Not even Joe DiMaggio could have hit this change up. Just one year ago, the United States financial system stood on the brink of failure. GDP had declined by 6.25%, the most severe contraction since 1982. In November 2008, non-farm payrolls were cut by 533,000, the most severe contraction since 1974. But just a few months later, right after the ink had dried on largest corporate bankruptcy filing in American history (Lehman Brothers), U.S. GDP managed to grow at a 5.7% annual rate — the the fastest expansion in 6 years.
It’s a remarkable turnaround, but the problems in commercial real estate persist. CMBS defaults at the end of 2009 registered a five-fold increase over 2008. In two of the hardest hit sectors, hotels and apartments, almost 10% of all CMBS loans were delinquent at the end of 2009. Fitch says overall CMBS default rates could reach 12 percent by 2012.
Indeed, even God is losing money on commercial real estate. Lenders are foreclosing on Stuyvesant Town and Peter Cooper Village, which was acquired in 2006 for $5.4 billion. Stuyvesant Town is a huge property, so it’s not surprising that the acquisition set the mark for the highest price ever paid for a multi-family residential asset. What is surprising is that just four years later, the value of the property is estimated to have declined by 70%. The investor group included the Church of England, and the foreclosure completely wiped out its $250 million investment.
Since divine intervention appears to be out of the question, investors are understandably nervous about the $1.5 trillion in commercial real estate debt maturing over the next three years. Nevertheless, despite the carnage yet to come, the decline in commercial real estate prices is unlikely to cause a rain delay in the nascent economic recovery.
This is primarily because the U.S. commercial real estate market is much smaller in comparison to other important markets. Based on flow of funds data from the Federal Reserve at the peak of the market in 2007, the corporate bond market was worth $3.5 trillion; U.S. government securities $5.1 trillion, single family securitizations stood at $6.8 trillion and all single family mortgages amounted to $11.2 trillion. Meanwhile, the commercial real estate market was worth about $6.8 trillion in total, with only $3.3 trillion of that comprised of debt.
Just as important, the problems in commercial real estate have been well-telegraphed, while the full extent of the problems in single family were not clear until we were well into the crisis. Not only have the problems been well telegraphed, and well documented, but Jamie Dimon (CEO of Chase) is already declaring a bottom. “Commercial real estate is a train wreck, but it’s already happened,” Dimon said during a speech at a J.P. Morgan health-care conference in San Francisco last month.
While commercial real estate debt maturities are clearly still a problem, sophisticated investors from all over the world have lined up piles of dough for America’s distressed real estate play. Combine that with banks and special servicers that are determined not to sell into a weak environment, and the result is 30 or more bids for distressed commercial property sales in major markets, with some bids coming from as far away as Germany and South Korea.
I personally was involved in the recent bank sale of a non-performing loan for 60 acres of entitled but otherwise empty desert outside of Phoenix, and that sale attracted 26 bids. If entitled single family residential land in Arizona isn’t the absolute belly of the beast I don’t know what is, yet most of the bids for that flaccid loan were all cash.
What we’re witnessing is the market’s sometimes noisy process of converting debt to equity. That process is working, greased by baksheesh from all over the world. So why all the unrelenting gloom and doom with regard to commercial real estate and the economy? It’s pretty simple really: in this era of populist schadenfreude, people love to read about it.
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{ 11 comments… read them below or add one }
RW,
I beg to disagree but disagree I do. Let's take RMBS as a parallel, since that's already happened. There are no new RMBS securitizations other than what FN or FH are bringing to market (with the Fed as buyers). None. No one wants to buy into a rating from a failed rating agency model. The few deals out there are reremics, where one or more bonds are tranched to exploit where the ratings agencies think losses will be, now. One can be forgiven for thinking that the ratings are not exactly trustworthy once, but not twice.
Let's extrapolate to CMBS. As long as delinquencies continue to mount, there's no reason to think that prices have hit bottom. I know that CMBS only represents a quarter or so of comm'l mortgages, yet it's representative. You aren't going to see any new CMBS multi-borrower offerings for a while because the ratings agencies model is the same, albeit with new loss parameters. Therefore, the shadow banking system remains throttled.
Hi Crabsofsteel, I'm glad you wrote because I was thinking of your comment on the previous post when I wrote this. The shadow banking system is definitely throttled, but the Fed isn't.
They have interest rates near zero, and they spent all of 2008 buying mortgage paper. As you point out, there is almost no new issue RMBS/CMBS, so if you want exposure to the asset class AND yield, where are you going to go?
You can sit in Treasuries and take your 1% (and likely get fired for doing so), or you can get 7% unlevered, secured by an 88% occupied, cash flowing property portfolio located in a major market. If you're the adventurous sort, you can get 10% secured by going to a secondary market and/or taking some credit risk.
Based on what I am seeing, doing and hearing, the bid/ask spread still exists, and to the extent that gap shrinks on any particular asset, it's typically because the bid side blinks first.
Prices have definitely come down, don't misunderstand me, but so far they haven't dropped nearly as far as I would have thought.
I would give some more thought to investor demand for yield, rather than supply of credit. AAA CMBS didn't come in from 20% on its own, and I know you witnessed that trade firsthand. The same demand factors appear to be at work here. It's true that if special servicers and banks start dumping assets en masse, prices should drop further, but that's too easy and so far it's not happening.
Only time will tell!
Cheers, RW
The Fed can buy multifamily paper issued by the GSEs, because the GSEs can package that. In fact, Freddie volunteered to finance a new Stuy Town buyer, because that would allow them to pay themselves off on their first round on financing (they provided most of the mortgage money for the original $3BB senior loan) with taxpayer money at as close to par as they can get. But where does that leave the other sectors? GSEs can not (yet) package Hotel or Industrial loans. So what's the Fed going to buy, whole loans? The mechanism may be there for Treasury quasi-purchase via TALF or PPIP, but frankly, I don't want the government involved in my business and I'm sure neither do you.
Many firms which bought CMBS usually are not set up to underwrite commercial mortgages, even if that is the smart trade. Insurance companies and pension funds have covenants which limit their investments to AAA-rated paper, and few commercial borrowers could get that rating. So, they chase the legacy CMBS which have yet to be downgraded.
Finally, you haven't seen much dumping by the special servicers simply because the process has slowed down and most of the defaulted loans are not yet REO. Some are just auctioning buckets of non-performing loans through places like Mission Capital. It used to take about 18 months to liquidate but that lag seems to have doubled. Don't worry, you'll be seeing plenty of supply!
Crabs, I'm sorry, but you need to look up from your Bloomberg terminal for a minute.
I bid on deals from Mission Capital. Loan to own, finger nails full of dirt kind of stuff. I could hire somebody full time just to sign their confidentiality agreements. I bid on non-performing loans in the Midwest. In Ohio. In places like Dayton, where nobody supposedly wants to be, and I am never the only bidder, not by a long shot.
The last Mission deal I bid was a broken hulk in SE Columbus, which is the absolute WORST side of Columbus. Three units were down because of a fire, the roofs on ten of the buildings needed to be replaced, and even the drug dealers were complaining about the parking lot. I couldn't get inside all of the units because they don't allow any due diligence – so I could only guess the condition of interiors and the mechanical systems. But that was OK, because I was outbid by a credit opportunity fund in NY that had never laid eyes on the place. They closed in 7 days.
I asked the Mission guy what their strategy was, he said they were a debt fund taking spreads over LIBOR. I hear this kind of thing all the time.
Roll back to the primary markets West Coast, or go forward to the East Coast, and you often see 20-30 bidders for class A properties.
Forget about default rates. They are going up. It's old news. I've been talking to the special servicers since 2007 – they are overwhelmed. Check, I got that too.
I used to sell structured whole loans to insurance companies and pension funds. They won't touch this stuff. I get that also.
Pay attention carefully here though: Insurance companies and pension funds won't touch subordinated equity either, so we sold all of that to somebody else. And I'm telling you there are a lot more "somebody elses" out there than ever. There is strong demand.
Second, again using Mission as an example, many NPLs that are offered don't trade simply because the seller decides to hold. Mission offered a potpourri of non-performing loans (retail, office and multi-family) on behalf of a certain bank that might have the numbers 5 and 3 in their name, and whose special assets group might happen to work out of Grand Rapids and might also happen to be very busy.
Did that bank sell? Nope. They are still collecting rent checks from the strip club located in one of their lovely shopping malls.
What might the special assets group that could work out of Grand Rapids have said about that particular deal if they were asked? Well I can't say for certain because I can't remember the guy's name right now, but I'm pretty sure he said they decided to hold because they didn't like the price. I hear this all the time too. Things are NOT being liquidated pell mell, even by banks. Supply is not going up in parallel with default rates.
I could go on and on – and I should probably do it in a proper post – but you get the picture. I DO think Q4 2010 is going to be really interesting. If we don't get some kind of catharsis then, it ain't going to happen.
I'm curious about one thing though: I know you know that the FDIC has issued new guidelines on the classification of bank CRE loans (less strict) and IRS has issued new rev procs on the management of REMICs (again, less strict), and I think you agree that this gives these two constituencies even less motivation to "liquidate", as Treasury intended. Don't you think this accounts for the increase in processing time (doubling from 18 months)? It sounds like an assertive question but it's not – I'm wondering if you think the two are related. It seems to me that they are.
BTW, when a loan stops performing in a state that uses a judicial foreclosure regime, it takes 8-10 months to get a receiver in place from start to finish. Then it takes another 9-12 to go through the foreclosure process. Those numbers add up pretty nicely, don't they?!
Chris,
I heard as much on Thursday at a conference in LA on Distressed CRE. It seems that cap rates are actually dropping again as a result which seems absurd. Eventually though, stupid money chasing stupid deals with continually weakening fundamentals are going to fail to capture sufficient yield and fail some more.
That and targeting properly is what is going to get the deals done.
Matt
Matt, cap rates have definitely firmed in primary markets. Everybody thought 2009 was going to be the year, so there's a lot of money burning holes in pockets. But that's only part of the issue.
In 1991, the government was put in charge of liquidating these loans. This time, they remain in private hands, generally speaking, and the profit motive is still very much alive with the owners. Nobody wants to hand somebody else a 20% IRR.
Rather than blowing them out wholesale, it's now looking like thousands of bad deals being sold off one by one over the next several years. In addition to proper targeting, I think we'll need to have lots of patience and stamina
Froggy?!?
Cheers, Chris
RW
Good guess on the bloomberg, although I don't use it for much other than quick property lookups. If you want the meat and potatoes on bonds backed by commercial mortgages, you have to have Trepp or Intex. But that gets expensive in a hurry, so I stick with Intex warts and all.
Your south-side of Columbus story was very funny; i didn't know drug dealers knew what alligatoring was. But the subsequent poster had a point; that this could be silly money chasing silly deals. I was just offered some Bronx tenements at a 9% cap rate. I don't think they'll sell there, but I don't think they'll sell at 20% either. Yet.
My thinking is along these lines: if CMBS delinquencies could rise five-fold in 2009, what happens if they do that again this year? CMBS funded the borrowers who could only get credit from Countrywide, e.g.. We all know how that turned out in resi space.
-crabs
I am new to the private equity raising side of this business and over the past year I was sweating it trying to get some capital together and hoping that somebody would step up and stake me. I am so glad that I didn't get anything until recently because there really wasn't anything to spend it on.
Part of the problem is that there are truckloads of dollars out there chasing the handful of deals that make it onto Mission/Carlton etc. I haven't even seen one on there that I would have bid on yet, but the people who can find the ones hiding in the bushes are going to be rewarded I think.
Every time I start feeling impressed with the CRE gurus that have come before me, I watch them or hear them do/say something stupid. Nobody has the market cornered and if you have a creative plan and are able to execute, you can beat these heroes.
Froggy is an allusion to my former career and blogging persona. It is military in nature.
I forgot to address your question about the FDIC and REMIC revisions. I don't think the FDIC revisions will affect loan liquidation lags; my understanding is that they relaxed qualification of what CRE loans is considered impaired, so that banks didn't need to reserve capital against them. The REMIC revisions said that if you are a borrower and you want a loan modification, go right ahead and ask for one, and we won't require a legal opinion that the CMBS your loan is in remains a REMIC. I'm seeing many high DSCR loans being transferrred, and I think it just clogs the specials up even more. Yes, it takes manymonths to get receivers in place, but still, on average it used to take 18-24 months to get loans resolved. That was back when a loan was a loan, and not (like stuy town) sliced into separate notes in different CMBS deals.
Boys, this is practically a virtual conference. We'll need to get together for drinks soon, seriously.
I just saw that RealPoint reported combined loss severity of 52.7% last month, which is a record high. Very few loans that are 50% underwater are going to get worked out by anybody, no matter what the FDIC and IRS codify.
Perhaps 2010 will finally be the watershed year. Here is another good stat: In 2009, the FDIC alone sold about 3,500 CRE loans with a book value of more than $6.1 billion. That compares to CRE loans sales in 2008 of just $153 million.
The 2009 numbers are probably inflated by the Corus sale, but if those numbers keep rising (loss severities included) at the same rate, Q4 2010 will indeed be a very interesting quarter….
Matt, I am aware of your former career, and I know it was quite distinguished. Hence my confusion. Why not "Don't Mess With My Shit", or something like that?!
Cheers, Chris
Well, I try not to be overly threatening in my internet communications since its bad for business, but I'll take your suggestion under consideration.;)
I actually would like to get together and have some drinks over this issue and see if we can't sync our strategies a bit. I'm going to be calling soon. Standby.