Hot Potato
Oct 1, 2008 12:00 PM, By Elaine Misonzhnik
Where do we go from here? That was the question on many people's minds during the tumultuous two-week period in mid-September that took the credit crisis to a harrowing new level. In quick succession, the federal takeovers of Freddie Mac and Fannie Mae, investment banking giant Lehman Brothers's Chapter 11 bankruptcy, Merrill Lynch & Co.'s sale to Bank of America for $50 billion and the $85 billion nationalization of insurance provider AIG made it abundantly clear that the credit crisis is here for the long haul. As of press time, Treasury Secretary Henry Paulsen had concocted a $700 billion bailout plan enabling the government to buy toxic assets from troubled banks and hopefully finally stabilize the system. Congress was preparing to vote on the package.
Moreover, the last two investment banks — Morgan Stanley and Goldman Sachs — abandoned their independent status and became bank holding companies, giving the banks access to a wider variety of lending facilities, but also opening themselves up to greater regulatory scrutiny.
The extent of the crisis has resulted in a complete overhaul of the structure of Wall Street. The potential implications for the retail real estate sector are profound. Most of the troubled assets on bank balance sheets remain tied to residential real estate. But increasingly, commercial real estate is coming to the fore in the ongoing crisis. One of Lehman Brothers's troubles is a $32.6 billion portfolio of commercial real estate whole loans and commercial mortgage-backed securities (CMBS) bonds. Lehman's commercial real estate portfolio in the United States was valued at $17 billion and its exposure to CMBS loans amounted to $600 million. As of May 31, retail made up 11 percent of its commercial mortgage whole loan portfolio.
In spite of its months-long efforts to sell the portfolio, Lehman could find no takers because potential buyers are terrified of risk. In other words, that $32.6 billion portfolio may not be really worth $32.6 billion. Perhaps that's why, despite low default rates, industry backers were lobbying hard to make sure CMBS are eligible for any bailout plan that gets passed. “Any action must include commercial real estate mortgages and [CMBS] in the targeted class of illiquid assets,” Real Estate Roundtable President and CEO Jeffery DeBoer said in a statement. “Including commercial real estate mortgages in the assets eligible to be purchased by the proposed new federal entity is critical to addressing current overall credit market illiquidity.”
CMBS investors, who typically don't participate in real estate management and rely on the credit rating agencies to show them which loans to invest in, are too spooked by the growing perception of risk attached to commercial real estate to buy those bonds right now, according to Sam Chandan, chief economist with Reis, Inc., a New York City-based commercial real estate information provider. Inland Mortgage Capital Corp., an Oak Brook, Ill.-based REIT, took a look at some of the loans Lehman was offering for sale, but found they did not fit in with Inland's conservative acquisition criteria, according to Art Rendak, vice president. Inland has set aside $300 million to acquire and originate new loans, but it wants well-performing assets, with an occupancy rate of at least 80 percent and a loan-to-value ratio of less than 85 percent. The firm wants returns ranging from 9 percent to 13 percent, and it wants to make sure that if it ends up having to take over the property, it will get its investment back.
“Some of the Lehman assets, at least what we've seen, are just so risky,” Rendak says. “If it's over-levered and has got significant leasing problems, it's not for the faint of heart, that's for sure.”
The problem, then, is that if Lehman were forced to sell, it might have to take deep discounts because of the risk aversion in the market. Besides Lehman, Merrill Lynch has a $20 billion exposure in CMBS and commercial real estate whole loans. Meanwhile, AIG provides insurance for commercial real estate in addition to being neck-deep in the $62 trillion credit default swaps market where the company got involved in insuring bonds. Overall, commercial real estate may be getting sucked further into the crisis.
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