties get dumped on an already fragile economy. Bargains galore...if you have the time and money to wait it out. The big question really is, "Now, how much time would that be...?"

Aug 10 02:28 PM

[Scrooder:]

"commercial property is reaching a tipping point of sorts"

I'm very new to the CRE arena so please forgive my ignorance but how can this small company that holds only $4 billion of commercial property (the vast majority of it office space) be a bell weather for the entire commercial property industry. Plus most of MPG's property is located in inflated SoCal area. I'm as worried about a rush of defaults in CREs as much as the next guy but I just don't think MPG is the tipping point.

Aug 11 04:23 PM

[Carneades:]

You raise a good point. I'd respond with the following:
1) The residential market's issues have been intensely concentrated in California and Florida, so we have a precedent set that a couple pockets of severely inflated real estate can cause some fairly sizable damage.
2) Maguire is a publicly traded entity, therefore we have the luxury of examining the state of it's portfolio. A huge amount of CRE is owned privately; when these properties slide into foreclosure, it doesn't make headline news. Private owners however don't have the same access to capital as a publicly traded REIT like Maguire; meaning of course that in all likelihood, these firms are having even more trouble servicing their debt.


On Aug 11 04:23 PM Scrooder wrote:

> "commercial property is reaching a tipping point of sorts"
>
> I'm very new to the CRE arena so please forgive my ignorance but
> how can this small company that holds only $4 billion of commercial
> property (the vast majority of it office space) be a bell weather
> for the entire commercial property industry. Plus most of MPG's property
> is located in inflated SoCal area. I'm as worried about a rush of
> defaults in CREs as much as the next guy but I just don't think MPG
> is the tipping point.

Aug 13 02:50 PM