Goldman's Call: CRE is Next

I have been speculating for some time that commercial real estate might be the next US asset class to take a hit. In fact I first wrote about this issue in May of 2007 in a post titled "Froth in Commercial Real Estate." We've been seeing turmoil in that marketplace for quite some time, but it looks like 2008 might be the first major leg down. Obviously any pronounced downturn will hurt businesses and commercial real estate. But, the longer and more pronounced the recession, the worse CRE could get.


Of all the Wall Street firms, Goldman has been perhaps the best at identifying major structural issues in the US economy over the past 2 years. They hedged against subprime better than any other firm, they have been correctly bullish on agricultural commodities, they saw the major bank writedowns coming and now they are calling for a major (20%+) CRE correction.

You can read the full article here. Or you can just read this ubiq-cerpt:

After suffering a beating from their exposure to home loans, banks and securities firms are about to take their lumps from office towers, hotels and other commercial real estate. And the losses could last longer than those from the subprime shakeout.

As the economy wobbles and financing costs rise because of the credit crunch, commercial-real-estate values are starting to slide, with analysts at Goldman Sachs Group Inc. projecting a decline of 21% to 26% in the next two years. That means misery for securities firms with exposure to commercial-real-estate loans and commercial- mortgage-backed securities.

William Tanona, a Goldman analyst, expects total write-downs of $7.2 billion by Bear Stearns Cos., Citigroup Inc., J.P. Morgan Chase & Co., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Morgan Stanley in the first quarter. Those firms had combined commercial-real-estate exposure of $141 billion at the end of the fourth quarter.

Goldman analysts predicts the financial damage from commercial real estate could last as long as two years, which would mean "a significantly longer tail than subprime." That is because only 28% of commercial-real-estate loans have been packaged into securities since 1995, while about 80% of subprime loans have been securitized; the higher level of securitization subjects the subprime assets to more-immediate mark-to-market accounting, which is playing out in the form of the write-downs that are dominating headlines.

I hate to say this, but I hope Goldman is wrong about the long tail effects of the CRE slodown. Hopefully the decline will be swift so that we can start putting this major real estate asset bubble behind us. For more on this issue check out this CNBC video.

In one final note I want to draw attention to the Markit CMBX indices. The particular index of note is the one that I first posted about back in July of 2008. At that point the CMBXNA-BB 3 index had a spread of 600 bps. As of today that same index has a spread of nearly 2000 bps:
Hat Tip: WSJ

Why Home Prices Won't Stabilize in 2008

Many economists are calling for home prices to stabilize in 2008. I think that this belief results from little more than wishful thinking. There is nothing in the fundamentals that supports the belief that home prices will reach a meaningful bottom this year. Inventory is still far too high, foreclosures don't appear to be slowing down and economic indicators are pointing towards a general economic slowdown and perhaps a recession.

The boom in home prices at the turn of the century was dramatic. From January 2000 to November 2005 the Case Shiller national home price index doubled and home prices in San Diego increased 2.5 times. Much of this increase was due to loose lending standards that resulted from global liquidity and low real interest rates. The ongoing liquidity crisis has led to a curtailment of many of the loose lending practices that defined the home price boom - 100% financing, negative amortization, no doc, "liar loans" etc. The lending led home price bubble will take a long time to unwind. I fear the unwind may end up being just as dramatic as the run up in prices. Below are the Case-Shiller home price index numbers from 1987-2007 for several cities and the 20-city composite. I am tempted to label this graph "The Anatomy of a Bubble":


At current levels all San Diego home buyers who purchased homes with no money down since April 2004 are underwater. Those who put 10% down are underwater if they bought between July 2004-December 2006. Those who put 20% down are probably not underwater unless they bought a condo downtown. Why does this type of analysis matter? Put simply, home buyers who are underwater are far more likely to walk away from their mortgage when it resets to a higher payment. Unfortunately every 1% decline in home prices pushes 1,000's more homeowners underwater and increases the probability that we will see higher foreclosure rates and more "must-sell inventory" to work off before we can establish a meaningful bottom in home prices.

If the real estate market throws the economy into a recession all the analysis gets much worse. Higher unemployment and slower wage growth along with general economic malaise will only exaggerate the correction in home prices. Until we see a stabilization in foreclosure rates, a fall in inventory, an increase in sales and an improved general economic picture our prediction remains that home prices will not stabilize in 2008.

If you bought a home in San Diego at the peak of the last cycle in July of 1990 it took a full 8 years before your home price returned to its original purchase price. This time around home prices may take even longer to return to their November 2005 price level. Since the average homeowner only stays in their home for 7 years, a lot of homeowners will be literally "trapped" in their home and, unable or unwilling to buy their way out, they will likely just walk away.

I don't like making long-term predictions about home price trends, but I'm thinking another 7-8% drop in in the Case Shiller home price index in 2008 is in order. We'll look at 2009 when it comes, but something tells me we won't be much more optimistic then.

I Never Get Sick of These!

Hat Tip: TBP

Tracking Commercial Real Estate with the CMBX Indices

It was through NYU economist Nouriel Roubini that I first learned about Markit's series of ABX indices that track subprime mortgage debt. So it is no surprise that it is through Roubini that I learned about Markit's CMBX indices. The CMBX Indices track the Commercial Mortgage backed securities market, which is the commercial equivalent of the residential mortgage backed securities market (RMBS).

I've written about the potential for weakness in commercial paper before. In fact I wrote a post back on May 2nd entitled "Froth in Commercial Real Estate." In that post I described how lenders were using insanely high rent growth projections in order to justify loans. The scary thing is the way the commercial market is unraveling is eerily similar to the subprime problem on the residential side.

1. First the lenders tighten up or disappear. This step is already happening. This is from the Wall Street Journal: "In the last three months, lenders have pulled back somewhat, tightened covenants and required borrowers to put up more cash. " While this is obviously different than say what happened to New Century Financial on the residential side, it is clear that lenders are at least starting to tighten up.
2. Investors price in the risk and the Markit indices show the change. This is already occurring. The CMBX index for the riskiest commercial loans has already widened considerably. See below:
3. Finally, the existing debt gets crushed in the secondary market as more and more borrowers default. This hasn't yet happened on the commercial side. In fact defaults are still at a low point historically. But, the rating agencies are calling for rising defaults in the months to come.

Is the commercial mortgage market the next shoe to drop? Nouriel Roubini thinks so, and he sure did call the subprime meltdown.

Froth in Commercial Real Estate

The news media has been intensely focused on the subprime lending crisis ever since some of the largest monoline subprime lenders went belly-up earlier this year. However, years of cheap money and loose lending standards did not only effect the residential real estate market. In many cases commercial real estate lending standards were just as loose as residential lending standards. In a New York Times article this morning Jim Duca (pictured above) of Moody's warned "underwriting has gotten so frothy we have to take a stand."

Jim isn't the first one to cry foul about commercial lending standards. Many were shocked when it was revealed that Blackstone's huge $36 billion Equity Office Property was priced with a sub 5% cap rate. I don't know about you, but locking up such a substantial amount of money at under 5% seems like a waste. In their defense, Blackstone had already lined up the sale of many of those properties at similarly ridiculous valuations and their own IRR calculations were undoubtedly rosier.

Due to structural differences between the residential and commercial markets, it is improbable that the commercial market will unwind as quickly as the subprime residential market. Commercial mortgages never got as exotic as the residential market and the interest only variety typically feature large balloon payments at the end of the term (typically 10 years). Due to these factors fallout may yet be years off. The root of the problem is not complexity of the loans, rather it is underwriters using inflated rent projections in their underwriting decisions and investors letting them get away with it.

For example when Blackstone bought EOP they had already reached a deal with Macklowe properties to sell off 5 midtown Manhattan office buildings in the EOP portfolio. The buildings currently rent for $55-59 a square foot but the projections in the Macklowe pro forma called for rents to increase to over $100 a square foot. Without those rent projections it is unlikely Macklowe could have justified buying the properties for $7.25 billion. Relying too heavily on exponential income increases like those in the Macklowe deal are the surest way to get the attention of guys like Jim Duca at Moody's. As the credit agencies tighten up investors demand higher interest to offset their risk, putting pressure on lenders. Though this will slowly squeeze the spigot of cheap money it may be too late for many who -- like subprime borrowers currently watching their equity fall and mortgage rates rise -- might quickly be underwater when rents moderate and the income isn't enough to cover their encumbrances.

The question is, how much excess has their been and when, if at all, will this effect companies like Credit Suisse, Deutsche Bank and GE?

Source: A Warning on Risk in Commercial Mortgages
Terry Preston