Tuesday, August 26, 2008

Are We Headed Towards a Global Commercial Property Meltdown?



It's time for me to get back to the ugly reality of financial markets. This morning we got more bad news from the U.S. residential real estate market as new home prices dropped by a record amount in Q2:

The Standard & Poor's/Case-Shiller U.S. National Home Price Index tumbled a record 15.4 percent during the quarter from the same period a year ago.

The monthly indices also clocked in record declines. The 20-city index fell by 15.9 percent in June compared with a year ago, the largest drop since its inception in 2000. The 10-city index plunged 17 percent, its biggest decline in its 21-year history.

However, the rate of single-family home price declines slowed from May to June, a possible silver lining, the index creators said.

"While there is no national turnaround in residential real estate prices, it is possible that we are seeing some regions struggling to come back, which has resulted in some moderation in price declines at the national level" said David M. Blitzer, chairman of the index committee at S&P.

As tempting as it might be, I wouldn't call a bottom in residential real estate any time soon. Even worse, there are now clear signs that the commercial real estate market is set for a marked slowdown in the U.S. and across the globe.

An article in today's Globe & Mail cited a report from CB Richard Ellis which shows that Canadian commercial real estate investment is sharply lower in the first half of the year:

Investment in the sector, which includes office, retail and industrial properties, fell 24 per cent to $10-billion from $13.1-billion in record-setting 2007. The slowdown is expected to continue, with total investment for the year forecast at around $20-billion, a 40 per cent decline from the year before, and lower than in the previous two years.

That would put the overall level close to the $19.5-billion invested in the sector in 2005, but unlike that year, a big pickup in activity likely won't come in the second half of 2008, said Stefan Ciotlos, interim president of CB Richard Ellis.

“....a strong second half is unlikely to occur this year because what began as a sub-prime credit crisis in the U.S. has become a de-leveraging of all global asset classes impacting Bay and Wall Street's views of real estate in general. The U.S. is currently undergoing a very difficult investment climate, and investment sales in the U.S. were down 60 per cent at the end of June, according to Real Capital Analytics, a firm which reports on the U.S. commercial real estate market,” Mr. Ciotlos said in a statement.

Despite the slowdown, a U.S.-style downturn doesn't appear to be in the cards for the Canadian market, he said.

If you ask me, it is still too early to state that the Canadian market will escape a "U.S.-style downturn". (Our Prime Minister isn't rushing to call snap elections because he feels we are going to escape the brunt of the U.S. recession).

A couple of weeks ago, the Financial Times reported that there are ominous signs for the European CMBS market:

The number of commercial property borrowers in Europe experiencing difficulties is increasing rapidly as can be seen from a sharp rise in the number of mortgages on servicers' watchlists, according to Moody's.

Watchlists are an early indicator of potential events of default or transfer to special servicing, which sees commercial property experts move in to explore the best ways to cure a mortgage's troubles or look at options for a work-out or sale, the agency said in a report published yesterday.

The Moody's report follows analysis from Fitch, a rival ratings agency, which showed a high chance of widespread defaults in the US and UK commercial property mortgage markets if the gloomy economic predictions for those markets were true.

Moody's said there were many reasons, not all performance related, for loans to be placed on watchlists by servicers of commercial mortgage-backed securities - whose job it is to monitor loans and ensure payments are being made.

But it added that watchlists were an early indicator of "potential loan event of defaults and transfer to special servicing".

The total number of loans on watchlists in Europe sat at five or fewer until the end of 2006, but then saw a change to rise to more than 10 over the first three quarters of 2007.

That number has since leapt sharply to 68, about 10 per cent of the more than 660 European commercial mortgages that Moody's monitors in CMBS deals.

"The number of loans experiencing adverse issues is growing, as can be seen from the number of loans which have been added and have remained on servicers' watchlists over the past four quarters," says Viola Karoly, a Moody's analyst and coauthor of the report.

The analysts expect the number of loans entering special servicing to rise, although it added that the impact on the ratings of European CMBS deals would not be significant in the coming quarter.

"Given that more than 50 per cent of all loans currently on watch are in breach of coverage or loan-to-value covenants, the number of loans defaulting and/or moving into special servicing is expected to increase over the next couple of months and quarters," the report said.

Nowhere is the CMBS market wobblier than in the United States, where CMBS spreads have skyrocketed in the last few weeks. As shown above, the latest CMBX chart from Markit (AA series 5) shows spreads widening fast:

From a spread of 475bps at the end of May, it’s now coming close to 1000bp. The particularly steep rise in the spread - in mid-August - occurred after Markit announced it wouldn’t be constituting a new index - there simply wasn’t enough issuance.

The spread widening of the double-B tranche (second chart) of the CMBX is even worse, nearly 3200 bps!!!

No wonder Lehman Brothers is having trouble offloading $40 billion of CMBS assets. In fact, more and more U.S. banks are scrambling to offload troubled commercial real estate loans as that market faces serious headwinds:

Banks are scrambling to dispose of these loans, typically made to hotels, office developers and retail strips, before problems arrive.

Broader real estate indexes are already showing signs of trouble. Moody’s/REAL Commercial Property Price Index has dropped nearly 12 percent since its peak last October. A more conservative index by the National Council of Real Estate Investment Fiduciaries shows growth slowing to one-half of a percent in the second quarter, from upward of 4 percent a quarter.

Loans made for commercial real estate are typically among the safest, because a building can be used as collateral and big property developers generate income from the investment, raising the likelihood they will repay their loans.

But cracks began to emerge late last year, when Morgan Stanley reported write-downs of $400 million in commercial mortgage losses. In the first quarter, Wachovia, which had transformed itself into a leading lender in the nation’s commercial real estate market, said it would take write-downs of more than $1 billion for commercial loans for the second half of 2007. Investors had already begun balking at buying securities backed by these bonds, so banks like Wachovia were stuck with loans of diminished value.

Around the same time, the New York developer Harry Macklowe was forced to sell seven office buildings he had bought in Midtown Manhattan, as well as the General Motors Building, after he was unable to refinance the loan with his lender, Deutsche Bank.

Now, the prospect of an immense default on a commercial residential property in New York — which has not suffered as much as troubled markets like Florida — has lent new momentum to concerns over the stability of commercial real estate loans.

In this environment, it is hardly surprising that CMBS originations hit a record low:

Commercial and multifamily mortgage loan originations continued to fall on a year-over-year basis in the second quarter, according to the Mortgage Bankers Association's (MBA) Quarterly Survey of Commercial/Multifamily Mortgage Bankers Originations. Second quarter originations were sixty-three percent lower than during the same period last year. The year-over-year decrease was seen across most property types and investor groups.

Now, I ask you, do you really think we hit bottom here? Is there any light at the end of the proverbial tunnel? Anyone seeing something I missed? Anyone?

I fear that we are just entering another downturn, one that will be much more severe and widespread than the slowdown in residential real estate market. Keep in mind that global banks are much more exposed to a slowdown in commercial real estate markets and global pension funds have billions invested in commercial real estate through direct investments, fund investments, CMBS and other debt instruments.

Going forward, that means you can expect a whole new batch of writedowns as banks and pension funds scramble to clean their books of more toxic debt.

But not everyone is as gloomy on commercial real estate. Some investors see opportunities in what they call commercial real estate's lost cycle. I found this report from Wurts & Asscociates particularly balanced and informative, outlining the current fundamentals driving commercial real estate markets. It is well worth reading before jumping to any conclusions.

However, given my views that we are heading towards a prolonged period of debt deflation, I see serious headwinds facing all alternative asset classes, especially commercial real estate. CMBS spreads are providing an early indication that global commercial property markets will continue to deteriorate for the next few years.

Finally, seeing what is going on in the real estate market reminded me of why Tom Barrack, arguably the world's greatest real estate investor, cashed out back in 2005 (I had circulated this article internally at a pension fund I was working for at the time but it was ignored).

In Mr. Barrack's own words: "There's too much money chasing too few good deals, with too much debt and too few brains."

I think that sums it up well.


***Update: Comment from Michael Hudson***

Dr. Michael Hudson was kind enough to share the following comments with me:

Dear Leo,

I worry that you miss the more pessimistic side of things. Suppose global real estate prices DO turn down. The property bubble has been the only flow keeping the balance of payments of the post-Soviet countries in balance, given their structural trade deficits.

Therefore, if new mortgage lending from foreign banks slows, their currencies will buckle. This means that ON TOP OF their downturn in DOMESTIC prices, the dollarized or euro-ized real estate price index will drop even further. The entire balance of payments of trade-deficit countries has been financed only by mortgages denominated in foreign currencies (as I found in Latvia). There will be a reverberatory effect.

Good news for Russia to recapture its influence over neoliberalized countries.

Michael

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