So What Should We Be Worried About in CRE/CMBS?

I like Heidi Moore.  She’s a very good writer and even better tweeter (IMO).  So I was keenly interested to see her article on commercial real estate and commercial mortgage backed securities.  It didn’t disappoint.  It’s a good read.

But I couldn’t resist playing devil’s advocate.  Because I think some folks are still wearing rose tinted glasses regarding CRE.  Consider what Richard Lefrak said in the piece:

Richard LeFrak, chairman of the LeFrak Organization, said at the Milken Institute Global Conference in April, “The failure that we were all anticipating in the commercial real estate market, it kind of didn’t happen. We blinked, it went away.”

via Where is the CRE/CMBS crash? – Jun. 8, 2010.

In the immortal words of Ace Ventura, Pet Detective: “RRRReeeeaaaallllyyyy.”  Then why would Fitch come out and say this in their latest CMBS loss study?

The average loss severity rate for U.S. commercial mortgaged-backed securities (CMBS) loans resolved with losses in 2009 was 57%, an increase of 33%, compared to the 43% rate in 2008. The higher losses can be attributed to declines in property values, adverse selection of loans resolved, and the tremendous number of loans in special servicing as of year-end 2009. Although more loans were resolved in 2009 than in previous years, the volume of specially serviced loans at year-end 2009 was at an all-time high, with 4,435 loans totaling $74 billion.

via Fitch US CMBS Loss Study: 2009

Not depressed enough?  Try this (also from the same report):

Fitch Ratings expects loss severities to continue to outpace the cumulative historical average of 37.2% through 2011.

 So in my mind, we’ve already seen a CRE crash.  I guess people were afraid it was going to be worse.  Go figure.  At any rate, the whole report can be found here:

The way forward that people are thinking of is interesting, and I think it’s largely correct.  The path is downward for CRE and CMBS, but it’s really a question of how far and how fast.  On one hand, there’s a crash:

Some predict foreclosures, loan defaults and a national crisis of disastrous proportions. In that corner is Elizabeth Warren’s Congressional Oversight Panel, which flatly predicted this year that commercial real estate loans are heading for a crash that will bring down small banks, destroy small-business lending and create “a downward spiral of economic contraction,” in her ominous words.

So that’s one camp.  It’s a scary scenario, to be sure.  But in my mind, there’s another that’s much, much worse:

On the other side, investors in commercial properties and buyers of commercial mortgage-backed securities believe that the commercial real estate market will continue to suffer until it hits a bottom, but it will never crash in the way that the residential market collapsed. They believe that commercial real estate will be an example of how a market can take the hits and keep on ticking, that not every spot of trouble results in a crisis, that an industry can actually, somehow, stop a crisis if it acts early enough and has enough support.

Right.  And I’m sure the same was said about Japanese real estate, circa 1990.  If you take a look at this chart from Richard Koo, you’ll see how *that* turned out for the Japanese:

The rest of Koo’s presentation can be found here:

The reason I worry more about the secnod outcome and the Japanese experience is simple: the time value of money.  The keyword being time.  Time is the one commodity out there that’s more valuable than money.  So whenever you are given the choice of realizing losses sooner rather than later, it’s best to do it sooner.  But it’s also more difficult to do because of the pain that’s usually involved.  You can get money back, but you can’t get time back.  That’s what worries more about the long, slow bleed. 

So call me crazy, but I have a feeling being underweight real estate going forward won’t cause me to lose too much sleep.

And I need my beauty rest…

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5 Comments

Filed under finance, macro, Markets, risk management, Way Forward, You're kidding

5 responses to “So What Should We Be Worried About in CRE/CMBS?

  1. thomas goodson

    The commercial bankers and their accomplice at the White House are hoping that the market will rebound with the greater economy before they have to recognize AND realize the losses ( 2 different things). Many still dont recognize that their CRE book is worth 50 cents or less on the dollar. The market is going to have to make a miraculous recovery quickly to regain par…. it is not going to happen. It is interesting to me that CRE and it’s players are always wearing rose colored glasses… inherent in the profession. If capitulation continues toward this correction, the locomotive that is commercial bank loans, CMBS pools, REITS will crest the hill and start a screaming run down the mountain…. bad for the short term, better for the longer term.

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  3. C

    Professor,

    I enjoyed Koo’s presentation.

    Our current economic problems are caused by what Koo calls a balance sheet recession. When assets are less than liabilities and the private sector switches from consuming to paying down debt, we end up in a balance sheet recession. The balance sheet recession continues until the private sector is done paying down the debt and home prices fall to their discounted cash flow values. Then, monetary policy becomes effective ones again and spending resumes. Until then, the government must utilize deficit spending to maintain the money supply.

    Perfect, all of that makes sense!

    Now I’m wondering… how can we help speed this process along? How can we restore the balance between assets and liabilities at a faster rate, thereby ending the balance sheet recession in less time?

    What do you think of this idea, which I read about 2 years ago (but I don’t remember where I read it)?

    When banks need liquidity they sell some of the mortgages on their books for cents on the dollar. The government could buy these loans for 70 cents on the dollar and sell it to the homeowners for 75 cents. The banks would receive the liquidity they need. The government would make a small profit on the trade. The homeowners would receive a 25 percent reduction on the principal owed. And, these homeowners could finance the purchase of their own mortgage at historically low rates, thereby lowering the monthly payments and restoring balance to their personal balance sheets.

    The same idea would be applied to business loans.

    The homeowners and businesses that benefit from this program would switch back from “debt minimization” mode to “profit maximization” mode, and this would help restore the economy.

    Certainly, this does not fix everything. But, would this idea actually work?

    Note: The amounts used in my example don’t need to be fixed amounts. The government doesn’t have to buy mortgages for 70 cents. I just used those numbers to create an example.

    • You bring up a very good question: how do we speed up the process? I plan on tackling that this weekend, but using a different context besides CRE. It’s a continuation of a post at Edward Harrison’s Credit Writedowns blog.

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