Saturday, April 25, 2009

The One Trillion Commercial Real Estate Time Bomb

Imminently, Zero Hedge will present some of its recently percolating theories about some oddly convenient coincidences we have witnessed in the commercial real estate market. However, for now I focus on some additional facts about why the unprecedented economic deterioration and the resulting epic drop in commercial real estate values could result in over $1 trillion in upcoming headaches for financial institutions, investors and the administration.

When a month ago I presented some of the projected dynamics of CMBS, a weakness of that analysis was that it did not address the issue in the context of the CRE market's entirety. The fact is that Commercial Mortgage Backed Securities (or securitized conduit financings that gained a lot of favor during the credit bubble peak years for beginners) is at most 25% of the total commercial real estate market, with the bulk of exposure concentrated at banks (50%) and insurance companies' (10%) balance sheets.

But regardless what the source of the original credit exposure, whether securitized or whole loans, the core of the problem is the decline in prices of the underlying properties, in many cases as much as 35-50%. When one considers that with time, the underlying financings became more and more debt prevalent (a good example of the CRE bubble market is the late-2006 purchase of 666 Fifth Avenue by Jared Kushner from Tishman Speyer for $1.8 billion with no equity down), the largest threat to both the CRE market and the bank's balance sheet is the refinancing contingency, as absent yet another major rent/real estate bubble, the value holes at the time of maturity would have to be plugged with equity from existing borrowers (which, despite what the "stress test" may allege, simply does not exist absent a wholesale banking system nationalization).

The refinancing problem thus boils down to two concurrent themes: The first is the altogether entire current shut down in debt capital markets for assets, which affects all refinancings equally (for the most immediate impact of this issue see General Growth Properties which was not able to obtain any refinancing clemency on the bulk of its properties). The government is addressing this first theme through all the recently adopted programs that are meant to facilitate general credit flow. Readers of Zero Hedge are aware of our skepticism that these are working in any fashion, especially with regards to lower quality assets. The second theme is the much more serious and less easily resolved issue of the negative equity deficiency on a per loan basis, which is not a systemic credit freeze problem, but an underwater investment problem. This analysis focuses on the second theme. The reason for this focus is that there seems to be an unfortunate misunderstanding in the market that lenders will simply agree to roll the maturities on non-qualifying loans, and that the expected percentage of loans that need special lender treatment is low, roughly 5-10% of total loans. In reality the percentage of underwater loans at maturity is likely to be in the 60-70% range, meaning that refi extensions could not possibly occur without the incurrence of major losses for lenders.

In order to demonstrate the seriousness of the problem it is important to first present the magnitude of the refinancing problem. To quote from an earlier post as well as data from Deutsche Bank, and focusing on the CMBS product first, there are approximately $685 billion of commercial mortgages in CMBS maturing between now and 2018, split between $640 billion in fixed-rate and $45 billion in floating rate. The figure below demonstrates the maturity profile by origination vintage. As noted previously, vintages originated in the pre-2005 bubble years are likely much less "threatening" as even with the recent drop in commercial real estate values, the loans are still mostly "in the money".

As Zero Hedge has pointed out previously, the biggest CMBS refi threat occurs in the 2010-2013 period when 2005-2007 vintaged loans mature. These loans, originated at the top of the market, of which the Kushner loan for 666 Fifth Avenue is a brilliantly vivid example, have experienced 40-50% declines in underlying collateral values, and the majority will have material negative equity at maturity (if they don't in fact default long before their scheduled maturity). Of these loans, only a small percentage will qualify for refinancing at maturity.

At this point cynical readers may say: well even if all CMBS loans are unable to be rolled, it is at most $700 billion in incremental defaults. Is that a big deal - after all that's what the government prints in crisp, brand new, sequentially-numbered dollar bills every 24 hours (give or take). Well, the truth is that CMBS is only the proverbial tip of the $3.4 trillion CRE iceberg. To get a true sense for the problem's magnitude one has to consider the banks and life insurance companies, which have approximately $1.7 trillion and roughly $300 billion in commercial loan exposure.

Banks have $1.1 trillion in core commercial real estate loans on their books according to the FDIC, another $590 billion in construction loans, $205 billion in multifamily loans and $63 billion in farm loans. The precise maturity schedule for these loans is not definitive, however bank loans tend to have short-term durations, and the assumption is that all will mature by 2013, exhibiting moderate increases in maturities due to activity pick up over the last 2-3 years.

Adding the life insurance company estimate of $222 billion in direct loans maturing through 2018 per the Mortgage Bankers Association, increases annual maturities by another $15-25 billion.

In summation as presented below, the total maturities by 2018 are just under $2 trillion, with $1.4 trillion maturing through 2013.

Combining all sources of CRE asset holdings demonstrates the true magnitude of this problem. The period of 2010-2013 will be one of unprecedented stress in the CRE market, and a time in which banks will continue taking massive losses not only on residential mortgage portfolios but also on construction loan portfolios, the last one being a possible powder keg: Foresight Analytics estimates C&L loan losses at a staggering 11.4% in Q4 2008.

And the bad news continues: there is a risk that commercial mortgages will under-perform CMBS loans, and delinquency rates for bank commercial mortgages will be magnitudes higher than those for comparable CMBS. The figure below demonstrates the undperformance of bank commercial mortgages: as of Q4 2008 the delinquency rate for CMBS was less than half of bank CRE exposure.

Reflecting on this data should demonstrate why the administration is in such full-throttle mode to not only reincarnate credit markets at all costs (equity market aberrations be damned) but to boost credit to prior peak levels, explaining the facility in providing taxpayer leverage to private investors who would buy these loans ahead of, and at maturity. Absent an onslaught of new capital, there is simply nowhere that new financing for commercial real estate would come from and the entire banking system would crash once the potential $1 trillion + hole over the next 4 years become apparent, as there is less and less capital left to fill the ever increasing CRE cash black hole.

An attempt to estimate the number of loans that would not conform for refinancing, based on two key criteria of cash flow and collateral presents the conclusion that roughly 68% of the loans maturing in 2009 and thereafter would not qualify. The amount of refinanceable loans is important because borrowers will either be unwilling or unable to put additional equity into these properties. Instead borrowers will be faced with either negotiating maturity extensions from lenders or simply walking away from properties. And despite the banks' and the administration's promise to the contrary, loan extensions will not provide the way out (see below), meaning losses taken against CRE is only a matter of time.

For the purposes of the refi qualification analysis, the criteria that have to be met by an existing loan include a maximum LTV of 70 (higher than current maxima around 60-65), and a 1.3x Debt To Service Coverage Ratio (equivalent to a 10 year fixed rate loan with a 25 year amortization schedule and an 8% mortgage rate).

The simple observation is that nearly 68% of loans in the next 4 years will not qualify for a refinancing at maturity putting the whole plan to merely delay the day of reckoning indefinitely at risk of massive failure.

The underlying premise of maturity extension as a solution to a loan's qualifying problem is that during the extension period the lender is either able to increase the amortization on the loan by some means (i.e. increasing the interest rate and using the extra cash flow to accelerate the loan's pay down), or achieve value growth sufficient to allow the loan to qualify by the end of the extension period. As the equity deficiency for many loans is far too large to be tackled by accelerating the amortization over any period of time, and as for "value growth", with hundreds of billions in distressed mortgage building up over time via these same extensions (even if successful), the likelihood of property price appreciation is laughable: the flood of excess supply of distressed mortgage to hit the market is about to be unleashed.

Then there is the logical aspect: maturity extensions merely delay the resolution and push the problem down the road. And as for CMBS, the issue of extension may be dead on arrival - not only are CMBS special servicers limited to granting at most two to four year maturity extensions, but AAA investors are already mobilizing to stanch any more widespread extensions as a means of dealing with the refi problem.

And, at last, there is the view that the refi problem could fix itself, based on the argument that CRE cash flows are likely to rebound quickly as the economy begins to improve due to pent-up demand. This argument is nonsense: even if cash flows recover to their peak 2007 levels, values would still be down 30% as a result of the shift in financing terms. Ironically, it would require cash flows rebounding far beyond their peak levels to push values up sufficiently to overcome the steep declines. This is equivalent to predicting (as the administration is implicity doing) that the market will be saved by the next rent and real estate bubble, which the U.S. government is currently attempting to generate.

In this light, anything that the government can try to do, absent continuing to print massive amounts of dollars, is irrelevant. The equity market can easily go up indefinitely, short squeezes can be generated at will, TALF can see 10 new, increasingly more meaningless permutations, the administration can prepare worthless stress tests that are neither stressing nor testing, and talk up a storm on cable TV to convince regular investors that all is well, yet none of these will do one thing to provide the banks and CMBS borrowers with the massive capital they will need to plug the value gap either during a CRE loan's term or at maturity. The multi-trillion problem is simply too massive to be manipulated and is also too large to be simply swept under the carpet for the next administration and generation. It is inevitable that the monster hiding in the closet will have to be addressed head on, and the sooner it happens, the less the eventual destruction of individual and societal net worth (however, it still would be massive). Delaying the inevitable at this point is not a viable option: Zero Hedge hopes the administration realizes this, ironically, before it is too late.

Gratitude to Deutsche Bank for data. Sphere: Related Content
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