Is Commercial Real Estate Loan Performance Really Improving?

by REIT Wrecks on December 17, 2008

Believe it or not, there was some good news for the beleaguered Mortgage REIT sector last month. Fitch said that commercial real estate CDO loan delinquencies actually fell in November. Translation: commercial real estate loans backing the CDOs that many Mortgage REITs issued by the bucketful were actually performing better, on average, than they had in October. Whether this reflects a reduction in the number of CDO loans that are likely to completely blow up (Alesco, Crystal River, Deerfield, Taberna, etc.) or improving fundamentals remains to be seen, since much of the improvement was simply the result of loan extensions.

As far as the data, Fitch reported that the delinquency rate for commercial real estate collateralized debt obligations, or CDOs, fell to 2.8% last month. This was down from 3.13% in October and it marked the first decline since July. However, there were 45 new loan extensions in November, up from 35 in October. Fitch said expects an average of 40 extensions each month going forward. This is about 3.5% of the $23.8 billion in commercial real estate loans backing the 35 CDOs that Fitch rates.

Anecdotally, Northstar Realty Finance’s third quarter earnings release supports this data. NRF reported an increasing number of loan extensions, all of which had been successfully refinanced, as well as a doubling of the loans on its watch list. This was the first time any signs of real trouble had surfaced at Northstar. Unfortunately, it also looks like Northstar’s triple net lease portfolio may get WAMbushed by JP Morgan later this month.

Apparently, the FDIC’s agreement with JPMorgan Chase allows Chase to pick and choose which WAMU real estate it will keep. Chase will then turn over the rejects to the FDIC. But here’s the kicker: the FDIC, as receiver, can then simply terminate the leases of those rejected properties, all contractual obligations void. Done.

Typically, in a bankruptcy case involving real estate leases, the landlord’s remedies are the greater of one year’s rent, or 15 percent of the rent on the remaining lease term (not to exceed three years). In normal times, this is meant to give landlords at least some breathing room while they line up new tenants. But these are obviously not normal times.

The New York Times reported today that Los Angeles is just behind New York in the number of properties that are or are likely to become distressed. Unfortunately, NRF’s WAMU leases happen to be located in the Los Angeles area. According to a Real Capital Analytics analysis cited in the story, the Los Angeles had an inventory of about $11 billion of potentially troubled properties, followed by Las Vegas ($6.6 billion) and southern Florida ($4.2 billion). So, if WAMU/FDIC do reject the leases, these NRF assets may lie fallow for longer than usual, with none of the “normal” bankruptcy relief available to Northstar.

Both Fitch and Real Capital Analytics separately said they believe the sectors most likely to be affected are the retail, apartment and hotel sectors. So, in addition to sticking to those commercial Mortgage REITs that avoided the hysteria at the height of the bubble (an almost impossible task), you can add another criterion to your list: diversity by geography and property type. Even “24 hour” superstar cities like New York and Los Angeles are unlikely to completely escape the ferocity of this downturn.

As always, it comes down to careful underwriting – not all commercial real estate loans will go sour. As I pointed out in Commercial Mortgage REITs: Reason to Believe?, the news is not universally bad. But Mortgage REITs that have asset concentrations in either of those two cities may get a bit more than they originally bargained for.

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Disclosure: long NRF at the time of publication


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