The Commercial Real Estate Mortgage Crisis and Beyond...by Bob Canter, Performance Realty Solutions

Implications: What is perhaps astonishing is the total lack of understanding from commercial real estate experts and economists alike that the credit crisis is just unfolding. Or as the article suggests the participants are in the “hear no evil, see no evil, speak no evil” mode. What is also incredible are the experts saying that due to the “solid” fundamentals of the commercial real estate market everything will be just fine and we’ll ride this credit situation out with virtually no problems. It is further predicted by these experts that although 2008 will be a tough year all will be well in 2009. This prediction is no different than weather men/women predicting in the beginning of December what the upcoming winter season will be like. I guess if you predict far enough in advance either people will forget your predictions or your chances on being accurate become greater.

Analysis: What is not being taken into account is the contagion the subprime and the collapse of the securitized credit markets will have going forward and how it will affect every corner of our business lives.  

As the referenced article details; the CMBS market has all but closed down with no foreseeable end to the problems at hand. There are “loans” the sponsors are holding because there are no buyers at any price to take them off their hands.

The buyers of the investment properties that “took” advantage of these lending products had the misguided judgment that rents and property values would only go in one direction. It is truly amazing that so called sophisticated buyers would take loans and buy properties with this premise with no thought to their downside risk. Perhaps that is due to the overall “non-recourse” nature of the loans whereby the borrower has no personal liability for the loans. The thought process is if it doesn’t work out oh well let the lender take it back.  

These lenders did not care either, as unlike the early 1990’s where lenders carried the loans on their books, if the property went into foreclosure, it would be the lender who had the problem of disposing of the property. What the securitized market has accomplished is it handed-off the ultimate liability to the bond holders.  

The big picture here is not those who bought properties at too thin margins or used overly aggressive income assumptions, and got ridiculous loans with terms unheard of in the commercial real estate markets, no the big picture is what all this will do to the American economy and beyond.  

Lenders have herd mentality, and as such if one lender goes running off the cliff they all will follow. This likens the wildebeest migration run that you can see on Animal Planet.  

What most folks do not realize is that most debt today is securitized. They are called in general terms CDO...Collateralized Debt Obligations. What has happened over the last 15-20 years is that lenders et al have figured out a very efficient method of recirculation their money put out for loans by selling the debt obligations as bonds to the buying public. The buying public being described as other banks, financial institutions, governments, and John Q. Public. The proceeds from the bond sales go back to the originator of the loans and the process can start all over again.  

Everything works well when the bonds are rating properly, and the returns are based on proper risk and there are no major defaults etc.  

Lets jump to the present and there is a subprime lending mess in the residential sector. Now the Federal Reserve looks at the commercial sector in early 2006 and guess what...the contagion now spreads to the commercial sector as it becomes apparent the same lessening of underwriting standards are rampant.  

The buyers of the CMBS notes/bonds and the subprime bonds are now at a loss and have voted “No Confidence” in these instruments and this financial sector is all but closed down.   The result is what I’ll call a cascading effect. Everyday you read that buildings are being withdrawn from the market because either bids are too low or financing not being obtainable. You see that the TIC (Tenants-in-Common) investment sector has come to a halt due to lack of financing.  

The current predictions are for investment sales volume to decrease by 60% in 2008. Ok you say, so that segment of the commercial real estate world slows down to what some will say is a more normal pace. Yes, however what happens is the taxes generated by these sales and the home sales hit local and state governments as they too based budgets on ever increasing sales and property values. So governments raise taxes or reduce spending or a combination of the two. That is less money for the consumer and businesses as business taxes will also increase.  

On top of all this, as the housing slump continues its downward spiral, you have lay-offs in the construction industry both residential and commercial. There has been over 200,000 jobs lost in the residential lending sector alone. Add the numbers for construction and so on.
Just look at all the industries related to the housing sector and you will get a clearer picture of the ramifications.

Coupled with the housing slump consumer spending drops. It hasn’t showed up yet as people went from tapping their home equity lines to using their credit cards which is far worse than using the equity lines. Credit card debt is unsecured debt...but that’s OK as long as the American consumer keeps spending.  

Businesses are now having difficulty getting regular non-real estate loans for expansion, cash flow, or whatever reason businesses borrow.   Next you will have companies cutting their dividends. Banks have already gone this route. Less dividend income less spending as well.  

The ripple effect of the housing slump can not be viewed as if its in some isolation ward. Just today for example December 18, 2007 Centro Properties an Australian REIT announced “Related Australian property trusts Centro Properties Group and Centro Retail Trust slashed their earnings forecasts yesterday because of increased debt-refinancing costs, prompting investors to strip 4.78 billion Australian dollars (US$4.12 billion) from their market capitalizations. The conditions being experienced around the world in credit and debt markets have made it difficult to refinance," Chief Executive Andrew Scott said.”

Lets face reality, the American and now Global economic engine is fueled by the use of CREDIT. Most of this credit is generated by CDO’s. From car loans to credit card debt, to store credit cards and business loans. When the credit markets become spooked bad things happen. If it something minor like the late 1990’s currency debacle due to the Russian currency play that Wall St. bet wrong on affected the credit markets, that was a minor head cold and was over fairly quickly. When you have trillions of dollars in real estate CDO’s and now other debt obligations and the buyers of those CDO’s questioning the risk reward ratio of what they bought you have a major problem.  

The unfortunate fact in today’s business world is that Wall St. has no patience nor willingness to wait for long term returns. Everything is viewed on a daily and monthly basis, not even quarterly. With Wall St. running around to find greater returns they leap before looking.  Wall St has taken as gospel which most companies have also adpoted is that growth is always a straight line up. No valleys just always pointing up.
That is so unrealistic, but surprising how many business executives believe that is how their bottom lines and sales should always go, straight up...  

Lastly, just because the Federal Reserve is dropping interest rates and infusing cash into the banking system does not mean loans will be readily available and if they are it will be to the best credit rated borrowers at very stringent terms. The banks especially are too distracted with getting out from under their current mess to want to deal with adding to it in their minds.   When credit becomes hard to come by which leads to less borrowing the entire economic engine will have no choice but to stall.   Demand for commercial space has already begun to slow to a snails pace.

There is new construction going that will have to completed that will increase vacancy rates in many prime areas. Even if vacancy rates don’t go up, you need to look at the absorption of available space. If that stays the same and space remains on the market for any sustained period of time the rents will drop. When companies lay-off workers they are still responsible for their lease, but they can sublease or not renew their leases. Subleases put downward pressure on rents.  

With a looming Presidential election less than a year away, many companies will hold off on their expansion plans until it is known which way the election goes.  

So the fundamentals look good for now, and the experts, even Sam Zell says this is what will save the commercial sector. Well ask yourself if Sam Zell sold which is arguably deemed to be the peak of the market what does that mean in “Reality”?  

No the world is not coming to an end, but there will be some dramatic changes to occur in the next 12-18 months.   Enjoy the Holidays...