It wasn’t all that long ago that the media and banking industry commentators would worry about the coming train wreck in commercial real estate. But peculiarly, that topic has more or less receded from view. It appears the public has only so much interest in banking stories, and the frenzied coverage of financial services non-reform plus eurozone sovereign debt woes, which are really eurozone bank woes, took center stage.
But as predicted, the decay in the commercial real estate loans continues at an impressive pace. This isn’t quite the disaster in the making that subprime was. CMBS is a smaller market and its defaults, while stunning in relationship to historical norms, are not expected, even in a worse case scenario, to reach the same level.
RealPoint’s monthly delinquency report for July (hat tip Richard Smith) shows how rapidly conditions are deteriorating:
• All deals seasoned at least a year have a total unpaid balance of $767.76 billion, with $60.45 billion delinquent – a 7.87% rate (up from only 5.28% six months prior).
• When agency CMBS deals are removed from the equation, deals seasoned at least a year have a total unpaid balance of $736.75 billion, with $60.39 billion delinquent – a 8.2% rate (up from only 5.46% six months prior).
• Conduit and fusion deals seasoned at least a year have a total unpaid balance of $655.41 billion, with $54.69 billion delinquent – a 8.35% rate (up from only 5.33% six months prior). (emphasis theirs)
Note loss severities have increased too, and now stand at 49% (which is really bifurcated; some properties are resolved at or barely under par values, while the rest averages loss severities of roughly 58%).
Deals that are performing are not necessarily out of the woods. CRE loans typically have large balloons; the expectation is that a mature property with a decent rent roll can refi. Wellie, that isn’t a given now, since funds for refis are scarce.
The report is chock full of data, but there is no good news here, only shades of bad. As Richard Smith observed, “I’m not sure why people say there isn’t a CRE crash. It’s just happening in slow motion, so far.”
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I had gotten the sense that banks had been allowed to kick the can down the road indefinitely via refinancing – if they choose to. So the only banks pulling the plug were the ones where the banks strategically thought there was enough equity in the deal to reduce the losses, but not in enough numbers to threaten their solvency.
Althought the banks are increasingly becoming defacto owners, they don’t want to own CRE and they do not have the staff and management structure competent to manage REOs. The management function has to farmed out to Realtors.
What is occuring with some regularity is restructuring which typically entails an equity infusion by the borrower; i.e., a paydown against the outstanding balance, a new lower interest rate and an extended term. There are roughly 24 structures that can be considered in any given deal. The banks objective is to be able to continue to carry the loan as a performing line entry on their books.
Where the loan has been sold into a MBS, special servicers are being activated and the CMBS indenture agreement is being reviewed for ways to facilitate a restructuring of the loans. Not infrequently the selected course of action is to sell the loan out of the portfolio and replace with another or several performing loans. This tends to be highly constrained so some form of forebearance is more common.
Taking 8% as a rational pricing cap rate, the recent 6% and 5.5% cap rates suggest a potential price reduction of 30% which about the rate of decline that we have seen in the market. Could that implied and generally realized decline in prices become greater? It could in that we have not seen, as yet, a wave of liquidations.
The banks that hold CRE paper are individually threshold to insolvency and a loan that goes south has the potential of forcing their liquidation. On the liquidation side of the CRE paper there is substantial resistance to pricing the properties down. This resistance is part denial and part fear of bankruptcy.
The early warning flag for this problem is evident in the trend of reported cap rates which for the period beginning 2004 began to be seriously south of 8%. A cap rate lower than 8% implies that you know something about the potential for an improved rent roll and the general trend of rents and expenses. What the trend of transactions over the period from 2000 forward suggest is that cap rates were no longer a determinant of price, they had become a resultant that was motivated by the ability to securitize the loan and pass the risk to some other dummy.
The repricing of commercial real estate will take time and in the process it will operate as a drag against the generation of a robust economic recovery. It’s not that we need continued or more investment in commercial real estate, it’s that the underwater CRE paper operates to deny other lending.
Thanks for the Realpoint Report, it a source I’d not had access to.
So far, so good, sort of. But what happens in the case of a “double-dip,” like the deflation that Krugman is predicting if the US stays on the present course? I’ll venture a guess. Expect debt-deflation to accelerate>
Don’t really know about CRE. However, I see CBG and JLL making new highs every day and reporting good numbers and good guidance. How do you have a bad CRE and yet two companies that make money from it doing so well?
Your post prompted me to elaborate on the theme: http://seekingalpha.com/article/218094-slow-motion-crash-in-commercial-real-estate
Great post! This is a hot topic in Arizona as well!