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US commercial real estate set to take a hit

Traders see bond defaults rising to the highest level since Great Depression

(LONDON) In the bond market, commercial property investors are about as creditworthy as US homeowners with sub-prime mortgages.

‘Commercial real estate is a full-blown bubble that feels very much at a bursting point,’ said Christian Stracke, an analyst in London at CreditSights Inc, a fixed-income research firm. ‘There’s a fairly toxic mix of factors at work.’

The cost of derivatives protecting investors from defaults on the highest-rated bonds backed by properties more than doubled in the past month, according to Markit Group Ltd.

Prices suggest traders anticipate defaults rising to the highest level since the Great Depression, according to analysts at RBS Greenwich Capital in Greenwich, Connecticut.

The seven-year rally in offices and retail properties ended in September when prices fell an average of 1.2 per cent, according to Moody’s Investors Service. More losses are likely because banks are holding US$54 billion of commercial mortgages they can’t sell, data compiled by New York-based Citigroup Inc showed.

Lenders are struggling to sell loans to investors after losses on debt backed by sub-prime mortgages to people with poor credit caused financial markets to seize up in July and August. Bonds with AAA ratings secured by properties ranging from the Sears Tower in Chicago to trailer parks in Delaware yield about 203 basis points more than similar maturity Treasuries, up from 92 basis points on Oct 12, according to Morgan Stanley indexes.

The benchmark CMBX-NA-AAA index of derivatives tied to the safest commercial mortgage securities rose to 102 basis points from 44 a month ago. It costs US$102,000 a year to protect US$10 million of bonds backed by property loans against default, up from US$44,000 a month ago.

Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.

Sales of debt secured by commercial mortgages tumbled 80 per cent to US$3.9 billion in October from a year earlier, data compiled by Bloomberg show. New securities backed by loans on buildings will fall 50 per cent in 2008 from US$220 billion this year, Moody’s said on Nov 2.

Real estate deals are coming apart at the fastest pace since September 2001, when the US economy was shrinking, because banks are tightening standards for loans, said Robert White, president of Real Capital Analytics, a New York-based research firm.

More than 75 deals have been withdrawn because banks aren’t lending, and that estimate is ‘probably conservative because not all deals that blew up were well-publicised’, said Mr White.

‘The commercial real estate market is imploding,’ said James Ortega, who manages US$150 million at Saenz Hofmann Fund Advisory in Sao Paulo. Mr Ortega has set trades to profit from a decline in property companies’ shares. ‘We’re about to experience a very significant correction.’

Mortgage brokers say traders are overreacting. Defaults are running at 0.4 per cent in the US, below the average of about one per cent over the past 10 years, according to Moody’s. That’s a fraction of the 15.2 per cent of subprime home loans that are at least 60 days in arrears, an index by the New York-based ratings company shows.

The decline in prices of the highest rated commercial mortgage-backed securities mostly reflects a slump in credit markets, not expectations of defaults on loans backing the securities, said Michael Sun, an analyst at Wachovia Corp’s Tattersall Advisory Group in Charlotte, North Carolina, which manages about US$5 billion of commercial mortgage securities.

‘They are, credit-wise, a no-brainer,’ Mr Sun said. ‘Nobody disagrees they are rock-solid credits.’

In Manhattan, the world’s largest office market, the vacancy rate rose to 7.6 per cent in October, the highest in a year, property brokerage Colliers ABR said. Rents rose 1.4 per cent on average to US$64.08 a square foot from September, the second-smallest month-to- month increase since June 2006.

The Bloomberg Real Estate Investment Trust Index measuring the stocks of 126 publicly-traded property companies fell 29 per cent from its peak in February.

Record-low interest rates in the past five years encouraged banks to loosen underwriting standards and caused prices to rise as much as 35 per cent a year.

Banks provided loans that allowed borrowers to pay only interest, not principal, and lenders offered financing that exceeded property values, according to Moody’s. The average loan-to-value ratio reached a record high of 117.5 in the third quarter for mortgages that were turned into bonds, from 90 in 2003, Moody’s said.

Bondholders helped feed demand for loans by purchasing a record US$273 billion of securities backed by commercial mortgages this year, up from US$95 billion in 2004, based on data compiled by Trepp LLC, a New York-based research firm.

Demand has dried up since July, when securities linked to sub-prime home mortgages contaminated credit markets and caused financial institutions to report losses or writedowns of more than US$66 billion.

Citigroup analysts said in a Nov 15 note to clients that derivatives indexes on commercial properties are priced for a ‘meltdown’.


Source: Bloomberg (Business Times 29 Nov 07)


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