Hot Potato
Oct 1, 2008 12:00 PM, By Elaine Misonzhnik
Lehman, which on Sept. 16, agreed to sell its broker-dealer division to the British bank Barclays, floated plans to spin off its commercial real estate assets into a separate, publicly traded company, Real Estate Investments Global. That would have parked its real estate assets for the time being and enabled Lehman to sell them later, presumably when liquidity had returned to the market. Its bankruptcy, however, has thrown doubt on whether that plan will come to fruition raising again the prospect of a fire sale. Such sales would have a cascading effect as banks marked to market. Banking rules dictate that hard-to-value assets on balance sheets get marked to values of similar assets sold in the market.
What the market wants to avoid is a scenario such as what happened with some of the residential bonds that Merrill sold earlier this year. The package was sold for 22 cents on the dollar. But it's even worse than that. Merrill provided financing for the deal. It also includes a put option, ensuring that if the bonds fall further, Merrill would have to take back the assets. In the end, the deal looks to be worth between 5 and 7 cents on the dollar of the assets. No one wants to see deals like that emerge on CMBS bonds.
Furthermore, continued instability on the investment side would keep the origination side mired in a complete lockdown. After crawling to $12.1 billion in originations in the first half of the year, CMBS issuance in each of the three months since July has amounted to $0, reports Commercial Mortgage Alert, an industry newsletter. As of Sept. 10, spreads on the highest-rated, triple-A, five-year, fixed-rate conduit loans stood at 285 basis points, up from a 52-week average of 161 basis points. On really bad days, spreads rise to more than 300 basis points, says David Akeman, director in the capital markets group of Stan Johnson Company, a Tulsa, Okla.-based commercial real estate investment firm.
Commercial real estate stands at the edge of another precipice. Up until now, defaults and delinquencies have remained low on commercial real estate debt — both on CMBS and with traditional banks. In the second quarter, the total delinquency rate for commercial mortgages stood at a conservative 2.1 percent, estimates Foresight Analytics, an Oakland, Calif.-based real estate consulting firm. The delinquency rate for CMBS loans was at 0.53 percent, according to the Mortgage Bankers Association (MBA). Rating agency Fitch put the number at 0.44 percent, but said that delinquencies on retail real estate were higher than any other sector. In contrast, delinquencies in August jumped to 24.48 percent on subprime residential loans, to 14.38 percent on option adjustable-rate mortgages and 10.73 percent on Alt-A mortgages, according to Applied Analytics.
Experts expect the picture to get worse shortly, especially as the number of loans that become eligible for refinancing rises. As of July, only 5 percent of all outstanding CMBS loans, which total $780 billion, were eligible for refinancing, according to Reis numbers. Most of those loans were originated 5 to 10 years ago, when underwriting standards were still tight, and have benefited from several years of increases in property values, so they shouldn't present much of a problem, according to Jon Southard, principal and director of forecasting with CBRE | Torto Wheaton Research, a Boston-based research firm.
Things will get a lot more complicated, however, over the next three years, as more of the loans originated in the carefree days of 2006 and 2007 come due, including some mega-billion-dollar deals on giant projects, says Chandan. Most of those loans were CMBS loans, often completed at 85 percent to 95 percent loan to value. Many have interest-only terms and very optimistic projections on future cash flows. Already in June, more than 15 percent of 2006 and 2007 CMBS vintages were put on watch lists, according to JPMorgan. Vintages from 2006 look particularly troublesome, according to JPMorgan analyst Alan L. Todd, with 40 percent of the loans originated that year showing cash flow drops of more than 10 percent. About 35 percent of the loans originated in 2007 appear to be under similar strain.
What's more, owners of retail real estate, who have certainly had a rough year thus far, haven't seen the worst of it yet, according to Gerard V. Mason, executive managing director in the New York City office of Savills, a global real estate services provider. Since 2007, the retail industry has announced more than 4,200 store closings, including some by major anchors, but come January of next year, the number will rise astronomically, he predicts. “If we are going to have any major distress, that's when it's going to occur,” Mason says. “That's when the lenders and the special servicers will have to stand up and say, ‘We are either getting these properties back or we'll have to do something about it.’”
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