General Growth Properties and the Commercial Real Estate Time Bomb

| About: GGP, Inc. (GGP)

Here is 2009 outlook for commercial real estate from Deutsche Bank. It does not paint a pretty picture. Run through it (it is mostly graphs).

Commercial Real Estate Outlook 2009 So? What to make of it? The short answer is there is still pain hovering out there for banks if they allow these loans to default.....if.

First we need to segment the commercial owners into categories. The owner who holds mortgages on a single strip mall in Des Moines vs. the REIT that hold 100 or more properties. What about the little guy who gets in trouble? Sorry bud but you are cooked. There will be no help for you from either the banks or the Feds. But, you big boys out there are going to be spared OR at least kept on life support.

Why? Scale. Let's say we have three property owners in a town. One guy holds 20 properties and the others each own one or two. All three are currently delinquent. Who does the bank care the most about? Of course, the big guy. If he is forced into bankruptcy, the entire town's property values are destroyed.

The chance of the bank recovering anywhere near their investment is virtually nothing. Now if they refinance his loans (extend maturity to lowers payments so they are covered by current rents) and let the other two go into bankruptcy, the market takes a small hit while it waits for the economy to come back. As the economy comes back, rents rise and property values rise with it and the bank gets made whole on its loans. The key point here is that the market survives.

But, with banks already strapped, how can we be sure there will be funds available to refinance?

From the WSJ:

Commercial real-estate debt is potentially more dangerous to the financial system than debt classes such as credit cards and student loans because of its size. The Real Estate Roundtable, a trade group, estimates that commercial real estate in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt. Partly because the commercial real-estate debt market is nearly three times as big now as in the early 1990s, potential losses in dollar terms loom larger.

According to an analysis of bank financial reports by The Wall Street Journal, the broad shift to real-estate lending can be seen by comparing commercial real-estate loans -- including both mortgages and construction loans -- with banks' so-called Tier 1 capital, a key indicator of a bank's ability to absorb losses. In 1993, less than 2% of the nation's banks and savings institutions had commercial real-estate exposure exceeding five times their Tier 1 capital. By the end of 2008, that had risen to about 12%, or about 800 financial institutions. A higher ratio means a thinner cushion for loans that go sour.


The Federal Reserve and the Treasury are moving to adapt a funding program to make it attractive for investors to buy debt backed by office buildings, hotels, stores and other income-producing property. The program, called the Term Asset-Backed Securities Loan Facility, or TALF, was begun to finance purchases of debt backed by consumer credit, and officials will expand its use to include commercial-property debt.

See, if CRE goes bust, all the aid to banks that has been doled out up to this point gets flushed away. It is in both the banks AND the government's best interest to assure that does not happen. Keeping it from happening in CRE is also FAR easier than the mortgage market. Rather than dealing with millions of individual homeowners, only a dozen or so REITs must be helped.

So, this all leads us to General Growth Properties (NYSE:GGP). It looks increasingly like two or three debt holders are going to force (or allow) it to file Chapter 11 (reorganization this weekend). If (when) that happens, what is in the best interest of all? GGP is the largest mall owner in the U.S. That means that whatever happens to it affects the entire CRE market in the U.S.

Because of that, a liquidation cannot happen. There are no buyers that can purchase enough of the properties with credit markets in their current state to avoid a total collapse of the CRE market. With $3.1 TRILLION of loans out there for it, it sort of makes the $50 billion given to Citi (NYSE:C) look like change found in the sofa and gives us some proportion of the potential damage. With mark-to-market accounting rules, the destruction of GGP debtors would cascade to all lenders and make what homeowners did to banks look like "the good 'ole days".

How bad could it be? Look at the following chart from Goldman Sachs (NYSE:GS).

Click to enlarge:

If you look at the third column you'll see that most banks are still carrying commercial loans at 99% or higher. This means they haven't even begun to write-down these loans. It also gives them more impetus to do anything possible to avoid having to do this... translation? Refinance...

As an aside. It would seem that Wells Fargo (NYSE:WFC) has been the most honest with its marks (that being relative to the others). It also means they may be done marking down assets. A lot of "mays" but worth watching.

Now is the problem with GGP that the business is going under? No. If the debt is refinanced, GGP can pay its interest from its operation (here is case law to support this). Don't forget, it did as of the last quarter have a 92% occupancy rate. That is sure to fall but is at the top of the industry. If the debt can be refinanced, everyone is made whole and we now have the largest player in the market stabilized and have provided a blueprint for the rest of the industry.

One cannot underestimate the positive effect on the CRE market as a whole should that happen.

Well, if all that is true, why hasn't it happened yet? TALF just went into effect and while it appears it will be expanded to include CRE, that has not officially happened yet. That is why we are seeing extension after extension. Once it comes into effect, we ought to see movement here.

Now as usual, a warning. I know people have been following into this investment. If you do, you must be prepared to lose it all. There is no guarantee of the above outcome. Buying this stock now is essentially buying a call option on the company's survival. If it hits, you win big, very big. If not, what you invested is worth nothing. I believe the above scenario will play out, but I am also not going to be broke should it not.


Disclosure: Long GGP, WFC

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