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18-01-2017 Hits:620 BoomBustBlog Reggie Middleton

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17-01-2017 Hits:984 BoomBustBlog Reggie Middleton

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12-01-2017 Hits:1622 BoomBustBlog Reggie Middleton

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 As my regular readers know, I have been banging the table about the unappreciated risk the commercial real estate market poses since September of 2007 - way before the crowd of investors, pundits, analysts and media. See:

Now that the nation's second largest mall property owner and REIT has just filed chapter 11, after I warned readers over a year and a half ago of this very distinct possibility, others are finally starting to jump on the bandwagon (See General Growth Files for Protection in Biggest U.S. Real Estate Bankruptcy then go on to read the 80 or so pages of research that I have generated to support riding the share price down from $60 to near zero: GGP and the type of investigative analysis you will not get from your brokerage house.)

 Well, now that a few months have passed since the big bankruptcy, let's take a look at where my premonitions stand, nearly two years since inception...

 

    Commercial real estate values in the U.S. remained on an upward trend long after the 2nd half of 2006, when the housing prices began falling in most MSAs. Commercial real estate values peaked and began falling towards the end of 2007 and continued to decline through 2008.


     The decline has gathered pace in Q1 2009, across retail spaces, offices, industrial properties and apartments. With high vacancy rates, rents across major cities are also declining.

  • May 2009: Nationally, commercial property prices fell 8.6% m/m in April 2009, after falling 1.7% in March, as per Moody's/REAL Commercial Property Price Index. Commercial property values are back at the levels of September 2004, 29.5% below the peak in October 2007. The sales volume in April was the lowest since the index's inception in 2000. (Moody's)
  • Movements in real estate values tend to lag home prices movements. The Case Shiller 20 city composite index indicates that housing values peaked in mid 2006, while Moody's/REAL index indicates that commercial property values peaked nationally in October 2007 (pretty much coinciding with my own proprietary findings), with a lag of 16 months.
  • Q1 2009: Commercial property prices in the U.S. fell 1.7% in Q1 2009. Apartment and industrial property prices remained largely unchanged from Q4 2008, while office values fell 18.6% and retail spaces fell 12.9% q/q.(Moody's)
  • For the top 10 metro areas in the U.S, retail space prices fell sharply, down 14% q/q while office prices fell 7% and apartments fell 3% q/q. (Moody's)
  • The NCREIF property index, measuring returns on individual commercial property acquired for investment fell 7.33% nationally in Q1 2009, with apartments falling 8.7%, industrial space falling 7.5%, office space falling 7.9% and retail space declining 4.3%.
  • April 2009: Non-residential construction rose 1.8% in April, at an annual rate of 408.2 billion and is up 2.5% y/y. Office construction fell 1.9% m/m and is 17.8% below April 2008. Commercial construction fell 2.1% m/m in April and is down 25.4% y/y. Manufacturing construction rose 3.5% in April 2009 and is up 70.3% y/y.

    Commercial Real Estate Lending
  • Q1 2009: Commercial and multifamily mortgage loan origination fell by 26% q/q in Q1 2009 and is down 70% y/y. Decreases continued to be led by a drop in commercial mortgage-backed security (CMBS) conduit loans.(MBA). CMBS issuance fell from $230 billion in 2007 to $12 billion in 2008 to essentially zero in 2009 (NAR). CMBS issuance has not resumed in 2009 although the spreads between 5 and 10 year triple-A CMBS have come off their peak. The lack of debt is affecting the transaction activity. In recent years, the CMBS market has satisfied about 40% of the credit needs of the commercial mortgage sector. If this market is closed, then the refinancing of maturing mortgages will be exceedingly difficult and this will exacerbate the drop in commercial real estate prices, loan defaults and the pressure on bank capital. (William C. Dudley, New York Fed)
  • More than $300 billion in commercial mortgages are estimated to mature during each year from now through 2011. These maturities will continue to constrain the banking sector and property values as the markets seek new sources of refinancing capital. (Jones Lang LaSalle)
  • Wachovia: Banks are trying to preserve capital by committing to fewer projects. Also, every lender is pulling back and tightening lending standards by essentially requiring stronger guarantees, better collateral and by taking less risk in general. This portends ill tidings for the refinance market in general.
  • Delinquency rates on commercial properties jumped 43% in Q1 2009 reaching $65.9 billion in Q1 2009, an increase of $46 billion since the end of 2008. (Real Capital Analytics)
  • Foresight Analytics:The delinquency rate on all construction lending is at 13.5%, highest since 1993. Worsening fundamentals and reduced liquidity in the commercial real estate sector will probably contribute to further rises in the delinquency rate for construction lending. For a visual example of a major root cause of these delinquincies, see "Who are ya gonna believe, the pundits or your lying eyes?" and "Who are you going to believe, the pundits or your lying eyes, part 2". As can be plainly seen from these posts, the delinquincies will be trending sharply upward in the near term, not downward.
  • Real Estate Econometrics: The default rate on commercial mortgages will reach 4.1% by the end of 2009 and reach 5.2 percent by the end of 2010 and peak at 5.3 percent in 2011 before starting to decline.
  • Q1 2009 Commercial property delinquency rates as per investor group: CMBS- 1.85%, Banks and Thrifts- 2.28%, Fannie Mae- 0.34%, Freddie Mac- 0.09%, Life insurance company portfolios- 0.12%. (MBA)
  • Roubini: Many of the same excesses that were observed in subprime – poor underwriting standards, loose and excessive lending to marginal projects – are also observed in CRE - Ditto as to Reggie Middleton's opinion.
  • Commercial Real Estate by Sector:
  • Office: The U.S. Office vacancy rate rose to 15.5% in Q1 2009 from 14.7% in Q4 2008 as per the CBRE Office Vacancy Index.
  • Prolonged job losses in 2009 will have a ripple effect on tenant demand through 2010, with sluggish leasing activity. Rise in vacancy rates will put pressure on office space rent through 2010. (Cushman & Wakefield)
  • Apartments are seeing an increase in vacancy rates, affected by a glut in single family homes and condos that are entering the rental market. Apartment demand closely follows employment. We do not see a real recovery in apartments for two years (Wachovia).
  • Industrial Spaces: . The U.S. Industrial Availability rate rose to 11.5% in Q1 2009. Until Consumer demand increases, industrial availability rates will continue to rise. While demand for industrial space is cooling off, construction in the industrial sector has been slow in the previous years compared to the office sector. Compared to the office sector, rental rates for industrial spaces rose slightly. (CB Richard Ellis)
  • Retail Spaces: The vacancy rate for retail spaces rose to 9.7 percent in 2008 and will probably rise to 12.1 percent this year and 15.8 percent in 2010. Average retail rent is expected to fall 2.1 percent in 2009 and 1.5 percent next year; it declined 2.0 percent in 2008. (NAR) Sharp cutbacks in consumer spending and falling sales activity will prolong weakness in the retail real estate sector.
  • Illiquidity and declining consumption has caused a sharp disruption in all components of the retail investment market, including transactions, financing, and macro-level property fundamentals. (Cushman & Wakefield)
  • Commercial property rents continue to fall as vacancy rates are rising and capitalization rates are falling. (Comstock Partners)
  • According to Trepp: Defaulted apartment loans that back commercial mortgage backed securities (CMBS) in May 09 surpassed 5 percent, while retail and lodging broke the 3 percent level and overall delinquencies were 2.77 percent.

A while back I detailed the hidden commercial real estate bombs that lay within the Wall Street banks. Shortly thereafter, Morgan Stanley admitted that they were expecting 45%+ losses in their commercial real estate portfolio. There were more honest then their compadres. Below is an excerpt from a post that I made in Q1-09...

 

Goldman Sach's CMBS Pressure Points and Other Risk Factors Not Reflected in VaR

This underappreciated risk of commercial real estate depreciation will reverberate through investment banks, insurers, money center and regional banks alike for these are the sourced of the large nonrecourse loans and CMBS that funded these vehicles. In addition, the retail mall REITs will see significant hits to asset prices and consequently rents (more so than they have already seen, which has been significant already) which will put additional stress on debt service. Keep in mind that the GGP issue is not confined to GGP. Debt that had financed assets during a property bubble cannot be rolled over due to a dearth in financing - causing bankruptcy. Chances are that this will be seen several more times in the next 8 quarters or so. Long story short - expect valuations, rents, credit quality and cashflows to drop as vacancies and delinquencies rise.

gscre.png

Break up of mortgage backed securities

 

 

 

 

 Q4 07

 Q1 08

 Q2 08

Total mortgage backed securities

54073

51852

37523

Commercial real estate

19,020

19440

16572

Residential

22837

19070

15238

Prime

14,370

12290

8597

Alt-A

6,358

4940

4704

Sub prime

2,109

1840

1937

Loan portfolio

12216

13342

5713

As the CRE market starts to deteriorate and the CMBS  market collapses, the entities that are holding these  securities through high leverage (Goldman currently has a roughly 22x leverage ratio) will be very sensitive to any changes in valuation. Goldman holds nearly $17 billion in CMBS, an at 22x leverage will be hurt if the GGPs of the world force realistic marks to be made through real world transaction, ex. Bankruptcy.  

 

 As a percentage of total mortgage backed securities

 

 

 

 

 Q4 07

 Q1 08

 Q2 08

Commercial real estate

35.17%

37.49%

44.16%

Residential

42.23%

36.78%

40.61%

Prime

26.58%

23.70%

22.91%

Alt-A

11.76%

9.53%

12.54%

Sub prime

3.90%

3.55%

5.16%

Loan portfolio

22.59%

25.73%

15.23%

 

The commercial real estate risk that Goldman Sachs is woefully underappreciated by the market and apparently unknown to the sell side analytical community. Take it from the guy that clearly anticipated the fall of Bear Stearns (Is this the Breaking of the Bear? [Sunday, 27 January 2008]) and (with the help of his readers) pointed out the Lehman Brothers CRE implosion connection (Is Lehman really a lemming in disguise? [Thursday, 21 February 2008]), as well as the GGP debacle in full detail (GGP and the type of investigative analysis you will not get from your brokerage house). Goldman has risk here, among other places that aren't even visible in its rapidly increasing VaR numbers....

gs_non_var_risk.png

 

Other risk exposure not included in VaR

 

 

 

 

 

 

 

 Q1 07

 Q2 07

 Q3 07

 Q4 07

 Q1 08

 Q2 08

Trading Risk

         

 

Equity

512

709

1,183

1,325

1,094

1,102

Debt

782

1,045

934

1,020

1,112

1,147

Non-trading Risk

         

 

SMFG

133

130

99

41

0

0

ICBC

217

205

231

250

239

262

Other Equity

462

591

1,059

1,054

1,083

1,224

Debt

222

277

403

500

550

637

Real Estate

455

497

708

1108

1241

1369

Total

2,783

3454

4617

5,298

5,319

5,741

See also: The Official Reggie Middleton Bank Stress Tests