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Commercial Real Estate

With Journalism Like This, Who Needs Confusion?

by TheFalcon on November 29, 2007

Commercial Real Estate & CMBS – Some News Commentary
The commentary below was inspired by an article published by Bloomberg on Nov. 28, 2007.  Click the following link for the full article:

 

Commentary –

It is a mixture of truth and hype and you have to take your time with the article to get below the journalists typical sensationalist spin. The author doesn’t bother to define terms and thus leaves the uninitiated reader confused, mislead or both. The very first sentence in the article is a case in point. It reads:

“In the bond market, commercial property investors are about as creditworthy as U.S. homeowners with subprime mortgages.”

In this sentence, who exactly are the “investors” being referred to? If you read it quickly you might be inclined to think these are equity investors in commercial real estate, however if you take your time to put the sentence in context based on further reading of the article, these investors must be the B Piece buyers. But hold the bus… how can the author compare a B Piece buyer to a US Homeowner? The risk of default is directly connected to the party responsible for providing the cash flow to pay the mortgage. Thus the Homeowners are comparable to the tenants in a commercial property, not to the B Piece buyers who buy the loan. The B Piece buyers can’t default on anything, but they can be defaulted upon if the mortgage isn’t paid. Thus this sentence is confused and grotesquely inaccurate and it sets the tone for the rest of the article.

The word “investors” in the first sentence must be referring to the B Piece buyers because the next time the word appears is in the first sentence of the 3rd paragraph which states:

“The cost of derivatives protecting investors from defaults on the highest-rated bonds backed by properties more than doubled in the past month”

Well direct investors into commercial real estate (e.g. TIC investors) don’t buy derivatives to protect themselves from defaults on the highest-rated bonds, but B Piece buyers do.

More indication of how flawed the logic of the first sentence is in comparing bond holders (who receive payments) to homeowners (who make payments). This kind of twisted logic permeates the whole article and can’t help but result in confusion.

However the article does go on to make several basic arguments that it supports fairly well and that I find myself agreeing with based on our current experience in the market place.

What the article begins to assert after a shaky start is that the B Piece buyers (i.e. bond holders) are afraid that commercial real estate may begin to underperform and thus begin to default on its mortgage payments. The article does not argue whether this is a rational fear or not. It goes on to bolster this argument by suggesting that lenders have made loans using poor underwriting standards in similar fashion as in the housing market. It suggests that lenders have been making loans with 117% LTV. I have never seen such loans, have you? That doesn’t mean they aren’t happening but I’ve never encountered a lender that would make such a loan. Maybe I’m not in the mile high club.

To make a long story short, in order for the commercial loan landscape to begin to go south, tenants would have to begin underperforming in their businesses and then begin defaulting on their rents, thus causing landlords to begin defaulting on their mortgages. Could this happen? Sure, but not tomorrow and I don’t see anyone suggesting that it is imminent nor is this argument being made in the article.

What the article does highlight is that never the less fear is running rampant in the B Piece / Bondholder arena and thus the cost of insurance is going up, and thus reducing their margin, but as of this article there bonds continue to perform. The article does not seem to argue that there is evidence that landlords are about to start defaulting on their mortgages.

The article also demonstrates that the available capital for new commercial loans is drying up (the numbers in the article bear this out), but not because of the underperformance of commercial properties but because of the shrinking capital base of lenders in connection with bad paper related to the residential mortgage mess.

It’s really weird because borrowing costs (spreads) have skyrocketed in the commercial re lending space even though the underlying real estate is performing. Why would commercial lending rates reflect increased risk when there have not been any significant defaults? I would call it gouging by the bondholders accept for the fact that B piece buying has dried up as the article demonstrates. Thus it would appear that fear rather than gouging is a dominant driver.

What’s the moral of this story? Journalists are superficial morons and we should close our deals sooner rather than later!

– The Falcon

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