Commercial Real Estate: Evidence that It's Ready to Come Crashing Down 7 comments
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Just over a week ago, Bloomberg revealed in "Geithner Says Commercial Real Estate Woes Won’t Spark Crisis," that the U.S. Treasury Secretary did not appear to be overly concerned about the threat posed by brewing problems in the commercial property sector:
U.S. Treasury Secretary Timothy Geithner said commercial real estate woes won’t set off a new banking crisis, in remarks to the Economic Club of Chicago.
“I don’t think so,” Geithner said, when asked whether commercial real estate could set off another banking meltdown. “That’s a problem the economy can manage through even though it’s going to be still exceptionally difficult.”
The global economy has accelerated since the worst of the recession and banking crisis last year, Geithner said, noting a U.S. Commerce Department report today showing the economy expanded 3.5 percent in the third quarter.
Is he serious? All you have to do is spend about 15 minutes reading through just a few of the reports that were published recently and it quickly becomes apparent that a tsunami of red ink is forming in the sector, ready to come crashing down on the whole of the banking sector -- as well as the economy -- in the immediate period ahead:
"Why This Real Estate Bust Is Different" (BusinessWeek)
Unrealistic assumptions, layers of investors, sky-high prices, and possible fraud will make it hard to clean up the mess in commercial real estate
When Goldman Sachs (GS) sold complex bonds backed by the Arizona Grand Resort and other commercial properties in 2006, it suggested the returns would be strong. The 164-acre luxury Arizona Grand, set against the Sonoran Desert in Phoenix, boasted an award-winning golf course, deluxe spa, and several swank restaurants. The on-site water park was named one of the best in the country by the Travel Channel. With the resort's new owners planning to refurbish hotel rooms and common areas, Goldman told investors that the renovations would help boost cash flow.
As was so often the case during the real estate boom, the lofty projections didn't pan out. When the economy softened and business travel slumped, Arizona Grand's bookings slipped to 67%, from 80%. The resort defaulted on the $190 million underlying loan in 2009—a hit that alone could largely wipe out investors who bought the riskier pieces of the Goldman mortgage-backed securities deal.
"It's one of the largest losses we have forecasted for an individual loan," says Steve Kuritz, a senior vice-president at Realpoint, an independent credit-rating agency. The property, once valued at $246 million, is now worth just $93 million. A spokesman for Goldman says the pricing on the bonds was in line with market levels at the time and not above what investors could get on similar securities. Grossman Co. Properties, which owns Arizona Grand, didn't return calls for comment.
"Gloomy Times for Commercial Real Estate" (San Francisco Chronicle)
Shopping centers, office buildings, industrial spaces, hotels and apartments can expect a period of "enveloping gloom" from the recession and credit crunch, according to a report released on Thursday.
Values will plunge, vacancies will rise and rents will decrease across all types of commercial property before the market hits bottom in 2010, according to the "Emerging Trends in Real Estate" forecast from the Urban Land Institute and PricewaterhouseCoopers LLP.
No quick recovery is in store, the report said. "2010 looks like an unavoidable bloodbath for a multitude of 'zombie' borrowers, investors and lenders," it said. "The shake-out period may extend several years as even some conservative owners with well-underwritten loans from the early 2000s see their equity destroyed."
"$500 Billion Of Commercial Real Estate To Mature Soon" (The Atlantic Business Channel)
There was a Congressional subcommittee hearing today -- in Atlanta. The House Committee on Oversight and Government Reform's Domestic Policy Subcommittee addressed the residential and commercial real estate market in the Georgia metropolis. Sadly, the meeting was not on C-SPAN, but I managed to skim through some of the prepared remarks by more than a dozen witnesses from judges to economists to bankers. I was particularly interested to hear what those testifying had to say about commercial real estate, as I think that market will be one of the big business stories of 2010.
Atlanta has been gravely damaged by the housing bubble's pop. As a result, it sort of makes sense that only one witness appears to have spent much time addressing commercial real estate. Luckily, it was Jon Greenlee, Associate Director, ision of Banking Supervision and Regulation at the Federal Reserve. So it's pretty high quality testimony.
His analysis is also rather broad, not focusing on Atlanta's commercial real estate as much as the bigger picture. His prepared remarks make one thing utterly clear: the Fed is keeping a very close eye on commercial real estate (CRE). And it's worried. CRE is a big market to watch. Greenlee notes that at the end of the second quarter, commercial real estate debt was approximately $3.5 trillion.
"Fitch Conference: Commercial Real Estate Decline & Negative Credit Effects; Muni Market Downturn" (BusinessWire)
Fitch Ratings will host its annual Morning Credit Brief Conference on Tuesday, Nov. 17, 2009 at the Grand Hyatt in midtown Manhattan with a focus on the broad credit implications for the collapsing commercial real estate market.
The performance metrics of commercial real estate (CRE), an area with a significant risk exposure for financial institutions and the structured finance market, continues to deteriorate at an unprecedented pace. While CRE loans, excluding the more problematic construction and development portfolios, represent more than 125% of total equity for the 20 largest banks rated by Fitch, the risk is even higher for banks with less than $20 billion in assets, as average CRE exposure represents more than 200% of total equity for these institutions. The negative credit implications of the declining CRE market are widespread, affecting not only large and regional financial institutions, but also CMBS entities, insurance companies and REITs whose investment portfolios are seeing a sharp decline in value due to their exposure to falling real estate prices.
"U.S. Shops and Apartments Head for Record Vacancies" (Bloomberg)
Stores, apartment buildings and warehouses in the U.S. will set new vacancy records before a recovery takes hold in the job and commercial property markets, according to a forecast by CB Richard Ellis Group Inc.
Vacancies at industrial properties will climb to almost 16 percent in 2011 and apartment vacancies will top out at 8.1 percent this quarter, CBRE chief economist Ray Torto said in a presentation at the Urban Land Institute convention in San Francisco. The proportion of empty space at shopping centers and malls will increase to about 13 percent in 2010, he said.
U.S. commercial real estate prices have plunged almost 41 percent since October 2007, the Moody’s/REAL Commercial Property Price Indices show. The highest unemployment since 1983 has lowered demand for office and retail space and reduced consumer confidence and spending. Job cuts are also prompting tenants to move out of apartments.
"Commercial Property ‘Long Way’ From Rebound, GE’s Pressman Says" (Bloomberg)
The U.S. commercial property market is far from recovery and needs job growth, sustained low interest rates and further government support, said GE Capital Real Estate Chief Executive Officer Ronald Pressman.
“We’re a long way from where we’d like to be,” Pressman said at the Urban Land Institute’s annual meeting in San Francisco yesterday. “The stakes are very big here.”
Defaults and late payments on property loans sold as commercial mortgage-backed securities jumped more than fivefold to 4.52 percent of the total in the third quarter from a year earlier, New York-based real estate researcher Reis Inc. said. About $26.6 billion of CMBS loans were 60 days or more past due.
And to make matters worse, the agency that oversees much of the bank sector has decided, as the Dayton Business Journal reports in "FDIC Makes Statement on Commercial Real Estate Workouts," that the way to deal with the problem is to encourage lenders to rely on a dangerously flawed approach that is nonetheless all the rage nowadays: pretend and extend.
The Federal Deposit Insurance Corp. adopted a policy statement supporting prudent commercial real estate loan workouts, it reported Tuesday.
FDIC’s statement emphasizes performing loans, including those that have been renewed or restructured on reasonable modified terms, made to creditworthy borrowers will not be subject to adverse classification solely because the value of the underlying collateral declined.
The policy statement gives guidance to examiners and financial institutions that are working with commercial real estate borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties, the FDIC said.
Click here (.pdf) to read the full policy statement.
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This article has 7 comments:
and when it pops, there will be an economic bloodbath.
CRE that provides cash flow high enough to support loan payments will be allowed to continue to do so. Banks don't want to run apartments, shopping malls, warehouses, etc.
CRE that no longer provides cash flow high enough to support loan payments will either lead to compromises with the banks or foreclosures and sales. And this will happen on a property by property basis.
Small local CRE investors will probably get hit the hardest. They won't have other assets to include in refinancing and will likely lose the entirety of their equity investment. The banks will likely lose some of their investment also.....but the good news is that the buildings will be sold and there won't be government interference in this process. That will allow a bottoming to take place. It will also curtail new CRE investments as banks ramp up their requirements to get financing. That will keep new supply down and over time CRE will find a floor and start to work its way back up.
Its not going to be a fast process (working the way back up), it will be slow and take many years. Investors that were earning 5-8% may not earn anything on some of their buildings for 5 years. But that is how the market is supposed to work......as opposed to the housing debacle.
The basic change of requiring loan amortization and 20% less debt in the capital stack substantially reduces cash flow available to equity and has the predictable effect of substantially decreasing value. The reset in the perception of risk and strained Net Operating Income exacerbates the decline in value.
As a result, almost any loan made at 80% of the capital stack in the late part of the boom is surely 20% underwater today and likely will not service debt if amortization were required.
This will take a long time to workout, especially if "extend and pretend" persists.
I don't think so.
I think it is the first sign that the local and regional banks are now going to face real government (read FDIC/Sheila Bair) pressure to begin to clean out the portfolios and carrots and sticks to incentivize that behavior.
We are not seeing a cycle writ large. We are seeing a transformation. CRE finance will not return as it was.
The ULI/Pricewaterhousecoo... 2010 Emerging Trends Report is quite revelatory; even the developers (who dominate the ULI, and thus the majority of participants in the survey) have now gotten past denial. And they don't know what to do.
One of the best quotations from the report emphasized that if you got into the business, or the support professions of law or accounting, after 1994 at the latest, you have no experience in this world, even though everyone is claiming they do. And if you got in later than 1990 you have minimal experience and certainly not in first chair position. Sadly there is lots of fraud going on right now......fraudulent claims from the parasitic professions.
This is a moment of great opportunity. But you have to know what you are doing or team up with someone who does...and you can't learn this just from reading. You have to have done it time and time again.
RJ Frick
It will cause pain in the CMBS world, possibly more than is priced in given the rally in these security prices since the lows. This won't be systemic as it is reasonably well disburse.
Bank held CRE probably will at the margin continue to cause FDIC takeovers of community banks and some smaller regionals. This is not systemic. Furthermore, there is a growing probability the government, as shown in the article, will tolerate extend and pretend. If the cash flow is there to support interest payments, with regulatory forebearance, being underwater is not fatal. Systemic in the sense of zombie banks not making new loans and therefore inhibiting a return to growth, ala Japan, yes. Take the system down, no. Additionally, the larger banks with a few exceptions, say possibly WFC, have a limited exposure to this sector.
Insurance companies generally underwrote to higher LTVs even during the go-go period. 70% or less LTVs remained common. This will not be systemic.
Critical to all this is the direction of prices from here. As noted above, few transactions provide limited visibility. The Moodys/Real Index was created by an MIT professor. In an article posted on the REAL website last month he found indications in the data that perhaps prices were bottoming. Recently the MIT/CRE center published another note based on what appears to be a different data set sent a stronger signal of a possible bottom.
Where the storm winds may blow stronger is with the European banks and forebearance is almost a foregone conclusion on the continent.
I am not trying to strike a Pollyanna note and have no doubt that Geithner/Bernanke et. al. have been doing a great deal of whistling past the graveyard this past year. Too many problems have been papered over. I just can see the arguments that CRE may not represent another tipping point in and of itself.
As for the Treasury, it would seem that even the repaid TARP money will not be enough for them in the future or they would not be fire selling their assets to the likes of Goldman. I don't believe for a moment that Geithner does not realize the extent of looming real estate problems that are still growing behind the synthetically rosy numbers due to government tax credits, faked interest rates by the Mac and Maes, and rising losses banks are having to deal with in real estate asides from the housing market which the government has already approved to let banks essentially cheat on the accounting as to how much loss they are facing.
Furthermore the taxpayer can't seem to catch a break. If assets the US buy goes up they give them away. And if they go down we keep taking hits. Goldman's point on this matter was well said when they completed their last deal with Geithner. It is as follows:
The CEO of Goldman Sachs, Ivana B. Richmore, remarked “This transaction solidifies the long standing relationship between our firm and the US Treasury, which over many years has been very beneficial to both parties, or at least to us."
Really, we are getting sick of the smug remarks of bankers who continue to take taxpayer money and then make veiled jokes as to how stupid the government is. It's true that they are stupid, that's why they have no business being in the private sector at all, but it is our money.
The only reasonable thing to do is make Obama eat his commitment not to give a single penny more in bailout money and prevent the wholesale giveaway of American assets to private banks. Revoke Goldman’s deal and block further bailouts to Fannie Mae, Freddie Mac, and every other rotten financing business out there. When the next hurricane hits lets make sure the taxpayer is not the one standing outside in the rain. It's time for those responsible to take the drenching. We call it capitalism. It's about time the US government learns about what that means.