Raw Finance

In its most recent monthly commercial real estate delinquency report, Realpoint Research observes that the delinquent unpaid balance for commercial mortgage-backed securities (CMBS) has risen an “astounding” 583 percent from a year ago.  The report shows that CMBS delinquent unpaid balances rose to $31.73 billion in September 2009 from $28.16 billion in the month prior and from $4.64 billion in September 2008.  Retail loans remained the greatest contributor to overall CMBS delinquency, at 1.2 percent of the CMBS universe and nearly 30 percent of total delinquency.  Individually, the retail default rate grew to 4.2 percent in September 2009 from 3.95 percent a month prior, up substantially from only 0.6 percent one-year ago.  The report notes that retail surpassed multifamily in May 2009 as the highest CMBS default contributor, for the first time since May 2004.

The report breaks delinquencies down into five categories (similar to a bank call report): 30+ days past due, 60+ days past due, 90+ days past due, in foreclosure, and REO (real estate owned – i.e. purchased in foreclosure by the lender).  In September 2009, the 90+ day, foreclosure and REO categories grew in the aggregate for the 22^nd consecutive month, increasing 8 percent from August and 547 percent year-over-year.  In addition, both the delinquent unpaid balance and the delinquency percentage over the trailing twelve months are trending higher.

Forecast

With these upward trends in place, Realpoint’s forecast for commercial real estate (CRE) in the next 6 to 9 months is grim.  “Based upon an updated trend analysis, we now project the delinquency percentage to grow between 5% and 6% before year-end 2009 (potentially approaching and surpassing 7-8% under more heavily stressed scenarios through the first half of 2010).”

Government’s View of CRE Also Gloomy

Testifying before the House Subcommittee on Domestic Policy, Committee on Oversight and Government Reform, Jon D. Greenlee, Associate Director, Division of Banking Supervision and Regulation, Federal Reserve Board commented on the state of banks’ loan portfolios: 

Loan quality deteriorated significantly for both large and small institutions during the second quarter of this year. At the largest 50 bank holding companies, nonperforming assets climbed more than 20 percent, raising the ratio of nonperforming assets to 4.3 percent of loans and other real estate owned. Most of the deterioration was concentrated in residential mortgage and construction loans, but commercial, CRE, and credit card loans also experienced rising delinquency rates. Results of the banking agencies’ Shared National Credit review, released in September, also document significant deterioration in large syndicated loans, signaling likely further deterioration in commercial loans.¹ At community and small regional banks, nonperforming assets increased to 4.4 percent of loans at the end of the second quarter, more than six times the level for this ratio at year-end 2006, before the financial crisis began. Home mortgages and CRE loans accounted for most of the increase, but commercial loans have also shown marked deterioration during recent quarters. 

Specifically regarding CRE, Greenlee commented: 

Prices of existing commercial properties have already declined substantially from the peak in 2007 and will likely decline further. As job losses have accelerated, demand for commercial property has declined and vacancy rates have increased. The higher vacancy levels and significant decline in the value of existing properties have placed particularly heavy pressure on construction and development projects that do not generate income until after completion. Developers typically depend on the sales of completed projects to repay their outstanding loans, and with prices depressed amid sluggish sales, many developers are finding their ability to service existing construction loans strained.

As a result, Federal Reserve examiners are reporting a sharp deterioration in the credit performance of loans in banks’ portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of 2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for multifamily housing developments. Of this, $1.7 trillion was held on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion. Also at the end of the second quarter, about 9 percent of CRE loans in bank portfolios were considered delinquent, almost double the level of a year earlier.³ Loan performance problems were the most striking for construction and development loans, especially for those that financed residential development. More than 16 percent of all construction and development loans were considered delinquent at the end of the second quarter.

Of particular concern, almost $500 billion of CRE loans will mature during each of the next few years. In addition to losses caused by declining property cash flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. The losses will place continued pressure on banks’ earnings, especially those of smaller regional and community banks that have high concentrations of CRE loans.

The current fundamental weakness in CRE markets is exacerbated by the fact that the CMBS market, which previously had financed about 30 percent of originations and completed construction projects, has remained closed since the start of the crisis. Delinquencies of mortgages backing CMBS have increased markedly in recent months. Market participants anticipate these rates will climb higher by the end of this year, driven not only by negative fundamentals but also by borrowers’ difficulty in rolling over maturing debt. In addition, the decline in CMBS prices has generated significant stresses on the balance sheets of financial institutions that must mark these securities to market, further limiting their appetite for taking on new CRE exposure. 

“Huge Crash” in CRE Coming: Ross 

If this article has not already destroyed the reader’s interest in an investment in CRE, billionaire investor Wilbur L. Ross, Jr., puts on the exclamation point.  In an interview on Bloomberg Radio last week, Ross stated unequivocally that the U.S. is in the beginning of a “huge crash in commercial real estate.”  He further noted that he would use “extreme caution” before putting money into commercial real estate, especially office space, because properties are losing tenants.  Ross has recently been investing in residential mortgage-backed securities as one of the private investors in the Treasury’s Public-Private Investment Program designed to relieve banks of so-called “toxic assets.” 

Another long-time expert in the purchase of distressed commercial real estate (but perhaps not so much when it come to newspapers) Sam Zell recently weighed in on the market, saying “This is a demand recession and I suggest to you that as the economy improves, it’s very likely that these buildings that are currently suffering vacancies will be full. That’s the good news. The bad is, they’ll be full at thirty percent lower rates.” 

Investment Analysis 

Judging by the research and analysis available on commercial real estate and banks, any investment in either sector can fairly be labeled “speculative.”  The world, and especially the U.S., is in the very beginning of a multi-year deleveraging process, at least we should hope we are because shedding debt, returning to responsible habits, and making products and offering services the rest of the world will buy is what is best for the U.S. economy in the long run.  This process will be very hard on banks and certain assets like real estate. 

For aggressive investors, it is easy to look at the present situation and speculate that banks and CRE will be more valuable in the near future because they have been down the most in this recession.  In “normal” recessions that concept is generally true: the worst performing sectors in the recession are generally the best performing coming out.  However, this recession was caused by a financial crisis, and such recessions never behave in predictable ways.  Investments in banks and CRE at this point should only be for the most aggressive investors who have a long time horizon to make up for potential losses.  There may very well be reward for such investments, but the risks are clearly beyond that which the vast majority of prudent investors should be taking in this environment.