Coming Soon: Commercial Real Estate Crash

Run-don’t-walk to read Jesse Eisinger’s article, Wall Street’s Next Crisis:

"In their own way, however, commercial-real-estate loans were no less foolish than those made to home buyers with speckled credit . . . The implosion is going to be a refreshingly simple and familiar story.

In 1995, $15.7 billion worth of commercial-mortgage-backed securities were issued. Through the third quarter of 2007, $196.9 billion was issued, according to Commercial Mortgage Alert, a trade publication. That amount means 2007 will be a record year, even though issuance collapsed in the fourth quarter as investors panicked over the credit crunch. Right now, there is about $730 billion in commercial-mortgage-backed securities outstanding. "Not only have we been in a rising tide, but the loans are very different in underwriting standards than even five or 10 years ago," says Alan Todd, head of commercial-mortgage-backed-securities research at J.P. Morgan. "We haven’t been through a cycle yet" with these new structures, he adds ominously."


Wall Street’s Next Crisis
Jesse Eisinger 
Portfolio, January 2008 Issue

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  1. Sam Park commented on Dec 20

    Media headlines overhype the potential of commercial real estate (CRE) prices crashing. Real estate prices tend to be stickier and do not go through wild swings (like stock indices). Not only are stocks more volatile, but stocks have generally taken losses before real estate returns fell.

    Commercial real estate value is a function of cash flow. CRE provide investors with actual cash flow stream.

    Drivers of commercial real estate returns are different from residential RE and are also unique to its sector.

    Homebuilders went overboard, and this is reflected by the large inventory of homes in the market.
    CRE inventory is low, and developers have been so far disciplined not to oversupply the current market.
    Low lumber prices also made it easier to build new single-family homes, while surging steel prices have had the opposite affect on supply of multiple-story buildings.

    Demand drivers:
    CRE investors favored markets with attractive fundamentals.
    Strong job and population growth with limited new development made good office prospect.
    Growing international trade and growing port and logistics locations favored industrial space.

    Home prices relative to income show that the ratio is currently much higher than the historical average, indicating housing prices are highly overvalued. However, commercial RE fundamentals remain intact, supported by actual cash flow and a relatively contained inventory.

    US CMBS delinquencies (heading into 2007) fell below 1%. Media headlines are misleading… especially when they claim “Delinquencies for CMBS May Double.” Even if CMBS doubles… doubling 1% is only 2%, which is nothing close to subprime delinquencies and hardly suggests commercial real estate is imploding. Those cheerleading that commercial real estate is imploding are typically from those who are in a short position. REITs are currently trading well below NAV, suggesting these shorters will need to cover fast if things don’t implode.

    The current credit crisis will impact commercial real estate activity, including M&A and buyouts, stock repurchase programs to drive stock prices, among others. Commercial real estate could implode only if the economy goes down the drain, which would drag down everything anyway.

    Overall, institutional investors have recognized the benefits of adding commercial RE in their portfolios and realizing the better risk-adjusted returns. Commercial real estate has become more sophisticated and transparent, which answers to the requirements demanded by seasoned investors.


    BR: Valid points, Sam.

    Thanks for making the other side of the argument . . .

  2. Al Czervik commented on Dec 20

    So Sam,
    In other words, “it’s contained”?

  3. michael schumacher commented on Dec 20

    let me guess….”sam” is a commercial RE broker….

    i agree that the swings are not as wild but your agenda is a bit too obvious.

    “seasoned investors” I love that…

    Too easy to see


  4. D. commented on Dec 20


    Are you trying to convince yourself?

  5. Peter Davis commented on Dec 20

    Nouriel Roubini wrote about this about a month ago, his point being that the credit crisis is not just limited to residential mortgages but to pretty much anything credit-related.

    A good friend of mine works for a commercial REIT. Fortunately, his company is not in debt, holds no CDO’s and nothing subprime; they’re looking to acquire right now. But the credit market is so locked up right now, they can’t even get anyone to sell to them – although something tells me that’s going to change.

    You have to admit: when we screw up in this country, we do it in grand style…

  6. Ross commented on Dec 20

    Commercial developers are basically the same as homebuilders in so far that if money is available, they will build and develope.
    Here in N. Texas, it is not as bad as it was in the 80’s with ‘free’ money from the S&L’s but it is frothy. I am familiar with one development that is just now nearing completion. The big box stores are in (JCP, BBBY, etc.),and the small for lease shops have been started. The developer is very professional. The financing was VERY creative. The take out loan was packaged with others, blessed by the rating cartel at sold to European Pension Plans with a 4% assumed cap rate. Of course this was possible because everyone knows that real estate only goes ……….UP in price. Time will tell but greed knows no limits where your thorazine is essentially FREE.

  7. Karen commented on Dec 20

    Bravo! great retorts to Sam! maybe he works for the bush administration… at least my reaction to his speech was identical to anything coming out of the white house.

  8. Sam Park commented on Dec 20

    Not a broker… private equity. By “seasoned investors,” I’m talking about pension investors.

    What are you MS? I’m guessing a daytrader.

    Us equity folks are holding out for some discounts (10-15%), but I’m not expecting a crash in commercial real estate. Some will be forced to liquidate because they can’t meet coverage… but that’s when deals look ripe for some basement bargin shopping.

  9. v commented on Dec 20

    I’m a novice so this is a question of both curiosity and to better educate myself.

    Who is holding the CMBS stuff? Is it once again big finance (i.e. the members of XLF) or are CMBS more spread out amongst banks/companies and also internationally?

    I understand specifics would be impossible, but I’m just curious in a generalized sense.

    Thanks in advance.

  10. Shrek commented on Dec 20

    Isnt is completely clear that the US economy is runnng into the law of large numbers. We are 100 percent a credit and finance based economy.

    For this system to work out trillions of dollars of credit have to created every year forever. Say this system survives. What is credit growth going to look like in 2015?

  11. michael schumacher commented on Dec 20

    >>What are you MS? I’m guessing a daytrader.>>

    You would be guessing wrong but that’s ok I see you’re thinly veiled attempt at applying the “levels of importance” in the financial pecking order.

    On the original post….Nice try….you seemed to be ferreted out by many more than just “a day trader”


  12. Eric Davis commented on Dec 20

    Most “pro” investors can’t afford to keep losing their own money, and had to get a job losing other peoples money.(no offence Barry)

    But that is just the opinion of a POS “Daytrader”

    and Yes… most of us are just trying to dump as much crap, Be it stocks or CRE, CDO on “seasoned investors” as I can.

    I’ll make a note, short CRE….


    BR; No offense taken — we are outperforming nicely this year . . .

  13. Peter Davis commented on Dec 20

    A couple of things:

    I think MS was parodying “seasoned investors” because these are many of the same geniuses who are now holding toxic waste. Not exactly “the smartest guys in the room.”

    As for who’s holding CMBS’s, Sam, the question might be: who isn’t? All the big banks are holding this crap. They’ve also sold much, much more of it to pension funds, municipal and state funds, hedge funds, Europe, China, me, you, my neighbor, his dog, his dog’s veterinarian, etc., etc. OK maybe not me and you, but everyone else on this list.

    Added to this fine mess is that many of these CDO’s have been levered up and packaged into CDO “squared’s”, whereby the returns are leveraged. Many a hedge fund have also levered up like crazy to buy this stuff. The end result is that the notional amount of this paper is far, far greater than the underlying mortgages it represents. So when this stuff declines in value by only a few percentage points, those who are holding levered assets see much greater declines. Factoring in how much this stuff has declined, and you can see why many people are in trouble.

    Because of the wizardry of modern financial alchemy (which is beyond my comprehension), what we have here is a house of cards. Due to the complexity of these derivative structures, a small failure in the underlying can result in significant and widespread losses.

    And given that nobody knows who’s holding what and how much it is (or isn’t) worth, banks don’t want to lend to each other, because they don’t know if they’ll get it back. All of this is, in my opinion, creating at atmosphere of uncertainty and fear. And it will only get worse, as mortgage resets don’t peak until May of 2008. And other lines of credit are now in trouble; credit card debt, student loans and auto loan delinquencies are at multi-decade highs and show no signs of diminishing.

    It’s a fine web we’ve weaved ourselves. I hope this long-winded explanation helps you out a bit.

    – Pete

  14. Eric Davis commented on Dec 20

    Hey, what is the pecking order??….

    I’m just trying to figure out who I’m supposed to “blow” on message boards, based on “reported” investor Cred.

  15. Cal commented on Dec 20

    The #1 reason why CRE is guaranteed to fail, the NAR is saying everything is fine.

  16. Bill commented on Dec 20

    I don’t have anything to do with the financial or real estate community; but, I am expecting a lot of businesses to have difficulty in making a profit, much less grow profits. Everywhere I go I see the competitors lined up (literally) diagonally across the street from each other at nearly every busy intersection competing for the same dollar (~pharmacies, grocers, hardware, fast-food, restaurants, you name it.) Somebody is going to get it and somebody is not. I think a lot of communities are over-built with commercial businesses vying for the same buck and I’m not sure there is going to be enough financially-healthy consumers to support them all. That’s just one more angle to the commercial real estate area that may exacerbate the problem directly ahead. I suspect many went in with excessive optimism which may be followed shortly with just trying to hang on until better days. It may turn out that there is just too much supply and not enough demand all within a slowing economy. On top of everything else, I suspect commercial real estate is also over-built just like residential.

  17. UrbanDigs commented on Dec 20

    I wrote about this too a while ago!

    both back in mid November..

    Just like the terms of LBO deals got loosened, so did the ones for Commercial real estate! I discussed cov-lite LBO terms and its potential drawback way back in July!

    Its all coming to a head. This problem will take years to work through as we still are not talking about the slowdown to the economy, globally and at home, as a result of ALL these bad loans and deals!

  18. la grande poussée commented on Dec 20

    Sam Zell said it best by his actions early this year…..

  19. GreenMachine commented on Dec 20

    I too was also under the impression certain REITs were starting to look attractive. I wouldn’t touch commercial “retail”, but the health care and education oriented REITs seem like they should do just fine over the next few years provided they can manage their debt. I haven’t researched CRE, but EDR looks promising. Might could hedge with SRS?

  20. Peter Davis commented on Dec 20

    I’m not even remotely an expert on anything real estate related, but I certainly wouldn’t touch anything in that sector with a ten foot pole right now. Way too much risk, way too many unknowns.

  21. michael schumacher commented on Dec 20

    R.E values will decline further until the inventory “issue” is dealt with. There is no bailout for that………

    Inventories need to be at the 4-5 month supply level for ANYTHING to have a remote chance of increasing in value-especially with the tighter lending standards. Anything else is just lip service. Beware the “Great deals of the New Year” they have already started in So Cal.


  22. v commented on Dec 20

    Eloquent, well stated long post. Similar to my own thinking, though perhaps I haven’t been as critical (though that might be mostly due to my own ignorance as a novice). That the financials aren’t taking a bigger hit is a bit peculiar to me. But this is the “efficient” market, lol.

    In any case, thanks for the post Pete (and others). Much appreciated by this novice.

  23. E commented on Dec 20

    A difference with Commercial versus Residential is the Loan to Value amounts. One of the major problems with the Residential loans is that everything was financed with little or no equity. There is no cushion to debt holders for declines in value. Most of the commercial loans have >15% equity in the deals, so the equity holders will take the first losses. Yes, the lending standards were loosened, and owners might have to put in more equity to meet interest coverage requirements when rent growth projections don’t materialize. But most commercial owners have capital for that, it just means returns will be less than expected, and possibly negative. The credit markets are certainly making an impact on commercial RE, but this seems far different than the residential situation.

  24. D. commented on Dec 20

    I have 3 Staples within 5 km of my home. 2 are always empty. Sometimes a shelf if out of stock so I drive to the other one.

    And that’s just one big box. I am going by feeling here, and my gut tells me the system is broken.

    You can talk about PE, PB bla blah blah… I don’t bother with the last few years’ numbers because they were articially inflated by the unsustainable credit bubble.

    I think that anyone playing with those numbers is missing the boat.

  25. PigInZen commented on Dec 20

    All CRE is not created equal. It’s best to split out residential from retail from office. And even in those categories there are many different types of each: Class A office, downtown, suburban, etc. This article makes no distinction between each. That’s lazy.

    A REITs such as Novastar (NOV) is hurting because of it’s reliance on subprime funding. A REITs that is self-funding such as Duke Realty (DRE) is doing much better than the market sector as a whole. Disclosure: DRE is my favorite REIT and I have a family member employed by DRE. DRE is trading at nearly 55% of its 52 week high. If you check the fundamentals of that company it’s not performance that’s driven the stock down. Essentially the whole sector is off which is fine by me since REIT stock yields are dividend driven.

    I don’t doubt that there are commercial REITs that will be hurting shortly. I do believe, however, that there are several fundamentally solid commerical REITs worth investing in.

  26. Diogenes commented on Dec 20

    Value of Building = net operating income/capitalization rate.

    I’ve been in commercial RE for 22 years.

    Cap rates during the last 2-3 years are the lowest I have ever seen, by a wide margin.

    The lower the cap rate the higher the value. Cap rate is the inverse of the P/E ratio.

  27. blam commented on Dec 21

    OK. What,my friend ( do you mind if I call you that ?) at any rate the fingers are always moving, so what! Catholic – Smatholic mormon and the underwear – don’t even try to think about that one it don’t make any difference if some guy thinks that the “Angel Gabriel” came to Iowa in 1923 and delivered a set of Tablets – I’m more concerned with the apparent discrepancy wether the earth is 6 Billion or 6 thousand years old – who cares, rite. Jesus christ could kich the shit out of mohamed any day of the week. Ya got any grass for the holidays ? God I’d love to get hammmered and stoned and have a good time without the cops kicking my ass. Of course, as you well know, I lived in Montana at the time and it was 40 below zero….

    Look at you making me carry on so>>> you darling. OK then, I’m going to bed knowing that nice boys like you from the neighborhood won’t let my darling country be destroyed.

  28. Andrew Horowitz commented on Dec 21

    If I have said it once, I have said it a thousand times…”Builders and developers are like puppy dogs. The puppy will eat and eat until he barfs, then back for more. The builder and developer builds and builds until they go bust, then back for more.” The truth is that this entire genre was way too high on their own arrogance. The lender would lend, the builders would build. Then, the finger pointing begins! The American Dream is now the Global Nightmare.

  29. alex norman commented on Dec 22

    I am a long time reader and infrequent poster (BR even returned some of my emails back in the day…!).

    Like Sam, I work investing private equity in CRE. I happen to agree with many of his observations. However, he could have acknowledged more the role that structured finance has come to play in the CRE market as well as the housing sector…

    Basically, what we have seen in CRE over the last 10 years has been a “perfect storm” of confluences:

    — CRE maturing as an institutional asset class with vast sums of capital coming into the market

    — CMBS market exploding in size

    — 2002-2005 slashing of interest rates

    — Equity bubble bursting in 2001 prompting investors to look elsewhere

    — Low yields in fixed income prompting investors to look elsewhere

    — AND FINALLY, the “miracle” of structured finance (CDOs, etc.) to keep the party going long after it should have stopped.

    As a result, Cap Rates are at all-time lows, and there is a serious underpricing of risk. The EOP/Blackstone deal and its bagholders (Macklowe, Maguire, etc.) will be seen as the peak of wretched excess in leverage and underpricing of risk.

    Right now the CRE market is at an impasse as buyers have stopped sipping the kool-aid and sellers havent faced the music. 10-20% fall in prices is inevitable simply due to re-pricing of risk without any fundamental underperformance (rise in vacancies).

    I believe the strongest sectors are Medical Office, Industrial with a focus on transport (I’ve been looking at Truck Terminals this year), and if properly bought, Multifamily.

    New retail construction to serve the mega-sprawl of new homes that should never have been built (re: Sacto, Central Valley and IE in Cali) will be hurt bad. So will Office buildings bought at 3% Caps in Midtown in anticipation of massive rent growth by re-upping the leases held by major banks and wall street finance firms who are all doing so well…whoops

  30. anon e. moose commented on Dec 26

    “sam park” is lawrence yun’s new moniker.



    BR: Its helpful to have the counter arguments, and be able to respond to them.

    Also, we are all a bit myopic, and tend to see only the arguments that support our views (selective perception and all that) . Its important to try to understand all sides — that only makes your argument stronger . . .

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