Commercial Real Estate – Alarm Bells Are Sounding

Late, as usually, US Lawmakers Sound Alarm About Commercial Real Estate Market:

WASHINGTON -(Dow Jones)- U.S. lawmakers rang alarm bells about the troubled commercial real estate industry, which has been walloped by the credit crunch and an implosion of property values.

“The commercial real estate time bomb is ticking,” Joint Economic Committee Chairman Rep. Carolyn Maloney, D-N.Y., said in opening remarks to a hearing before her panel Thursday.

U.S. Sen. Sam Brownback, R-Kansas, said he was distressed about the situation the industry is facing.

Banks have yanked back on lending to developers of shopping malls, apartment complexes, hotels and office parks. Meanwhile, the securitization market – a key source of funding for the commercial real estate industry – has been in a deep freeze since last year.

The situation is fueling concerns that property developers won’t be able to refinance roughly $400 billion in commercial real estate debt coming due this year. Property values have plunged about 24% since their peak in 2007, further hampering developers’ ability to obtain refinancings or loan extensions.

General Growth Properties, one of the largest U.S. shopping mall owners, filed for bankruptcy protection along with 158 of its properties in April, citing lack of financing.

A wave of defaults of commercial real estate loans would deal a blow to the already weakened banking industry. The U.S. commercial real estate market is roughly $6.7 trillion in size and is underpinned by about $3.5 trillion of debt.

The Federal Reserve has taken steps to get lending flowing to the industry. On June 16, it announced it would accept as collateral new issuance of commercial mortgage-backed securities as part of its emergency program to thaw the securitization market. As early as next week, the Fed is expected to extend that to existing, or “legacy”, CMBS already held by investors.

The commercial real estate industry believes these steps will help unleash lending to property owners and developers by spurring more investor appetite for CMBS. To the extent that CMBS investors are able to buy and sell the securities again, spreads will tighten, the Fed argues. That will allow financial institutions that make loans backing the CMBS to free up their balance sheets and make new loans to the industry or refinance existing debt.

Ah sure. The Fed will once again jump in heroically and this time help us by unleashing the dragon of commercial property loans. Let’s have a look at the terms of CMBS Talf:

Operation Announcement
Subscription Date: July 16, 2009
Closing Date: July 24, 2009
3-Year Maturity Date: July 24, 2012
5-Year Maturity Date: July 24, 2014
Facility Open: July 16, 2009 1:00 p.m. ET
Facility Close: July 16, 2009 3:00 p.m. ET
Administrative Fee: 20.00 basis points
Eligible Collateral: CMBS1
Loan Term: 3 or 5 years
Rates will be set at 12:00 p.m. ET on July 16, 2009
Haircuts for New Issue CMBS and Base Dollar Haircuts for Legacy CMBS:

CMBS Average Life (years)



Commercial Mortgage




Fixed 3 year loan
(Average Life, in years)

Fixed 5 year loan




Commercial Mortgage



3-year LIBOR swap rate
+ 100 bps

5-year LIBOR swap rate
+ 100 bps

1As defined in the terms & conditions

Loans will be made over 3-5 years, with CMBS as collateral. The objective being that the lenders, now afloat in new cash, once again start making loans to commercial real estate buyers and/or developers.

This misses the fundamental point as to why commercial property owners and developers are in trouble. It is the fact that the consumption credit expansion has brought about an abundance of retail space in malls, shopping centers and elsewhere. On top of that, a lot of businesses from the lending business were utilizing a significant portion of prime office space.

Now those businesses that were utilizing these spaces are going out of business. The recession is trying to send a signal that the resources are needed elsewhere. They are unable to make their rent payments. The owners of the properties start defaulting on the loans made during the credit expansion. The lenders notice that way too much space was built. There is no demand for any more retail space. In fact, there is a significant surplus. Nobody wants any more retail space. People are sick and tired of debt and over consumption.

Now, what are those very lenders going to do when they receive additional loans from the Fed, at around 2.9% to 3.7%, maybe even more for higher maturities. So they would have to earn at least an additional 100 basis points, probably more, in rental yield in order to make this investment worth their while, and that over the next 3-5 years.

Is this going to happen in an environment of falling prices for commercial properties, falling rents, and record vacancies? No, absolutely not. When people have had enough of something, they’ve had enough. If this is still not clear, I would recommend reading Robert Prechter’s example on Jaguar Inflation which I posted in Inflation and Deflation Revisited.

CMBS TALF will be a miserable failure, just as all other lending facilities launched by the Fed. It is possible that this failure will actually expose the dire situation of commercial lenders and accalerate the downward spiral. Thus, look out for the aftermath of first CMBS TALF auction on July 16th. Rather than it being a cure, it is likely that it will usher in a significant acceleration of commercial property loan defaults.

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Crunchtime for Mall Owners

Reuters writes U.S. mall vacancy rate soars, rent dives:

NEW YORK, July 8 (Reuters) – The vacancy rate at U.S. strip malls reached a 17-year high in the second quarter, and empty space at regional malls struck a nine-year record as more retailers downsized or went out of business altogether, according to a leading real estate research firm.

The consumer-led U.S. recession has hurt retailers hard and pummeled their landlords, forcing many store owners at neighborhood shopping centers and malls to shutter their businesses. Those still alive have reduced their space needs or negotiated for lower rental rates.

Falling incomes of landlords have made it increasingly difficult for them to meet loan payments and may fuel an already-rising rate of defaults within the retail real estate sector.

“It doesn’t take much to knock your incomes down if you’ve levered up,” said Victor Calanog, director of research for Reis Inc, which released its quarterly report on Wednesday. “There’s just no support for income-generating properties being able to meet fixed-debt obligations.”

During the second quarter, the vacancy rate at U.S. strip malls reached 10 percent, the highest level since 1992, the report said.

Meanwhile, asking rent fell 1.7 percent from a year ago to $19.28 per square foot. Asking rent fell 0.7 percent from the prior quarter. It was the largest single-quarter decline since Reis began tracking quarterly figures in 1999.

Factoring in months of free rent and other concessions, effective rent declined 3.2 percent year-over-year to $17.01 per square foot. Effective rent fell 1.1 percent from the prior quarter.

About 7.9 million square feet of space was returned to the market during the quarter. The amount was second only to the 8.1 million square feet in the first quarter.

The picture was no prettier for U.S. regional malls, whose vacancy rate rose to 8.4 percent, the highest vacancy level since Reis began tracking regional malls in 2000.

Asking rents for regional malls continued to deteriorate but at a faster rate, falling 1.4 percent in the second
quarter, compared with 1.2 percent in the first. Year-over-year asking rent fell 2.9 percent to $39.42 per square foot.

Rising U.S. unemployment and soaring home foreclosures point to a longer recession and greater insecurity among consumers. With a dearth of positive indicators, it does not look like a green shoot of recovery will be able to fend off deteriorating rents and occupancies in the sector.

“Right now it looks like all signs are pointing to rents and vacancies, big components of income, getting shot down,” Calanog said. “Until we see stabilization and recovery take root in both consumer spending and business spending and hiring, we do not foresee a recovery in the retail sector until late 2012 at the earliest.”

That does not bode well for mall owner General Growth Properties Inc (GGWPQ.PK), which filed for bankruptcy
protection in April, after it failed to refinance maturing loans.

It also could translate into tougher business conditions for shopping center owners, such as Cedar Shopping Centers Inc (CDR.N), Equity One Inc (EQY.N) and Kimco Realty Corp (KIM.N).

This is commercial property crunchtime in action. Remember, what the article I referenced back then said:

Since late 2007, a total of 47 banks and savings institutions have failed, of which a dozen or so had unusually high commercial-mortgage exposure. Foresight Analytics in Oakland, Calif., estimates the U.S. banking sector could suffer as much as $250 billion in commercial real-estate losses in this downturn. The research firm projects that more than 700 banks could fail as a result of their exposure to commercial real estate.

Why there is more pain to come for commercial mortgage lenders:

Mortgage Losses To Come (note the whopping 3.5 trillion for commercial mortgages):

Click on image to enlarge.

To add some personal experience: A friend of mine leases an entire floor at a prime location in the San Francisco financial district. He used to pay $40 /sqft over the past 2 years. His lease is now coming up for renewal. He negotiated it down to $27 /sqft for the new lease. And this was 2 months or so ago. I think there are even better deals to come as the market for prime locations continues to get flooded with vacant space.

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Commercial Real Estate Poised to Implode

Nothing but grim news on the commercial real estate front. The New York Post writes NO NEW LEASE ON TRILLIONS IN DEBT:

A trillion-dollar storm is gathering over the commercial real estate landscape that’s threatening to add further pain to an already bruised US economy.

At the center of the worries is some $3.5 trillion in debt backed by everything from strip malls to offices and apartments across the nation — the lion’s share of which is badly underwater because this recession followed a five-year commercial property boom fueled by easy money and loose underwriting standards.

Now the owners of the less-than-full malls, apartment complexes and office buildings are succumbing to the worst economic collapse since the Great Depression — because they can’t refinance the debt.

The commercial debt securitization market is dead.

“Because there is no securitization the system cannot process the wave of maturities coming due,” said Scott Latham, commercial property broker at Cushman & Wakefield.

“This is arguably the most important fact we’re going to be dealing with. If there’s no mortgage market that can feed the machine you’re just not going to have deals,” he said. “It’s going to be years before we recover and even when that happens we’re going to discover that we’re in a new paradigm,” Latham added.

About $1.4 trillion in real estate debt is set to mature over the next four years, with some $204 billion coming due this year alone.

Most of that debt won’t be able to be refinanced or restructured because lending standards have tightened and commercial real estate values have cratered since last year, according to Deutsche Bank analyst Richard Parkus.

The debt behind the commercial real estate boom, commercial mortgage-backed securities, or CMBS, entails pooling together commercial mortgages in apartment buildings, shopping malls or trophy offices in different locations, packaging them into bonds and selling them to investors.

CMBS issuance reached its peak with $230 billion transactions completed in 2007. Last year, as the market was dying, a relatively anemic $12 billion in activity was seen, according to industry newsletter Commercial Mortgage Alert.

Most of this does not seem to have a major impact on large national banks, but the total number of small banks affected will be huge, according to the Wall Street Journal Small Banks Face Hits on Commercial Real Estate:

Thursday’s “stress-test” results will bring fresh scrutiny to the nation’s biggest banks. They also are likely to highlight the woes from commercial real-estate loans that are piling up at large and small banks alike.

In the worst-case scenario, federal regulators examining the 19 largest U.S. banks are projecting losses of up to 12% on commercial real-estate loans over two years, according to a document viewed by The Wall Street Journal. The regulators are likely to cite commercial-property debt problems as a major reason why at least some of the large banks need additional capital.

My comment: Does anyone seriously believe that in a worst case scenario the banks will lose no more than 12% on commercial real estate loans? But even then:

With that loss rate, “you’re talking about a depression in the U.S. economy and a major crisis in the banking system,” says Richard Bove, an analyst at brokerage firm Rochdale Securities LLC.

… say hello to commercial property crunchtime.

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Markets Slide Alongside Lousy T-Bond Auction

Markets took a slight hit today. The significant event of the week, maybe even of this quarter was a lousy auction for bonds maturing on 05/15/2039.

They traded as low as 4.13% before the auction and went as high as 4.30% to close at 4.26%, or 13 basis points higher.

Some random observations/expectations:
– Tech stocks, which lead the recent rally, lead the decline today.
– Short interest on some stocks is remarkably low
– In particular I am monitoring commercial property businesses, such as Simon Properties Group, and Vornado, both of them have a short interest of close to 0% in spite of the impending commercial property crunchtime.
– Jobs data on Friday will probably report something between 400,000 to 600,000 nonfarm jobs lost again, based on today’s ADP jobs report.

Nonfarm private employment decreased 491,000 from March to April 2009 on a seasonally
adjusted basis, according to the ADP National Employment Report®. The estimated change of
employment from February to March was revised by 34,000, from a decline of 742,000 to a
decline of 708,000

Whether these are signs that the recent bear market rally is coming to an end…only time will tell.

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Commercial Property Crunchtime

The Wall Street Journal writes Commercial Property Faces Crisis (notice the bold part) :

Commercial real-estate loans are going sour at an accelerating pace, threatening to cause tens of billions of dollars in losses to banks already hurt by the housing downturn.

The delinquency rate on about $700 billion in securitized loans backed by office buildings, hotels, stores and other investment property has more than doubled since September to 1.8% this month, according to data provided to The Wall Street Journal by Deutsche Bank AG. While that’s low compared with the home-mortgage delinquency rate, it’s just short of the highest rate during the last downturn early this decade.

[smartads]Some experts say it now looks as if the current commercial real-estate slump will rival or even exceed the one in the early 1990s, when bad commercial-property debt played a big role in dragging the economy into a recession. Then, close to 1,000 U.S. banks and savings institutions failed. Lenders took about $48.5 billion in charges on commercial real-estate debt between 1990 and 1995, representing 7.9% of such debt outstanding.

Since late 2007, a total of 47 banks and savings institutions have failed, of which a dozen or so had unusually high commercial-mortgage exposure. Foresight Analytics in Oakland, Calif., estimates the U.S. banking sector could suffer as much as $250 billion in commercial real-estate losses in this downturn. The research firm projects that more than 700 banks could fail as a result of their exposure to commercial real estate.

These numbers are truly staggering. This goes to show us that the correction is very very far from over. Anyone who talks about a speedy recovery or calls a bottom at this point is blithely ignoring, among other things, the impending collapse of commercial property values, rents, loans, and the effect that it will have on a significant number of banks and businesses.

The fact that the delinquency rate is still relatively low shows us that this is only just the beginning:

Who seriously doubts that this commercial property implosion will be much more severe than the one in the 90s and in 2003?

Some excerpts of my writings on this topic over the past year:

Holiday retail sales down:

I expect that in 2009 commercial real estate will finally be recognized by the wide public as the disaster it is. Amercia doesn’t need any more Malls. Companies with high exposure to commercial retail properties will suffer. Stocks of Simon Properties Group (SPG) and Federal Realty Trust (FRT) will follow General Growth Properties (GGP) and tumble.

2009 – An Outlook:

  • Commercial real estate and consumer credit will be the next sub-prime crisis and companies from those industries will get in line for massive bailouts

Macy’s to Close 10 Stores:

…more bad news for commercial real estate as already mentioned in Holiday Retail Sales Down. The impact of Macy’s closing down just 1 location will be devastating for anyone who rents out the space. Multiply that by 10.

Retail and Food Service Sales Down:

This is consistent with a miserable shopping season, closing chain stores, and contracting consumer credit. In addition it is important to stress again and again the disastrous consequences that this whole trend will continue to have on commercial real estate in the US.

Virgin Closes 2 More Megastores:

It cannot be pointed out often enough what a devastating disaster still awaits the commercial property industry. It will make the current residential real estate bust look like a soft landing.

I may add to this: This implosion of commercial real estate will not be confined to the United States. It will spread like a global epidemic. In particular China has a lot of excess space. Its current export contraction will only add to the decline in values and rents. It will affect the entire region around it, including the popular property trusts in Singapore and Hong Kong.

Buckle up, get ready for commercial property crunchtime…

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