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The WSJ reported in this morning's paper that real estate investment trust Maguire Properties (NYSE: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

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