Saturday, March 28, 2009

The Fundamentals Behind CRE - Part 1

Continuing the trend of disclosing the dirty laundry in Commercial Real Estate, I am presenting some raw data which the general readership should be made aware of before determining how fair (or not) any PIPP, TALF or other plan is to various beneficiaries.

Here is the summary:

In simple terms, the CRE fundamentals in Q1 are dramatically weaker across most markets and most property segments:
  • Price declines of 35-45% (or more) expected, exceeding those of early 1990s
  • Rent declines and vacancy rates may approach those of the early 1990s
  • Current downturn is demand shock induced versus over-supply induced downturn of early 1990s
The total delinquency rate is likely to exceed 3.5% by year end and 6% by 2010, and the biggest threat facing CMBS is maturity default risk: a large percentage of CMBS loans made in 2005-2008 will not qualify for refinancing without substantial equity injections due to:
  • Much tighter underwriting standards
  • Massive price declines
  • Declining cash flows
Enter TALF, with its inclusion of CMBS as applicable securities: government programs are critical to avoid hundreds of billions of dollars of distressed CRE hitting the market and perpetuating a vicious downward spiral in CRE prices which would exacerbate the damage to bank and insurance company portfolios, and impact other financial institutions.

The facts:

Aggregate delinquency rates are rising sharply, with 30- and 60-day delinquency rates up 300-400% in the past 6 months, and as noted earlier, aggregate delinquencies are expected to hit 6% by 2010.

Monthly total delinquency rates (TDR) are increasing at record pace: prior to September 2008, monthly increases in TDR were in the 0-3 bps range, and in September and October have accelerated to 10 bps. Since October, TDR have accelerated sharply to the 20-25 bps range, an unprecedented pace of deterioration.

As we pointed out yesterday, the deterioration is spilling over into seasoned vintages: all vintages are now demonstrating significant deterioration, however 2006, '07 and '08 vintages are by far the worst performers.

What is the impact by sector?

Hotel loan deterioration is in full take off mode, and expectations are that this will be one of the worst hit sectors during the downturn. As most independent hospitality firms are predicting 10-20% declines in NOI, the result would be TDR worse than the 2001-2003 downturn when cum default rates hit 25%.

The deterioration in the industrial sector is moderate by accelerating: declining production and the collapse in international trade (Long Beach harbor seeing cargo traffic down ~ 30%) implies trouble for industrial space demand.

The deterioration in Multifamily is by far the worst, with the current delinquency rate of 3.53% surpassing the previous 2.35% peak in October 2005.

Of particular note is the accelerating deterioration in recent CMBS vintages

Curiously, the Office deterioration to date is the least pronounced by likely the space where a lot of the pain will be concentrated shortly: it is likely that the recent 85 bps TDR will soon skyrocket.

Lastly, the degree of deterioration in retail is extraordinary. The Retail TDR of 1.66% has surpassed the previous peak in September 2002 and not likely to slow down any time soon. Curiously, the delinquency increases are not driven by single-tenant retail.

The Maturity Risk

As ZH pointed out, chronological series are performing sequentially worse, however, CMBX 4 is underperforming both CMBX 3 and 5.

In the Term market, floating-rate Loans are also beginning to deteriorate. While low LIBOR is a natural hedge, the second LIBOR increase picks up, the term market is poised for the double whammy of constrained lending and higher interest costs.

Additionally, loss severity rates also appear to be rising, although still nowhere near previous peaks of 2002 and 2004, implying there is much more room for deterioration.

As pointed out maturity and refinancing risk is by far the highest threat to the CRE market. Key considerations in looking at maturity risk are: amount and timing of scheduled loan maturities, the current situation in maturity defaults and extensions, the quantifiation of default and extension risk, and whether the end result will be widespread maturity extensions or mass foreclosures and liquidations. The two main sources of maturity default risk are:

Risks that loans will not qualify to refinance due to:
  • tighter underwriting standards
  • massive price declines
  • weakening cash flows
  • a 2010-2012 time frame
The complete disruption of of capital markets, even for refi qualified loans:
  • CMBS market
  • Banks/thrifts
  • Life insurance companies
  • Pension funds
  • 2009 onward time frame
The 09/10 absolute maturities are moderate ($15 billion in 2009 and $30 billion in 2010) but rising precipitously afterward, mostly in 2011 and 2012 ( a high concentration of risky 5 year Interest Only loans from 2005-2007).

Intuitively, declining property prices pose a significant refi threat to loans over the next decade. Absent significant equity checks, and forgiving lenders, the carnage will be widespread. CRE prices peaked in October 2007 after appreciating 30% from 2005 and 90% from 2001! In the meantime Moody's CPPI is down 16.4% from its peak, implying there is much more room for price declines over the next several years.

As these indicators are lagging, it is interesting to see where hypothetical market tests would come out to generate comparable ROE as those seen during the 2007 bubble... And the results are scary: prices need to drop by 45% for comparable returns, assuming an 8.6% cap rate (35% assuming 7.4%) cap rates.

The continuing property price declines are at the heart of the problem: price declines that have already taken place pose significant problems for 2006 and 2007 loans that mature during 2011 and 2012, while inevitable further price declines will create significant problems for earlier vintages.

Cap rates will determine how far prices will fall (and also by implication how soon the death knell for REITs sounds). Cap rates increases to 7% imply a 14% price decline, 8% imply 25% price declines, 9% imply 33% decline and a 10% cap rate is equivalent to a 40% property price decline.

To be continued.

Thanks to TREPP, Intex, Deutsche Bank and others for primary data. Sphere: Related Content
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Anonymous said...

What happened to the audio feature?

Anonymous said...

i can't see TALF helping much with this as it will only take the senior tranche and take a haircut on that as well. who is going to take equity tranche in a falling market?

Tyler Durden said...

Was slowing people down. If enough want it back will reinstall it

TPC said...


Won't the PPIP be used to buy up the CRE as it sours? The more important factor here is whether the government will be able to hit up taxpayers over the coming 12 months as CRE losses build. What are your thoughts?


Anonymous said...

I know I'm misunderstanding something so someone please correct. Assume 6% default on cmbs as zh says comes in 2010. assume 50% recovery rate, that means they should be worth around 97 on the dollar. Why are they trading so much lower if this one of the grimmer predictions?

Tawei Liao said...

Great post! Look forward to reading
your updates on CMBS.

Anonymous said...

6% total delq rate is at end of 2010. slyler's material doesnt quote anything beyond that. so depending on where delq rates go between say 2010 and 2017 would determine ultimate total delinquency of the pool of loans and eventually cumulative loss.

good ol tyler,.."just a guy with a schwab account and some lil 'ol web page with write ups to help him out,.. a guy who just started out with some simple cap arb trades and market commentary and look what he can write about now",..very interesting... interesting indeed my friend.

qadi said...

.gov will depreciate USD just like Harold Wilson did the GBP.

This will be a net positive for RE, but CRE still has over-capacity issues.

Anonymous said...

Hey ZH - as a CRE virgin, can u point me to some Bloomberg pages to track the CRE data upu are using - would love to build some of my own sheets. I track CMBX every day but would love to find a 'simple' page on BBG to get this data - any ideas?

Anonymous said...

Cumulative losses will be upwards of 30% for AAAs in the riskier vintages (CMBX4 & 5). This is going to be a maelstorm.

P.S. I have been long the steepener for a year now.

Anonymous said...

"Cumulative losses will be upwards of 30% for AAAs in the riskier vintages (CMBX4 & 5)."

this comment makes no sense.

if you have been long the credit steepener, you probably havent made much money, and the CMBX AAA rally in the past couple weeks probably finally put you back in the black on your trade. In the last year: AAAs are down about 30 points, BBB- down maybe 35. you are up 5 points in a year, nice!

Lastly, if cum losses will be 30% on AAAs (whatever that means), why would you have a steepener on in the first place? seems like an outright short of AAAs or AJs would have been the trade as you would have made 30 points on notional. instead you made little to no money on your steepener.

for the sake of any investor, i hope its your own money you're playing with and not managed money

Anonymous said...

All of those charts are from a DB presentation last week, straight cut and paste, you should give them more credit than "primary data".

Regardless, it was a great conference call, and I haven't seen a sell-side research guy that gloomy on CRE before. Pretty shocking.

Tyler Durden said...

little to add to the DB stuff - like you said they are finally becoming surprisingly realistic on the issue. Curious what the DB angle is. they followed this piece up with another doom and gloom report on sunday. and yes, all props to DB