'Technicals' Catching Up to Fundamentals

MBA (8/26/2008 ) Murray, Michael
The “technicals” in the commercial mortgage-backed securities market—and lack of liquidity—could be catching up to property fundamentals as the economy continues its slowdown.
Rick Williamson, principal of WLJ Partners, Coral Gables, Fla., said “technicals” in the commercial mortgage-backed securities market—spreads and pricing driven wider by CMBX synthetic derivatives that caused a disconnect—are beginning to catch up to property fundamentals.

Williamson, a former commercial real estate bank lender, said banks will need to “shrink” and not lend anymore on commercial real estate because of prior lax underwriting.

“A year and a half ago, it was just crazy,” Williamson said. “Money was free, and the deals that were getting done were just insane. At the bank, for the last two years, we were just sitting around twiddling our thumbs saying, 'this is crazy. We can't participate in these deals.' It was extremely hard but, I'll tell you, the folks that are still at the banks are sure glad they didn’t."

Michael Grupe, executive vice president of research and investor outreach at the National Association of Real Estate Investment Trusts, said economic events, including consumer spending and corporate investment, are true unknowns that can affect commercial real estate property fundamentals.

“There are clearly some structural problems in the economy,” Grupe said. “It is reasonable to expect that some of those problems—perhaps excessive levels for debt in the household sector that could constrain spending on the retail side going forward—those are challenges going forward. They are real. They cannot be ignored.”

"Retail is definitely hurting,” Williamson said. “They are already talking about a bust to the 'back to school' season, saying it will carry over to the bust in the Christmas season. I don't see how they avoid it. I think you are going to see alot more bankruptcies, a lot more store closings from January to February. They will be out there for one last gasp—the 'Hail Mary'—hoping that Christmas saves them. I don't think it is going to happen. Come January and February, it is going to be a real thud."

Some industry analysts view commercial real estate as a lagging indicator of the residential real estate market. Reports have Lehman Brothers, New York, trying to rid itself of $40 billion in commercial real estate assets.

The New York Times reported last week that Wall Street banks were trying to unload bridge equity and floating-rate loans made to hotels, office developers and retail strips. It said holders of nearly $100 billion of CMBS feared problems in the commercial property market could lead to more write-downs.

Commercial Real Estate Direct.com reported the previous week that CBRE Realty Finance wrote off $40 million in mezzanine debt used by Macklowe Properties to finance their acquisition of four office properties from the Blackstone purchase of Equity Office. Macklowe and their senior lenders had been trying to sell the buildings but “indicative bids came in at below expectations.”

Williamson said office properties in Orange County, Calif., are closing down as a result of the residential subprime crisis.

Matthew Mowell, analyst at Property & Portfolio Research, Boston, compared the economy in the Inland Empire—the Riverside and San Bernardino counties in Southern California—to Cleveland or Detroit.

“Most of the economic indicators—job growth and unemployment—paint quite a dire picture,” Mowell said. “A recovery here will require the housing market to stabilize, net migration to pick up to steadier levels and restored consumer confidence.”

Mowell forecasts “severe occupancy losses” for the next four quarters in office properties—not much change from the past year.

“The metro is seeing the weakest demand in over a decade, and although construction is slowing, it is still a force to be reckoned with," Mowell said. "The Inland Empire will rank fifth for occupancy losses over the next year—down by 330 basis points."

Grupe, however, said commercial real estate property fundamentals remain at a “decent balance” compared to prior cycles.

“It’s not like we started off with significant excess supply of space,” Grupe said. “I think we were pretty well balanced and, in that respect, should be able to handle any weakness in far better shape than we might have otherwise.”

"Multifamily seems to be holding up better, but that's also going to follow because, as we get further and deeper into a recession, household formation is going to fall and reverse itself—entry level workers moving back home with their parents or combining into one apartment,” Williamson said. “There is a huge shadow market of condos and empty houses out there competing for established multifamily properties. The multifamily market is going to be hurt as well."