A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Sunday, January 15, 2012

Transcript: 489 Commercial Real Estate revisited

One of the key parts of the Demand Side forecast last time was the vulnerability of regional banks to commercial real estate’s collapse. Our calculation was simple: continued high vacancy rates would put downward pressure on rents. Since much CRE is highly leveraged and its owners have limited liability legal structures to hide behind, as soon as rents stopped covering the debt service, owners would walk away. Although because leases are typically locked in for five years, the slope of the decline would be shallow, it was inevitable. Banks would be left with properties they didn’t want. Prices would plummet like residential real estate. A downward spiral of rents and prices would put banks in charge of more and more.

Didn’t happen. It is probably not going to happen. Why?
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Of course, it is more interesting to be wrong than right. Being right just cements your previous opinions. And boy, are ours cemented. Being wrong, you get to learn something.

Why didn’t it happen?

One, CMBS —commercial mortgage backed securities – were far easier to work out than residential mortgage backed securities, which were essentially not worked out. Many now sit on the Fed’s balance sheet. Banks don’t want commercial buildings, and they’ve been willing to restructure and rework the loans. The short step is that CMBS are far more amenable to being unpacked by the owners. This may be a “default” in layman’s language, but in economist-speak, that’s only for sovereigns and things that trigger derivatives. So, one, fewer banks own the properties. They remain in the hands of the people who know how to run them.

Two, financing is available and people are buying. In many markets, those current owners who see yields getting squeezed can sell. Low-rate financing is available to well-qualified buyers, as the radio phrase goes, and the well-qualified include the well-connected to financial firms. They include out-of-country money or money being repatriated into the dollar, which sees high quality CRE as a safe dollar-denominated asset. In this sense, CRE is benefitting from weakness elsewhere. Capital cannot lie under the pillow, not when there are so many Wall Street geniuses ready to put it to work – providing it is not theirs to lose. So, more sales in spite of weak yields.

Third, employment has not fallen to the degree we projected. In particular, public sector employment, though negative, is not negative to the degree we saw coming. At least not yet. Employment earnings are coming down, but not employment itself. Employment drives CRE demand.

Fourth, this is a forward-looking market. Happy thoughts will generate activity. People are looking for yield, need yield, in the case of pension funds, and cannot get it in the traditional safe bonds. It should be noted that total returns for U.S. long bonds is the best performer over the past couple of years. As the yields go down, the price goes up. Capital gains.

Fifth, our interest was on basically major commercial structures like downtown office buildings and business parks. Apartment buildings are also part of CRE, and they have been doing well, or better than bad anyway, as the nation returns to housing as a service instead of housing as a speculative investment. The apartment market tightened considerably between early ’09 and mid 2011, and it has continued to tighten, but at a dramatically lower rate.

All that said, the overleverage of the society is still enormous, and the downward pressure from the macroeconomy continues unabated. The yield on CRE is down even though the average rental rate has stabilized. This follows from the five –year basic lease. Another caveat, I am looking at this through the lens of my neighborhood – Seattle – which is doing better than other neighborhoods. I should look into that.

Well, lookee here. From the Wall Street Journal, January 10. Trouble Is Brewing for Office Market
Penn Mutual Towers, an office complex across the street from Independence Hall in Philadelphia, has seen its vacancy rise and income fall after one big tenant left and another renewed its lease for 15% less than it had been paying. Its creditors are foreclosing on the property, according to data company Trepp LLC.
Similar problems are mushrooming in office markets throughout the country, foreshadowing a new wave of real-estate trouble.
While the housing market was at the heart of the most recent real-estate crisis, office buildings—the center of past meltdowns—until now haven't been a major source of concern.
But many owners who have been able to keep their heads above water are being undone by tenant contractions and the expiration of five-year leases that were signed at the peak of the boom.
Rents in most markets are still well below what they were in 2007, with the drop in some areas as much as 26%, according to data firm Reis Inc. Because of the weak market, landlords with empty space or expiring leases also have to spend large amounts on incentives to attract tenants, like free rent and interior work.
Defaults and foreclosures are rising. The delinquency rate of office loans that were securitized hit 9% in December, up from 7.4% in June.
Analysts expect the rate to keep rising. Meanwhile, the delinquency rate of other asset classes like apartments and hotels has begun to fall, according to Trepp.
"These people have turned into zombie landlords," says Kevin Traenkle, a principal at Colony Capital. "They have been able to service mortgages with rents that are above marketplace today. When those rents roll, they will get a much lower number."
Problems are particularly acute for owners that purchased or refinanced buildings near the top of the market.
So, Seattle is advertised as one of the best cases, and so it seems. Still, however bad the turn for CRE, it probably won’t bring down the banks, for the reasons above, that the apartment component will not be weak and the foreclosure on commercial real estate will be avoided with workouts and writedowns.

Calculated Risk opines: quote “Even with a little improvement in the economy there is still more pain to come for commercial real estate, especially for offices and malls.”

Now, it is quite stimulating when we find a Wall Street analyst who is not in denial, and we’re featuring one after a few notes on the European mess.


The ECB’s $625 billion to European banks at low rates is apparently being hoarded by the banks, and deposited back to the ECB. At least so far. A small amount may have come out and moderated the interest rates for Spain and Italy in recent auctions, but it is likely this ECB action will be treated by the banks in the same way as the zero percent interest rates are treated by U.S. banks. The ECB had hoped, we think, to float the sovereigns for a little longer with this move. Maybe it will still happen. But, as with the Fed in the U.S., the banks are the central concern. And it is delay, not solution.

Hedge funds may be slowing the dance of death with Greece.
Confidence in financial markets plunged yesterday as hedge funds held up a crucial deal to restructure Greece's €350bn (£290bn) debt pile.
The euro fell to a 16-month low against the dollar after signs that the agreement, designed to put the country's public finances on a sustainable path, might be derailed.
European leaders reached an agreement last October with the Institute of International Finance (IFF), the global banking lobby group, that Greek bondholders should suffer a "voluntary" 50 per cent haircut on the value of their investments.
While large European banks have agreed to the deal, several hedge funds are understood to be holding out in the belief that the European Union and the International Monetary Fund will have no choice but to pay them off in full if they refuse to play ball.
The IIF said yesterday it hoped the deal would be concluded in a matter of days and its managing director, Charles Dallara, flew to Athens to finalize the agreement.
But the IIF confirmed that no offer has yet been made to bondholders.
"Hedge funds and other investors will need to see what the final detail is before deciding," a spokesman said. European leaders have also been increasing the pressure on bondholders this week. The German Chancellor, Angela Merkel, said on Monday that the next tranche of EU/IMF bailout funds that Greece needs to avoid a default in March will not be paid unless the restructuring deal is completed first.
Nicholas Spiro, of Spiro Sovereign Strategy, warned that hedge funds frustrating the deal could end up getting burned as the next haircut is likely to be more than 50 per cent. "If hedge funds insist on driving an even harder bargain, they could lose even more in the end," Mr. Spiro said.

Well, clearly the financial markets have been making the play that Greece is a special case and this won’t reflect on the other nations impacted by current account deficits and rising costs of rolling over their debt. We at Demand Side disagree. Any nation whose debt service goes up by the amounts in prospect while it is importing more than exporting is going to be in trouble, sooner or later. Adherence to the Euro blocks the natural balancing act. Unless there are systematic restructurings – which would be bad news for banks – there will be more Greeces.

1 comment:

  1. I suspect that the reason that the CRE has done better than expected is that corporate profits have held up well until recently. So rents were not so crucial but now that profits are struggling to increase rent cuts will become a bigger factor.

    In past CRE slumps in London many properties were kept empty to maintain the average rents on those let at a set amount per square foot. So there would be rents set at that target rate, but what would not be counted would be the rent free periods or additional funding for redecoration etc. So they could insist that they had superior properties that maintained high rents. That said while there was no slump in UK housing for a long time there were clear CRE rental cycles.

    As for Greek bondholders refusing to settle terms, in many ways I see why the bond holders especially hedge funds do not accept them. By voluntarily accepting such terms they would not get reimburse by the CDS market. The efforts of Geithner to avoid a credit event is why it has to be voluntary. Though Hedge funds who bought at a discount to take advantage of CDS to make them whole as a precaution will not walk away from easy profits.

    Longer term if the liabilities of Greece are not lowered to a level that fixes the deficit then there will be a future crisis. The current plans for a 50% write down are simply extend and pretend on a sovereign basis. the markets suspect that the end write downs will be closer to 90% so why all the delay?