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Sunday, August 30, 2009

Commercial Real Estate Lurks as Next Potential Mortgage Crisis - WSJ.com

Ugh. Just when you thought it couldn't get much worse....

>http://online.wsj.com/article/SB125167422962070925.html?mod=rss_whats_news_us#printMode
By LINGLING WEI and PETER GRANT AUGUST 31, 2009

Federal Reserve and Treasury officials are scrambling to prevent the commercial-real-estate sector from delivering a roundhouse punch to the U.S. economy just as it struggles to get up off the mat.

Their efforts could be undermined by a surge in foreclosures of commercial property carrying mortgages that were packaged and sold by Wall Street as bonds. Similar mortgage-backed securities created out of home loans played a big role in undoing that sector and triggering the global economic recession. Now the $700 billion of commercial-mortgage-backed securities outstanding are being tested for the first time by a massive downturn, and the outcome so far hasn't been pretty.

[Outlook]

The CMBS sector is suffering two kinds of pain, which, according to credit rater Realpoint LLC, sent its delinquency rate to 3.14% in July, more than six times the level a year earlier. One is simply the result of bad underwriting. In the era of looser credit, Wall Street's CMBS machine lent owners money on the assumption that occupancy and rents of their office buildings, hotels, stores or other commercial property would keep rising. In fact, the opposite has happened. The result is that a growing number of properties aren't generating enough cash to make principal and interest payments.

The other kind of hurt is coming from the inability of property owners to refinance loans bundled into CMBS when these loans mature. By the end of 2012, some $153 billion in loans that make up CMBS are coming due, and close to $100 billion of that will face difficulty getting refinanced, according to Deutsche Bank. Even though the cash flows of these properties are enough to pay interest and principal on the debt, their values have fallen so far that borrowers won't be able to extend existing mortgages or replace them with new debt. That means losses not only to the property owners but also to those who bought CMBS -- including hedge funds, pension funds, mutual funds and other financial institutions -- thus exacerbating the economic downturn.

A typical CMBS is stuffed with mortgages on a diverse group of properties, often fewer than 100, with loans ranging from a couple of million dollars to more than $100 million. A CMBS servicer, usually a big financial institution like Wachovia and Wells Fargo, collects monthly payments from the borrowers and passes the money on to the institutional investors that buy the securities.

CMBS, of course, aren't the only kind of commercial-real-estate debt suffering higher defaults. Banks hold $1.7 trillion of commercial mortgages and construction loans, and delinquencies on this debt already have played a role in the increase in bank failures this year.

But banks' losses from commercial mortgages have the potential to mount sharply, and the high foreclosure rate in the CMBS market could play a role in this. Until now, banks have been able to keep a lid on commercial-real-estate losses by extending debt when it has matured as long as the underlying properties are generating enough cash to pay debt service. Banks have had a strong incentive to refinance because relaxed accounting standards have enabled them to avoid marking the value of the loans down.

"There is no incentive for banks to realize losses" on their commercial-real-estate loans, says Jack Foster, head of real estate at Franklin Templeton Real Estate Advisors.


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