Thursday, March 26, 2009

Commercial Property Report Courtesy of WSJ

As regular readers of Mock the Market know, I like to blog about commercial real estate deals gone awry.  For one thing, I find it incredibly amusing that many of the same developers who lost their empires in the early '90s are knee-deep in doo doo this time around as well.  It's as if they are a bunch of five year olds who have no ability to predict the consequences of their over-leveraged actions, even though most of them are seasoned real estate developers who have been in the business for over 25 years.  More importantly, I am a big believer in utilizing anecdotal evidence to predict larger economic trends.  The commercial property crisis has been brewing for some time and while the actual delinquency and default rates were extremely low until very recently, all of the high profile blow-ups, foreclosures, and legal maneuvering have been pointing to an impending crisis with a big large flashing arrow.

The Wall Street Journal article entitled "Commercial Property Faces Crisis" is good summary of how quickly the commercial property market is unraveling.  Delinquency rates on $700 billion in securitized loans backed by commercial property more than doubled since September to 1.8%.  It is just short of the highest delinquency rate reached during the last downturn and we're just getting started.  Foresight Analytics estimates the US banking sector could suffer as much as $250 billion in commercial real-estate losses in this downturn, compared to $48.5 billion between 1990 and 1995.  The market is nearly three times as big now as in the early 1990's, estimated to be roughly $6.5 trillion in value financed by $3.1 trillion in debt.  While the leverage ratio doesn't sound particularly high overall, there is little doubt that many of the loans negotiated in the past three years, when the market was surging, were structured with loose lending terms, assumed impossibly high cash flow levels, and required little equity from the owners (i.e. a recipe for disaster in general, but particularly acute in an economic downturn.)

The article talks about the Fed and Treasury's struggle to structure the TALF to alleviate the financing issue that has halted the ability of developers and investors to refinance or do new deals.  But again, if this were merely a liquidity problem, the TALF might actually work to revive the commercial property market.  The problem is that valuations were too high, cash flows are dropping off a cliff as the economy suffers from a steep downturn, and the best financial resolution for many a developer, or property owner is to walk away.  The alternative is to cough up more equity into the deal.  But as every successful real estate developer knows, it's far easier to walk away and do the whole dance again in a few years when the market recovers.  If this wasn't the case, names like Donald Trump, Harry Macklowe and Ian Bruce Eichner wouldn't be experiencing deja vu right now.  Unfortunately, no amount of financing from the government can solve this fundamental problem.  Frankly, I would prefer it if the Fed required that the equity investors cough up more equity to support the debt that is going to be financed by the Fed in the TALF.  Unfortunately, given all the defaults and bank failures on the horizon, the government will more than likely be holding RTC-style auctions once again.      

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