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Will Anything Stop The Decline of CRE Prices?

Submitted by Econophile on 06/11/2010 00:47 -0400

Fitch reported today that commercial real estate (CRE) values continue to decline giving rise to greater loan losses on CRE. On the average throughout 2009, lenders recovered 43 cents on the dollar on distressed loans. They see the loss rate only going up.

The average loss severity rate or the ratio of realized loss to liquidation balance for U.S. commercial mortgaged-backed securities (CMBS) loans resolved with losses in 2009 was 57% compared to the 43% rate in 2008, according to new data from Fitch Ratings. Those losses outpace the cumulative historical average of 37.2%.

"Loss severities are expected to remain above the current cumulative average through 2011," said Fitch managing director Mary MacNeill. "Assets liquidated in the current economic environment will be those not likely to see cash flow improvement from an extension or modification."

"Assets will take longer to resolve as special servicers continue to see high volumes of underperforming loans," added Fitch senior director Richard Carlson. "Continued high inventory and the declining frequency of modifications means there is no relief is in sight." ...

"Property value is the barometer of potential losses for CRE debt," [Xiaojing Li, senior debt analyst for CoStar Group] said. "In the first quarter of 2010, there were already $270 million in losses via liquidation. Among the $17.7 billion in loans newly added to special servicers this year, 7% have already had appraisal reductions, threatening a new wave of losses."

Losses by property type were:

* Hotel: 81.9%.
* Multifamily: 58%
* Office: 56.9%
* Industrial: 48.8% and
* Retail: 48.2%.

I am reprinting this refi timeline chart to give you a better idea of the problem:

As you can see, there is a huge problem through 2013. Which translates into fall CRE prices. This price index from Moody's in March:

There are factors that are positive and negative at work in the economy with regard to CRE.

First, lenders are in trouble. CRE is held mainly by local and regional banks. However the very large loans are held by many insurers. S&P and Moody's recently downgraded some insurers as a result of this, despite the fact the insurers had raised $32 billion in capital. Downgraded were:

NLV Financial Corp. and subsidiaries, Pacific LifeCorp and subsidiaries, and Principal Financial Group Inc. and subsidiaries. The ratings on MetLife Inc. and subsidiaries remain on CreditWatch, where they were placed on Feb. 3, 2010. Standard & Poor's affirmed its ratings on Teachers Insurance & Annuity Assoc. of America (TIAA); the outlook on TIAA remains negative.

Only New York Life Insurance Co. was upgraded - to stable from negative and its ratings affirmed. ...

Basically S&P argues that current economic conditions in commercial real estate are tantamount to a 'BBB' scenario and insurers must have fundamentals to withstand even worse economic conditions to get a higher rating. For an insurer to rate a 'AAA' financial strength rating, for example, it would have to withstand the Great Depression - not the one that just past but the one of the early 1930s.

Second, this is why regional and local banks are in trouble. See my article, "How Bad Economic Theory Caused Santa Barbara Bank & Trust To Fail

The other side of the coin is that the vultures are gathering. For example, insurers who have licked their wounds clean are ready to jump back in:

Hartford Financial Services Group Inc. Chief Executive Officer Liam McGee, who promised to reduce risk when the bailed-out insurer hired him eight months ago, is comfortable enough with his work that he’s looking for deals in the U.S. property market.

“We’re no longer on our heels when it comes to real estate,” McGee said in an interview yesterday at Bloomberg headquarters in New York. “Our bias going forward would be less about selling and more about realizing value.”

Read this as cherry-picking.

Add to that the pools of capital that local investors are putting together on the sidelines, waiting to jump in as they see values making sense. Based on my knowledge of these markets, this phenomenon is nationwide, and represents a huge pool of capital in the aggregate.

What these buyers will do is act as a backstop to the CRE market. I can't guess what that level will be, but I believe the vultures are getting impatient. I believe there is still a lot of risk in this market, but then I am very adverse to risk. Most of what I hear is anecdotal but investors are chasing yields, and in the right market with the right property that makes sense.

I just don't think we are at bottom yet. And this will continue to harm the small banks. Without the small banks recovering I believe we will continue to have problems with a lack of liquidity, a credit freeze, deflation, and a slow recovery.

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Sat, 06/12/2010 - 16:21 | 409828 Econophile

Let me clarify a few items.

1. The REITs were bid up by the market last year because they were cheap relative to their debt structures. This is a big generalization, but those REITs that had stable long-term debt or very low debt relative to their asset base, were pretty good deals. I am sure there are some crap that was bid up with the good ones. SPG? Dunno (although Herb S. lives here--whoops, name dropping again).

2. The market is indeed "compressing" cap rates which is a fancy way of saying that prices are dropping. I am familiar with the So. Cal. market and, taking the LA area as an example, there is a major collapse. Values are down, cap rates are up, rents are down, and the competition for tenants is cutthroat, as I can personally testify. Oh, I almost forget to say that getting a loan is difficult.

3. There is always a market for gilt-edge properties. At some point, a prime property will be bought up, but not quite at the dramatic discount you'd think. The reason is that there is a lot of capital from major investors (REITs and insurance companies, etc.) who would like to buy them. Nothing new there.

4. CMBS is not really the major problem with CRE. A relatively small portion of CRE debt, as shown in the GS chart, are MBS. The vast majority of loans are from regional and local banks and that's the problem. IMHO there is no way MBS can do anything to impact this market in a positive way -- yet. As Cheeky points out, these new deals are just to test the waters and crank cash out for the Streeters. These attempts are futile, as Cheeky points out.

5. I see deals all the time, mainly from banks. My anecdotal evidence is that there is some movement with their REO. It appears that the FDIC and OCC are starting to pressure them to deal with the problems rather than extend-pretend. Many of the deals are financed by the same lenders. Most of them require recourse. As I mentioned, I don't need deals bad enough to go recourse in order to bail out some lender for a bad loan. They should be paying me to solve their problem. Many of these deals need a lot of work: remodeling or completion, rebuilding tenant base, and the like and while "bad boy" guarantees are OK, recourse on repayment in such a bad environment isn't a good move for me.

6. What would help is for the government to force lenders to deal with their problems rather than keep extending their time frames in the hope that the market or inflation will bail them out. In the early '90s the RTC was created to push foreclosed CRE out the door as fast as they could. No recourse for the most part. As a result a lot of great deals were made for buyers, but the positive effect was the clear out the "malinvestment" and get the economy rolling again.

7. This time the problem is huge in that the entire world is impacted by this boom-bust. The quicker we find bottom the sooner we will recover.

Sun, 06/13/2010 - 01:29 | 410260 Econophile

Whoops, I meant "rising." Sorry. Thanks Grommit.

Recourse? Not to take over bad deals. Healthy on "normal" deals and recourse was the norm pre-crash.

Sat, 06/12/2010 - 16:48 | 409846 Gromit

2) No, cap rate compression means prices are rising.

5) As for recourse, like it or not, it's back. And it's healthy.

6) Oh yes, lotta angry bears sitting on a pile of cash waiting for price discovery. The scary thing is, it doesn't seem as close as it did two years ago.

7) Yes but to go there we have to go somewhere unthinkable. Better to kick the can.

Sat, 06/12/2010 - 11:00 | 409632 SamuelMaverick

I have been working for a utility / communications company for quite a few years now. During the height of the real estate boom in 2005 I was bringing new service to both new and existing commercial real estate in New York. I had to physically go in every floor of many multi floor office buildings, and in a ton of tech parks and industrial parks. First hand I witnessed that almost all the floors of every existing older buildings were totally empty ( and were in shambles) , and in the new buidings the empty space was worse. I am talking occupacy rates of 20% ( my estimate). Best (worst) part was most of the existing tenants were quasi government / public /private bogus agencies.

Sat, 06/12/2010 - 12:04 | 409671 pitz

Makes since, since the peak of US employment was in 2000, and automation, telecommutting, and online shopping has allowed employers and retaillers to reduce their real estate requirements substantially since.

That any CRE was newly constructed since 2000 is kind of bizarre since there wasn't actually a shortage in 2000 and the economy hasn't grown since.

Sat, 06/12/2010 - 09:41 | 409586 Kreditanstalt

Actually I don't see them declining anymore. The big REITs have been pumped and pumped for months. SPG is at $87 now: a ludicrous price given the economic maelstrom approaching. The bigger question is WHY they aren't declining...and, after months of trying to short those SOBs I have figured out that it is

a) because they are 90%-95% institutionally owned and, absent redemptions, higher interest rates or demands for cash, the funds backing them need never sell.

b) because they pay dividends in cash still. Never underestimate the short-sightedness of investors who, when they should be fleeing all paper assets for gold and commodities, STILL grub for dollars. (On the other hand they NEED to: they have to pay all their own investors, unitholders, mutual fund clients and lenders in USD cash).

Sat, 06/12/2010 - 09:51 | 409592 Gromit

Yes that's right. REITs were bought for yield but that's run up about as far as it can , SPG yields 2.75% now. But it will need a catalyst to take them back down.

Price discovery has been resisted by government, lenders and sellers alike and it probably requires a major player to BK (remember GGP in 08 before QE?) to send all players cascading down.